CLSA's Mike Mayo Discusses A Financial Industry On Steroids, Lays Out The 10 Main Problems With Banks

Tyler Durden's picture

Mike Mayo lays out the ten main problems with the financial industry:

One – enhanced performance with excessive loan growth: Banks and the financial industry in general grew loans twice as fast as the natural rate, approaching 8% or about 10% or more adjusting for securitization (pre-crisis), above nominal GDP of 5%. We – consensus – strongly believed that nominal GDP would slow for the past decade, but banks still pushed for loans that should never have been made. This difference is even greater after adjusting for securitization of loans, or when banks packaged and sold loans, often with little if any “skin in the game” with regard to the loan’s performance.

Two – pumped up profits with higher yielding assets: Higher yields means higher interest rates and – for banks – higher interest rates mean higher profits. To pick two higher risk loan categories, for the last decade, banks had over 20% average annual loan growth in home equity and over 15% average annual growth in construction loans, areas with higher than typical yields. In securities, banks reduced the percentage of low yielding treasuries from 32% in the early 1990s to under 2% in favor of more risky securities. In the extreme, the ability of a bank to make higher profits in the short-term is as easy as making a phone call. The issue is that higher yields get realized immediately but it comes with higher risk that gets paid later.

Three – side effects ignored with concentration of assets: The rush in real estate was no secret. Of the 11 loan categories listed by the FDIC, all five of the fastest growing loan categories were real estate related. This is as simple as the old banking adage, “if it grows like a weed, maybe it is a weed” or, perhaps more generally, “don’t put all your eggs in one basket”.

Four – higher dosage with higher balance sheet leverage at banks and brokers. By 2006 – before the problems hit the industry – U.S. banks had the highest level of leverage in a quarter of a century. There are many ways to look at this, but I took tangible capital and reserves for loan losses (source: FDIC). This data was also not a secret since the data comes directly from bank regulators. Similarly, leverage in the brokerage industry steadily increased from 20x in the 1980s to 30x in the 1990s to almost 40x in the past decade until shortly before the crisis (source: SIFMA).

Five – investment banks originated more exotic dosages. By this, I mean instruments such as CDOs, CDOs-squared, etc. that amplified leverage in new and untested forms. It is always hard for us analysts to know what type of risk banks have on their balance sheet. These forms were so complex that not even CEOs, directors, and auditors fully understood their risks. As a reminder, some of these products were created by experts with Phd’s in mathematics. This type of complexity is often used as a reason to pay people massive salaries. The argument goes that if you don’t pay the salaries, good people will go elsewhere in the economy. Isn’t that a good thing? The exotic securities are a clear example of several where Wall Street needs to shrink in importance. The protection from monoline insurers also proved much less than met the eye. Innovation often outpaces regulation, but in this case it was more than usual.

Six – consumers went along for the ride. Consumer debt to GDP has reached a record level of 100%, versus only 50% 25 years ago. This leveraging created a false illusion of prosperity that allowed for the purchase of homes, cars, and other items, many of which should have never been financed and purchased. It is no secret that everyone from kids, pets, and dead people received solicitations for loans.

Seven – accountants assisted with performance enhancement. In 1998, the SEC required banks to move closer to a pay-as-you-go approach when accounting for losses on their loans. This was wrong. The result was that banks made more risky loans with better profits but set aside even less reserves for future problems. The banking industry saw a steady decline in reserves for problem loans from the time of the decision in 1998. The move by the SEC was well intentioned since it came at a time of concern about “cookie jar reserves” but misguided since it failed to reflect the unique situation related to banks when it comes to conservatism and reserving for future loan problems. This is only one of several accounting examples.

Eight – regulators facilitated performance enhancement. Banks pay insurance premiums for the coverage that they give on deposits at banks. Banks have paid this fee since the FDIC was established after the Great Depression. Yet, banks paid zero deposit insurance for the decade ending 2006 because the insurance fund was deemed fine. This was a ridiculous insurance model that is analogous to an auto insurance company not charging premiums until somebody has an accident or a life insurance company not charging premiums until somebody dies.

Nine – the government doled out some of these steroids. GSE’s and their role in the mortgage market helped to accelerate the growth in housing related securities via subsidies to banks and consumers whose absence would have meant less of a housing bubble. The government created more of a commandeconomy model that had the effect of allocating an excessive amount of
capital to the housing sector.

Ten – incentives encouraged the behavior. To still further the analogy, the system shunted the “doctors”, that is, those whose job it is to report on the financial health of companies and the industry, in lieu of those with more positive outlooks. Compensation of banks steadily tracked revenues for all of last decade. The problem is that compensation only tracked profits until losses increased later in the decade, highlighting that prior compensation was far above normal after incorporating losses that were attributable to prior year revenues. I saw issues first hand. First, in the past decade (2000-2008), the stocks in the bank index (“BKX”) declined by over 40% but industry compensation failed to decline in a similar amount. Yet, when I wrote about compensation issues a decade ago, the reaction about me was that these issues were none of my business3. Second, only 7 months after I testified to Congress in 2002 about the backlash against analysts who provide unflattering research, I faced what I saw as backlash by a large bank against me and my critical views when I had lack of management access similar to others. It reached a point where I put a disclaimer about this lack of access in my research reports. My point is that if I face a backlash even after I testify to Congress on backlashes, how can a loan officer who is under pressure to produce loans realistically say “Maybe we should sell less loans?” and keep their job.

Mayo's full testimony and powerpoint presentation:


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Anonymous's picture

I like where youre going with this, but words like material and nonpublic are nearly impossible to prove and tend to get hung on amateurs like Martha Stewart, not the vampire squid. The toothless C student that is the SEC sticks to rubes in its own weight class, it doesnt go courting an ass beating......

Oso's picture

go back and take a look at Mayo's analysis of MER and others.  Its incredible this guy is their "expert" when he was as oblivious to it as every other idiot out there.

AnonymousMonetarist's picture


The banksters are still to bankrupt to go broke.

Steroid's picture

Please don't blame me!

Edna R. Rider's picture

I recall Mayo's big interview on 30 Mar of last year.  He basically said the banks are all pretending to be solvent and that despite that massive rally of bank shares we should unload them immediately.  With that said, after reading this piece I've doubled down on the XLF and KBE.  As a thread above says if the banks are that bad off then they are surely going to be assisted by their friends in government and we have nothing whatsoever to worry about.  I say all this not be sarcastic but to remind myself that for the past 10 months only the most cynical trades have worked.

sgt_doom's picture

Shades of yesteryear!!!!

Sounds almost exactly what Bill Gross (PIMCO), economists like Steve Keen (and many years ago, Prof. Michael Hudson) and a number of other observers said quite some time ago.

Although I do appreciate and thank TD for this blog.  Still excellent!

jmc8888's picture

Six – consumers went along for the ride. Consumer debt to GDP has reached a record level of 100%, versus only 50% 25 years ago. This leveraging created a false illusion of prosperity that allowed for the purchase of homes, cars, and other items, many of which should have never been financed and purchased. It is no secret that everyone from kids, pets, and dead people received solicitations for loans.


Well we used to get paid.  Since the change we got bigger credit lines.


But credit lines can be pulled.  It's much harder to lower someone's pay. 


What really happened is that with increasing credit lines, people sought raises less aggressively.  If they didn't get one, it's ok, you can buy on that credit card that said you were approved for. 


We the American people were suckers.  We accepted no or low raises just so our jobs weren't outsourced.  We had credit cards after all. 


The question that should be asked is, why was the American people so ready to accept this deal? Why weren't they more skeptical.  Simple.  They needed it, and their jobs weren't providing it.  The credit card was tangible, the non-existant raise wasn't. 


But then again if you're making less than 52,000 a year you're working for less than minimum wage if account for inflation.  If you make 100k a year, congrats, you are making merely double minimum wage. 


You say that isn't our minimum wage.  That's right, it's what it should have been if it kept up with inflation.  So why did we use credit cards again? Simple, we're working for peanuts.



Anonymous's picture

Wednesday, January 13, 2010
Obama to Announce $120 Billion TARP Fee

But Team Obama does not want to play up the extent to which the industry has benefitted from public munificence; that only stokes the deserved and correct public anger, which includes the Administration for cutting such a crappy deal with the industry. So it has the PR conundrum of having it be beneficial for political reasons for them to beat up on the financiers, but now being so deeply aligned with them as to make that impossible, save perhaps on a few narrow issues that it hopes will have sufficient peasant-appeasement value. Any full-bore attack would represent an embarrassing change from the Administration’s past fawning posture, and would also require the sacrifice of a senior head or two, presumably starting with Timothy Geithner, to look credible. But Obama seems constitutionally incapable of firing anyone, no matter how much it would serve him to do so.

The sketchy announcement du jour, that Obama will announce a $120 billion TARP fee this week (hhm, conveniently timed to distract attention from the start of the hearings into the crisis and Wall Street bonus announcements) illustrates the bizarre position the Administration is in. Alert readers may recall that Obama was touting the performance of the TARP at his Lehman anniversary speech in September.

Anonymous's picture

"But Obama seems constitutionally incapable of firing anyone, no matter how much it would serve him to do so."

It certainly didn't used to be like that!