They say that the simplest analysis is always the most powerful one. That appears to certainly have been the case with our presentation of global banks' Tangible Common Equity ("TCE") ratio to total assets from last Thursday, and specifically our observation of the glaringly obvious, namely that of the 30 most undercapitalized banks in the world, Canadian ones represented a whopping 33% of all. Note: this was not an attack on Canada, this was not some hedge-fund inspired start of a bear-raid on the Canadian banking system, this was nothing but an attempt to warn our readers of, again, what is out there for anyone (who is not blinded by cognitive bias) to see for themselves. Alas, the reaction to that post, particularly in the Canadian media, has been swift and severe, provoking such respected publications as The Globe And Mail to pen not one but two responses, one being the by now so-oft discredited attempt to ignore the message and target the messenger (Who is Zero Hedge, and why should we care?), followed by a more coherent attempt to debunk the claim that a painfully low TCE ratio is never a good thing (Is Zero Hedge looking at the wrong numbers?). The argument of G&M's Boyd Erman boils down to the statement that TCE is not a fair indicator of balance sheet stress and instead one should focus on a "Tier 1" approach of risk estimation, one that includes Risk Weighted Assets. Here we could provide the reference to Lehman's Tier 1 ratio, which was well in the double digits on the day when it filed for bankruptcy, even as the bank's true leverage was about 40x, a number which eventually brought on the biggest bankruptcy in history. We could but we won't, instead we will ask, rhetorically, who is John Paulson, and why should the Globe and Mail care?
Because while those "oddballs" at Zero Hedge may be hyperventilating or whatever the verb du jour may be, the (one time legendary) hedge fund's opinion probably should count for something, even in the G&M's esteemed opinion. And specifically his take on the whole Tier 1 vs TCE debate...
Back in March 2009, John Paulson (when he still was actually making money for his LPs, perhaps because he was rightfully quite bearish on the financial system, and wasn't running the world's smallest mutual fund) and JPM's Chairman of China Equities, Jing Ulrich, sat down and discussed the then-imploding economy, in a Q&A which we are confident is about to get much more airplay over the next several weeks. What is most notable about this discussion, in addition to what a difference two years can make to a person's P&L and outlook on the world, is that it was Paulson himself who chimed in, well in advance of the current debate on TCE vs Tier 1, with his personal thoughts on the issue. We present them below as we preemptively answer the rhetorical question posed above with a resounding yes.
Jing Ulrich: Things seem to be getting worse in the financial services area – how much worse is it going to get? Do you think we now know the true extent of the underlying problems?
John Paulson: The problem with financials is that they are very leveraged and don’t have enough tangible common equity to absorb anticipated losses. Large American and European banks have on average 40:1 leverage, defined as Total Assets / Tangible Common Equity. The Tier 1 capital ratios commonly used by banks present a misleading picture as to the capital adequacy of banks. The Tier 1 ratio includes preferred stock, hybrids and subordinated debt as capital and then risk weights assets, leading to a risk weighted asset number that is much less than the total asset number. This can lead to a situation where banks have high Tier One Ratios but very low tangible common equity ratios (see graph below). As a common shareholder, we only care about tangible common equity.
Hence, while we are confident that McKinsey is more than capable of putting together any analysis goalseeked as per the paying customer's demands (because at the end of the day, consultants and rating agencies are the same: they both tell their clients what they want to hear, and somehow this is only now being discovered for S&P and Moody's), we will go with the facts, as per what the world's (once upon a time) most vaunted investor had to say.
So while we relegate this simplistic debate over whether TCE or Tier 1 is more appropriate (best to just ask Dick Fuld) to the compost heap of legacy media click-thru monetization attempts, we leave our readers with the following far more fascinating interview with John Paulson, which provides some much overdue flashbacks to why he was, at one time, one of the world's most respected asset managers. Something tells us the topics discussed in it will become yet again quite salient in the immediate future.