Bank capital

[Munger]

"However the lending criteria imposes higher requirements on the unsecured borrower. In other words the borrower must have a greater ability to pay than with a secured loan."

 

You assumed this "criteria" secures the loan...you're kidding right?

 

Unsecured lending is complete air.

 

 

 

 

[cwericb]

"Unsecured lending is complete air."

 

As someone who deals daily with unsecured lending your comment really is complete hot air.

[Munger]

So wait -- "dealing daily with unsecured lending" gives you the ability to "claim" that the assets are really/honestly/i'm telling the truth secure because we banks make sure to only give unsecured loans to people who are secure...c'mon

 

Capital related to unsecured ledning evaporates during periods of stress.

[libor.plus1]

I dont know what is going on in this thread. But what has been read, cannot be unread.

[cwericb]

Sorry Munger, it seems that you probably have no experience with unsecured lending and have difficulty in grasping the concept.

 

While no one said it should be valued at the same rate as secured credit, I can assure you that it is a long way from "complete air". If you actually feel that unsecured credit is essentially unrecoverable I would strongly advise you to keep that opinion to yourself the next time you speak to your banker about a line of credit.

[Guest Hester]

 

This argument reminds me of the argument for computing cost of capital for use in DCF analysis, by using equity values. The higher the stock price the lower the cost of capital, and thus the lower the discount rate, and thus the higher intrinsic value DCF will spit out. Firms are rewarded for having rich valuations and punished for having cheap ones.

 

If gyratians in bank's stock prices effected capital ratios and could render them insolvent (as was suggested), why would any bank go public? And how could any bank survive for a long period of time?

 

Use your brain.

 

[Kraven]

Sorry Munger, it seems that you probably have no experience with unsecured lending and have difficulty in grasping the concept.

 

While no one said it should be valued at the same rate as secured credit, I can assure you that it is a long way from "complete air". If you actually feel that unsecured credit is essentially unrecoverable I would strongly advise you to keep that opinion to yourself the next time you speak to your banker about a line of credit.

 

This is absolutely correct.  I suppose contractual rights are worth nothing.  I guess there isn't any point in documenting anything and those long contracts can just be tossed in the trash!  It's all "air" anyway.  We can go back to the days where a loan was secured by some pigs or cattle that were brought from the borrower to a pen held by the lender, or just a hand shake even since a man's word is his bond.

[Josh4580]

Sanjeev, I demand a full refund of my BRK Board subscription fee after reading this thread!

[cwericb]

Hey Josh4580, you get what you pay for :)

[Munger]

How many times do I have to repeat.

 

During periods of STRESS, the capital associated with unsecured credit comes into serious question, which greatly heightens the risk of investments in bank stocks.

 

"I suppose contractual rights are worth nothing." -- here is the point, those contractual rights get you NOTHING if the borrower can't pay the bill, which guess what happens A LOT during periods of stress...there is no recourse and consequently, the capital is complete air.  

 

 

[cwericb]

Munger you are making suppositions that are not correct. Much of that unsecured credit would involves line of credit to individuals who are relatively secure in their finances. As for being no recourse, again that is also not quite correct.  If you are under that illusion, try defaulting on an unsecured loan and see what happens.

 

Also, no secured or unsecured portfolio of loans is 100% collectable. However to suggest that unsecured loans are uncollectable is simply incorrect. Yes, in times of stress the loss rate will increase on both types, but do not overlook the fact that in times of stress the security taken on loans often has little value.

 

 

[Munger]

"If you are under that illusion, try defaulting on an unsecured loan and see what happens."  

 

regardless of the legal consequences the debtor faces for defaulting, the bank still gets nothing.

 

At this point, the only "right" or "wrong" will be shown with passage of time.

 

After thinking this through, I agree with Denninger that unsecured credit represents a meaningful risk during periods of stress.

 

You disagree (as do some others) -- here is the solution...buy bank stocks hand over fist because Mr. Market is giving you the opportunity of a lifetime if you are correct.   And if I'm wrong, I live to see another day because I am not short these stocks.

 

 

[Kraven]

"I suppose contractual rights are worth nothing." -- here is the point, those contractual rights get you NOTHING if the borrower can't pay the bill, which guess what happens A LOT during periods of stress...there is no recourse and consequently, the capital is complete air.  

 

 

 

Of course there is recourse via a lawsuit.  If you're saying that when they can't pay the bill they have nothing, then I guess yeah, a lawsuit is going to be worthless.  But assuming that not every unsecured borrower will both default and have nothing to their names, then there is recourse.  As Cwericb I think it was mentioned, presumably this was priced into the loan.  So if you are modelling the draconian and unrealistic situation where all unsecured loans both default and have a zero percent recovery rate, then I guess I agree with you.  But in that situation I suppose we are all gathering up our guns, ammo and canned goods anyway.  Do you really think that the banks are going to be in this situation both all other companies are twirling around singing Walking on Sunshine?  

[Munger]

"Do you really think that the banks are going to be in this situation both all other companies are twirling around singing Walking on Sunshine?"

 

Yes -- I think if equity (i.e., stockholders) of some large banks got wiped out (I am NOT predicting this scenario), the country would go through a tough period but the country and the capitalistic system would survive, with the best companies thriving over the long term.  I own companies that I believe could survive the worst case scenario, recognizing that the stock prices can easily go down over the near to mid term if some of the large banks go bankrupt.

[Munger]

"If gyratians in bank's stock prices effected capital ratios and could render them insolvent (as was suggested), why would any bank go public? And how could any bank survive for a long period of time?"

 

Without question, a collapsing stock price can render a bank insolvent.  

 

Here is the problem -- bank stocks only collapse during periods of stress...during periods of stress, the value of the assets come into question...if unsecured credit defaults (which happens a lot during periods of stress) -- the bank's capital ratios implode becuase there is no recourse value...at that point, you can't sell enough stock to replinish the capital or if you do, you essentially wipe out existing shareholders (which by the way has already happened with C and BAC)...implicit in counting non recourse loans in the capital base, is the assumption that you could utlimately sell stock to re-capitalize any losses associated with such loans because there is NO collateral underlying the non-recourse loans included in the capital base against which the bank lends...however, during periods of great stress, you can't recapitalize without destroying existing shareholders if the stock price is too loo

 

To reiterate -- I have no idea what is going to happen...but I do believe that a collapsing stock price and unsecured loans greatly heightens the risk of insolvency during periods of stress.   And if these banks collapse, you can bet that unsecured loans will not be included in the capital base in the futre.

 

 

[cwericb]

Re unsecured credit.

 

Okay, quick reality check. I have worked in various aspects of the credit field for a long time, so here are some things you shouldn't overlook.

 

1) If you have ever tried to get an unsecured loan you will know that:

a) Banks just don't give away money

b) Banks get a higher interest rate on unsecured loans

c) Those who qualify for an unsecured loan are much more financially secure than those who's loans have to be secured.

 

2) Secured loans are often little safer than unsecured loans. If someone defaults and the security is repossesed several factors come into play:

a) The security has often depreciated to the point where it has little value

b) The costs of repossession, storage, advertising and sale usually often eat up much of the value of the security.

c) In my experience I have often seen banks over estimate the value of the security so the banker can write the paper.

d) Most repossessions sell for a severly depreciated value - at the best of times.

e) In a seriously depressed market there are few buyers for the security. I have seen times when all sorts of property has been repossesed and had to be maintained by the bank or repossers to the point where it actually cost more than the equity was worth.

 

In the example I used previously:

Which would you rather have

a) $10,000 line of credit to a doctor secured only by his signature or

b) a loan to a teenager for a 5 year old mustang?

[Rabbitisrich]

Munger, I found the Denninger quote and I think that you misunderstood his point. He didn't argue that banks lend against their market cap; equity, in his usage, referred to book value, or risk adjusted book value, which he believes is overstated in times of stress. At least, that's what I hope he meant or he is an incredibly stupid idiot.

 

That is just part of banking, or any industry that plays the yield curve. If there is a bank run, for pretty much any reason, valuations melt and the bank is in serious trouble. One thing to watch for is deposit performance through this period, which may get hairy as BAC seems to receive an inordinate amount of negative attention. If depositors aren't calling their funds, then the points you have raised will be largely irrelevant in comparison to the cash flow generated by air and other things.

[moore_capital54]

This argument and thread seem to completely disregard the facts of life as we now know them.. IE: The Fed steps in and supports banks when they come close to insolvency, and will never let any of the banks mentioned find themselves in those situations. To disregards the actions of the fed would be dismissing an important lesson in history.

[Munger]

Wrong Rabbitisrich -- another guy who likes to throw aroung personal attacks.  Somehow you can't understand that implicit in counting unsecured assets in the capital base is an assumption about the stability of the value of common stock.  Unsecured assets by definitition are not true capital because there is no collarteral -- the value of the common stock is mistakenly seen as a backstop.  Capital has value (i.e., protection) because it can be accessed during periods of stress -- during a period of stress, unsecured assets that default are worthless...no contribution to capital AT ALL.   This is exactly what Denninger meant.  

 

Loading up the balance sheet with unsecured assets is what is incredibly stupid.

 

And no -- the "air" doesn't generate any cash if an economic downturn renders the debtor unable to pay.

 

 

[Munger]

Rabbitisrich -- I see from your prior posts that you are long BAC, which I'm sure explains your tone.  Never fun to own a stock down 20% in a single day.  Hang in there man -- if you're confident in your analysis, you should be loving today...Mr.  Market gave you an opportunity of a lifetime. 

[cwericb]

Munger, with all due respect there is really no such thing as unsecured loans (assets). Some loans are secured by physical property others by a signature. As per my previous example, would you rather have the doctor's loan on your books or the teenager's?

 

Am I wrong that you are making the assumption that at some point all unsecured loans will default? In actual fact I would not be surprised if the default ratio on unsecured loans was actually lower than that of secured loans.

[Rabbitisrich]

Munger, you are changing your argument halfway. You say that you will defend your position that a bank lends against its market capitalization, then you proceed to argue that a loan that goes to zero is worthless and can't be "accessed". Yes, if a loan goes to zero it can't be accessed. Good point.

[Munger]

"Am I wrong that you are making the assumption that at some point all unsecured loans will default?"

 

 

Here is the point again -- as the stock price collapses, the % of unsecured assets that need to go bad in order for the equity to be impaired decreases.

[Munger]

"Munger, you are changing your argument halfway. You say that you will defend your position that a bank lends against its market capitalization, then you proceed to argue that a loan that goes to zero is worthless and can't be "accessed". Yes, if a loan goes to zero it can't be accessed."

 

It is obvious to me you don't understand the difference between unsecured and secured assets and the implications for bank capital.

 

No doubt a rough day for BAC holders -- hang in there man...and don't beat yourself up...if you're confident, you'll make a fortune by loading up -- so look on the bright side.

 

I'm simply agreeing with Denninger who pointed out how accounting for capital understates risk to investors durign periods of stress.

 

 

 

 

[oec2000]

Munger,

 

If you think unsecured loans are "air," then you must consider equites "less than air" since they rank behind unsecured debt. If that is the case how do you rationalise investing in stocks? Most companies carry some form of unsecured debt (e.g. Trade receivables) on their balance sheet. All these companies are worthless?

 

If a banks capital ratio is dependent on it's market cap, how do you determine capital adequacy of privately owned banks?