Money Stuff: Banks Are Expecting Loan Trouble

Loan reserves We talked yesterday about ways in which banks are pretending that 2020 isn't happening. For instance, banks have made loans to companies, and those loans have covenants requiring those companies to have at least a certain amount of income each quarter, and for the next few quarters of 2020 banks are saying things like "ehh don't worry about having that much income" or "we'll just use your 2019 income and pretend 2020 is the same." The basic theory is that 2020 is terrible, but maybe things will get better, and the best way to handle it is to just pretend things are fine and hope that eventually they are. Taking reality into account all at once could cause further disasters: If you insist that every borrower have a lot of income in 2020, they will not, and you will foreclose on all of their loans and cause a cascading series of defaults, and you'll lose a lot of money. If instead you pretend that everything is fine, a lot of those borrowers might actually recover and repay their loans on time, and you will avoid disaster just by ignoring it. This is not a crazy theory, though that doesn't mean it will definitely work.  But in other ways big U.S. banks have rushed to pretend that the reality of 2020 is worse than, so far, it actually is. For instance, loan loss reserves: JPMorgan Chase and Wells Fargo — which on Tuesday were the first two major banks to report earnings this quarter — set aside billions of dollars each for losses on loans to customers who may soon no longer have the means to repay them. The chief executive of JPMorgan, Jamie Dimon, said the bank was preparing for "the likelihood of a fairly severe recession." JPMorgan, the country's largest bank, added $8.3 billion to its reserves to prepare for impending defaults — a $6.8 billion increase from the same quarter last year. Wells Fargo set aside $4 billion, which was an increase of $3.1 billion. "The actual level of losses we incur will be driven by how long this period lasts and the level of support the government provides," Wells Fargo's chief executive, Charles W. Scharf, said on a call to discuss the results with Wall Street analysts. Banks don't literally "set aside" money for loan losses; there's not a pile of cash somewhere that they can dip into when people don't pay back their loans. It's just that JPMorgan's net income for last quarter is reduced by $8.3 billion, in the expectation that people won't be paying back their loans this quarter, or next quarter, or later. If in fact everyone pays back all their loans, that will be a pleasant surprise, and JPMorgan will have higher income in future quarters as it reverses those reserves. But because the future pain is pretty visible and predictable now, the banks reflect it in their current income. The banks aren't pretending that March 2020 was the same as March 2019; they're pretending that some of May 2020 happened in March 2020, and May will be even worse than March. This is not an optional exercise in imagination by the banks, I mean; pretty standard accounting rules require them to reflect changes in expected loan losses in present income. This is kind of how banks work. It's not, like, you lend people money, and they pay you back, and those repayments are income. It's like, you enter into contracts that entitle you to a stream of future payments, and the expected value of that stream of future payments goes up and down, and those fluctuations are your income. A bank's accounting isn't just money coming in and money going out; it's also changes in present value of expected future cash flows. Or you could just not do that, I suppose that's another approach: European banks are seeking to avoid setting aside billions of euros to cover bad loans after the coronavirus outbreak, in a departure from U.S. competitors collectively taking a $25 billion hit. European lenders are set to report comparatively small increases in loan loss reserves in the first quarter and plan a similar approach during the rest of the year, according to senior bankers and regulators, who asked not to be identified because the earnings figures have yet to be released. They have the blessing of regulators to be flexible applying rules to avoid a spike in provisions. Banks are in talks with auditors and rivals to determine which economic forecasts can be justified to avert stashing large amounts of money, people with knowledge of the matter said. Using forecasts that are less severe would reduce the amount they need to set aside, while massive government guarantees are also making it easier for banks to assume lower default risks, the people said. European banks will likely try to spread out provisions over a period of 18 months, according to one of the people. … "Regulators have told banks not to apply accounting rules too strictly," Alexandra Annecke, who helps manage more than 340 billion euros ($372 billion) including European bank stocks at Union Investment, said in a phone interview. "We're asking ourselves just how much the results will correspond with reality." There are two things going on here. One is that if European banks take a lot of provisions now, they will lose money. (Not in the sense of "actual cash will go out the door" but in the accounting sense.) If they lose money, that will reduce their capital. (Again, in the accounting sense.) If their capital is too low, they will have to raise capital (tricky now!) or cut back their balance sheets by selling assets or reducing lending. No one—not the banks or their lending clients or the regulators—particularly wants that. So the banks would prefer not to take lots of provisions now, and the regulators will not particularly object. The other thing going on here is that it's a little hard to predict the future, and you could quite reasonably—as the U.S. banks mostly did—expect the next few months to be absolutely dreadful for loan defaults, and decide to account for those defaults now, but you could also expect something else. Maybe someone will find a vaccine tomorrow. Or maybe government and central-bank rescues and general social solidarity and the banks' own assistance to customers will be so effective that no one will actually default on their loans. There is a very high likelihood that the economy will be bad for the near future, and that customers' incomes will be down, but that doesn't necessarily translate into a wave of defaults. The wave of defaults is partly a policy choice—partly a choice for the lenders, too—and maybe it will be averted. The first part is the more important part, which you can tell by the fact that big U.S. banks are taking large provisions. If you are a well-capitalized bank, now is a great time to announce bad news: Everyone expects bad news, everyone knows it's not your fault, you might as well take a lot of pain up front. If you are a less well-capitalized bank, too much bad news will land you in trouble, so you have to defer the bad news and see if it goes away. Still one thing to emphasize is that neither choice is, exactly, objectively "real." It's not like $8.3 billion of JPMorgan loans vanished last quarter. That's an estimate, just like the much lower European estimates. Nobody exactly knows what will happen, and JPMorgan will undoubtedly be thrilled if its loan loss provisions turn out to be much too high. What is happening here is not as simple as "U.S. banks are recognizing reality while European banks are avoiding it"; what is happening here is that there are accounting rules about how to stylize and estimate the future, and different banks (and regulators) have different views about how useful those rules are in a pandemic. It is a difference of opinion about accounting, but accounting is not exactly reality. Insider oil trading Here is a stylized version of one aspect of the 2020 oil price wars: Saudi Arabia, which decides the price of oil, made that price a lot lower. This caused the stock prices of big publicly traded oil companies to fall a lot. Saudi Arabia bought stock in a bunch of big European oil companies. Then Saudi Arabia, which, again, decides the price of oil, made that price higher again. This was good for its investment in big oil companies' stocks. This is, as I said, a stylized version of the story, and most of the details aren't quite right. Saudi Arabia does not, in fact, decide the price of oil on its own; the Saudi entity that (partly) decides the price of oil is different from the Saudi entity that sells the oil, which in turn is different from the Saudi entity that bought stock in other big oil companies; the production deal that Opec+ reached recently has not done much to raise the price of oil due to collapsed global demand; those European oil stocks might not even be trading above the prices that Saudi Arabia paid for them earlier this month; etc. Still there is a basic truth to the story. Saudi Arabia blew up oil prices by announcing discounts and production increases, and then helped fix them by agreeing to production cuts, and in between those two actions it bought a lot of stock in foreign oil companies at a discount. Is that … you know … ? The timing of these massive purchases – on the eve of OPEC's historic production cut agreement – is at best curious and at worst a flagrant case of insider trading: the Kingdom and Russian insiders acquired shares of these companies at record low valuations just days before the deal (temporarily) boosted oil prices and raised the values of the companies involved. Royal Dutch Shell and France's Total saw their stock prices jump around 5% between the PIF purchases reported Wednesday, April 8 and Monday, April 13 (the day after the OPEC+ announcement). … The insiders who purchased shares of oil companies based on information disclosed to them as a part of their participation in, or closeness to, the OPEC + talks stand poised to benefit substantially from the price coordination should markets rebound. It is worth noting that Yasir Al-Rumayyan, a man that runs the PIF for the Crown Prince, is also the Chairman of Saudi Aramco, the Kingdom's state-owned crown jewel. Serving these two roles, he may be conflicted, being in possession of high-level insider information while advising the Crown Prince, who in turn sets the production goals and is able to influence oil prices globally. I mean, you know my basic views on this sort of thing. You can always trade on inside knowledge of your own plans. If Warren Buffett buys a big stake in a company, the stock will go up when he announces the stake, but Warren Buffett is allowed to buy the stake before announcing it. There are more moving pieces here, but the basic story seems fine. Saudi Arabia, considered as an entity—the government that sets oil production goals, the mostly-state-owned oil company that produces the oil, and the state-run Public Investment Fund that buys stakes in foreign companies—had its own knowledge of its own plans, and it used that knowledge to buy oil stocks opportunistically. Perhaps it had a confidentiality obligation to its Opec+ partners not to trade on the basis of production negotiations, but the simple view here is that Saudi Arabia and Russia set oil prices and they traded on their own knowledge of what they were going to do with oil prices. Insider trading, I always say, is not about fairness; it is about theft. Warren Buffett's lieutenants are not allowed to trade on advance knowledge of what Warren Buffett is planning to buy, but Warren Buffett is. Saudi Arabia is allowed to trade on knowledge of what Saudi Arabia is going to do, even if nobody else has the same knowledge. Sponsored Content by Masterworks Did you know the Yale fund only put 3.5% into U.S. stocks in 2019, with 30% into alternatives, like art? Like other tangible assets, art holds its value even into bear markets. Now is the time to start looking at art with Masterworks, an investment platform delivering historical returns of 8–30%.   Congressional insider trading Meanwhile: Sen. Richard Burr's sale of up to $1.7 million in stocks shortly before the recent market crash was one of the lawmaker's only market-beating trades since record keeping began eight years ago, according to a new study. The new analysis, presented by researchers at Dartmouth College, shows just how unusual the North Carolina senator's transactions were. On a single day, Feb. 13 of this year, Burr unloaded a significant portion of his net worth — a departure from his typically low-volume trading history. … Since 2012, Burr picked stocks that performed poorly: On average, six months after he bought a stock, it was down .8% relative to stocks in the same industry; after a year, his stocks were down by 6% compared with that benchmark. … But on Feb. 13 of this year, Burr made more than 30 stock sales. These sales were both well-timed and well-chosen: After Burr sold the stocks, they underperformed the market by 8%. This means the stocks performed worse than comparable stocks in the same sector between the sale and the end of March. Ehhhhhhhhhhhhhh. You have to think a little about what your theory might be. We have talked about Richard Burr's well-timed stock sales in the past, and I have some sympathy for the view that they're a little suspicious. Burr was getting secret congressional briefings about the spread of the coronavirus, he seems to have been more pessimistic than the average investor, and he dumped a lot of stock shortly before the market crashed. There's no proof that he sold the stock because of information he got in those briefings, and he says he did it based on television reports, but I can understand if you don't believe him. But that's not a theory of particularly astute intra-sector stock-picking. If you sold any stocks in February you'd have done well; the S&P 500 was down 33% six weeks after Burr's sales. Nobody thinks that Burr's secret congressional briefers were like "this pandemic is really bad and it will hit Wyndham Hotels & Resorts Inc. worse than the rest of the hospitality sector," come on. If the stocks Burr sold underperformed the market, that just suggest that he was bad at picking stocks, back before the coronavirus, as in fact he was. He didn't sell all those stocks in February because he was making concentrated bets against particularly vulnerable companies; he sold them because he owned them. The fact that he sold them at just the right time is suspicious on its own, but their later relative underperformance adds nothing to that evidence. Libra Even in these strange times, it is comforting to know that some things never change. For instance Facebook Inc. is still pretending that it is going to launch its own currency, called Libra. Though it is no longer pretending that Libra will be a universal global currency: Facebook Inc. and its partners said their Libra cryptocurrency project will now support multiple versions of the digital coins, the majority of which will be backed by individual fiat currencies like the U.S. dollar, as part of changes made to appease skeptical regulators worldwide. The Libra Association, the governing body overseeing the proposed project, redesigned the currency and made other changes responding to financial regulators concerned the effort could undermine the power and control of central banks. The group said Thursday it plans to support multiple Libra stablecoins, with each working like a digital version of a country's existing currency. Ah. So now you will be able to use Facebook to send dollars to people. It'll be like Venmo, but with a vastly larger lobbying budget. Back in happier times, when Facebook announced its grandiose plans for Libra, it said that there'd be only one global Libra, which would be tied to a basket of national currencies. I wrote:  If Libra gains widespread acceptance, its lack of one-to-one correspondence will give it a tendency to displace national currencies. If you mostly spend dollars, and Libra is always going up and down against the dollar, that will be annoying and you won't want as many Libras. But if you mostly spend Libras—if Facebook is successful at making this the main currency of the internet—then that dynamic will reverse. If the dollar is always going up and down against the Libra, that will be annoying and you'll want more Libras. The dollar will start to seem unstable and useless. If you buy most things online, and if everything online is priced in Libras, then you'll end up living your life denominated in Libras, and only converting your Libras into dollars on your occasional touristic visits to the physical world. The goal is for Libra to be more useful than any national currency, accepted in more places and with fewer complications; pegging it to a single national currency would only hold it back. That was always maybe a little implausible, but it was a wild aspiration; now it is gone. Now it's like "oh, I want to send my friend some dollars on Facebook Messenger, better do that with the Libra widget." Ehh. "Funding secured" When Elon Musk pretended that he was going to take Tesla Inc. private and that he had "funding secured," was that securities fraud? I know I go around saying that everything is securities fraud, but I am kind of kidding; you can try to convert every bad thing that happens at a public company into securities fraud, but you will not always succeed, nor should you. The Tesla thing, on the other hand … I mean, yeah, sure, that is totally securities fraud? Musk announced that he had the funding to take the company private; he absolutely did not; the stock soared, then collapsed; seems fraud-y, no? The Securities and Exchange Commission agreed, and sued Musk and Tesla, but they settled, so I guess that does not definitely prove anything. Shareholders also sued, and yesterday they won a victory in court as a judge refused to dismiss their claims. Here is the opinion.  One fun part of Musk's defense is that he didn't actually say he was taking Tesla private. What he said, on Twitter, was "Am considering taking Tesla private at $420. Funding secured." The first part of that was, in some loose sense, true: He didn't take Tesla private, but he considered it. You can't sue him for that. The second part—"Funding secured"—was totally false; he had had some vague conversations with a potential investor but had no agreement for any funding, never mind the $60 billion or so he'd need to take Tesla private at $420. But Tesla argued that you have to read that in light of the first sentence: Because Musk didn't say that he was taking Tesla private, only that he was considering it, it didn't matter that he didn't have any funding. He wasn't promising to do the transaction, so his promise that he could fund it was irrelevant. The judge (correctly) isn't having it: Defendants argue that the tweet was neither false nor misleading because the only reasonable interpretation of the "funding secured" phrase was implicitly conditional: e.g., it would be subject to Tesla's Board of Directors voting to proceed with the going-private transaction, and Mr. Musk's tweet started with his statement that he is merely "considering." But any implication that the decision to go forward had not been finally made does not condition the representation of "Funding secured." That funding was "secured" may reasonably be interpreted as a standalone representation; notably Mr. Musk used the past tense in this regard. The word "secured" implicitly negates any condition.  If you are considering taking your company private and you have lined up $60 billion of committed financing, that is very different from just idly musing about taking your company private. Anyone can consider taking a company private, but once you have $60 billion of committed financing, stuff tends to happen. In fact Musk was idly musing about going private, so the fact that he said he had funding secured, and didn't, seems pretty relevant.  Things happen Cantor to Cut Hundreds of Jobs in Break From Wall Street Pledge. European Regulators Extend Short-Selling Bans, Frustrating Investors. Banks Have $13 Billion of Junk Debt They Can't Wait to Sell. Fight Over Commercial Rent Gets Ugly With Default Wave Looming. Fraudsters target those who are self-isolating. Argentina's Economy Minister Calls for Three-Year Grace Period on Foreign-Debt Payments. Here's What You Do With Two-Thirds of the World's Jets When They Can't Fly. New York forms team to develop 'Trump-proof' economic reopening plan. Rich-Investor Site Finds Fraud in $89 Million of Ship Debt. Lawmakers introduce bill that would let Americans sue China over 'Wuhan Virus.' 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