Shareholders should pay as well as bankers

Like turkeys voting for a cut in the dividend

In a speech last month, Andrew Haldane, executive director of financial stability at the Bank of England warned it could take many years for the UK economy to recover from its debt hangover. During that period we’d experience low growth as all sectors of the economy, consumers, companies, banks, and government pay back debt

The Government is doubly indebted since the credit crunch as it’s borrowed to stimulate the economy and bail out banks, while consumers and companies have barely started repaying it.

Meanwhile, investment banks have made a windfall trading financial products as prices have recovered after the crisis last year. In 2009 global banks are expected to make £60bn, as much as they lost in 2008, and their share prices have recovered over half their losses, more in the UK.

It’s that windfall that has given them the opportunity to reward traders with multi-million pound bonuses, which just about everybody, except the bankers themselves, considers unfair. Hence the Government’s super tax on bonuses, and a letter today from Lord Myners, the Treasury’s City Minister, to institutional investors imploring them to put pressure on the major banks to cut bonuses.

The argument as I see it, is relatively straightforward. Banks manufactured the debt mountain, watering down their own balance sheets to lend more and more to consumers and companies and trade in debt-related derivatives, the prime (excuse the pun) example being sub-prime loans to American homeowners. When the credit bubble burst, governments stepped in to avert a collapse in the financial system. It was government action that saved the banks,and created a vast opportunity for them to profit, so it seems most unjust that bankers should be the beneficiaries.

Especially since banks still need to repay debt. The issue is not just about fairness, it’s about practicality as Lord Myners said in his letter:

Public attention will focus on the decisions that boards make about bonuses. Many banks have earned large profits this year from remarkably benign conditions, conditions created through the interventions by governments across the world. These profits must surely be retained by shareholders in the business as capital.

Robert Peston points out one irony in Lord Myners’ letter. Since the Government owns 84% of RBS and 70% of the voting rights, he was, in part writing a letter to himself. Perhaps another thing he should have mentioned was a cut in the dividend shareholders will approve for themselves this year, or doing away with the dividend altogether (admittedly RBS didn’t pay a dividend last year, but plenty of banks did).

Haldane thinks that withholding bonuses and dividends would allow banks to repair their balance sheets and support lending, thereby boosting growth and ameliorating the debt hangover he is so concerned about.

And he provides the justification for it. Although global banks lost $60bn in 2008, they paid out over $60bn to shareholders. Between 2006 and 2007 net income for global banks fell 20% but dividends grew by 20%. Going back as far as 1965 Haldane notes banks have paid higher dividends than other companies in relation to their profits, in good times and bad, behaviour that is unlikely to support banking stability, he says:

It risks profits being distributed as dividends when they are most needed to augment capital ratios and boost confidence.

If UK banks had reduced their dividend payout ratios by a third between 2000 and 2007, trimmed bonuses by 10%, and not paid dividends when they had made a loss they would have salted away more money than the Government used in bail outs during the crisis.

The criteria I look at hardest when evaluating a company are its earnings, and the ratio of its equity to its assets. If the earnings are rising and the ratio of equity to assets is stable or rising, that’s a very good sign. It suggests that a company is funding its current profits from past profits, and not by borrowing more and more money. This derives from the most fundamental formula in accounting:

Shareholders’ equity = Assets – Liabilities

According to Haldane, the ratio of bank assets to equity rose dramatically in the twentieth century from single digits to over 20. Since the ratio of assets to equity is the inverse of the ratio of equity to assets, that’s a bad thing.  If assets are twenty times equity, bank balance sheets look like this:

5% = 100% – 95%

In other words the bankers have robbed the banks, replacing their equity so they’re now funded by 95% debt, and bought off shareholders with high dividends over many years.

In assessing who should recapitalise the banks, we should consider who got them into this mess.  Everybody except the bankers themselves seem to think they should pay. Why are we letting shareholders off so lightly? Or to put it another way. The government can pressure shareholders to make bankers do the right thing. Who can it pressure to make shareholders do the right thing and demand lower dividends?

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A sideways market is for stockpickers

To profit in a sideways market you’ve got to ignore the average, says Robert Hagstrom, and look for the variation within the market.

John Hussman says net profit isn’t the best measure of owner earnings, it’s the change in book value plus dividends. On that basis: “Investors now rely on the renewed attainment of bubble valuations in order to achieve acceptable returns.”

T30 constituent, Quadnetics’ interims leave us pondering the second half-year.