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On Investors and the Banks

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The papers today are full of teeth-gnashing over big losses taken by institutions and hedge funds. The Wall Street Journal singles out Pimco's Bill Gross for not only selling out of Treasuries but then making bets against them, all in the belief that inflation was about to emerge. Alas, as the economy weakened, so did inflationary pressures, and Treasuries rallied, dunking Gross in a scalding red bath. In "Not so happy returns," the Financial Times describes how investing superstars such as Gross, John Paulson and Bruce Berkowitz have all taken large losses, particularly as bank stocks have been hammered. Indeed, the gloom in banking is very deep -- perhaps too deep. Back in the WSJ, Francesco Guerrera peers at the banks and compares the industry to the -- well, you guessed it -- recent hurricane. Guerrera sees gloom as high as your candy-colored Wellies, describes 2009 as a "false dawn" and reports that investors, beyond the aforementioned superstars, have sent "share prices of many below liquidation value." Guerrera lunges for this bait, not unlike a panicky investor. "Put bluntly: Wall Street will never be the same," he writes. Well, nothing in this world of change is ever quite the same. Such definitive statements of despair may be the clarion call to get back into the market for bank stocks.

The FT is more circumspect. After all, these Big Names of Investing are legends. And how can legends be wrong for long, particularly since retail investors follow them like lemmings? "All three could still make their way back," the paper offers to the sound of a hedge being constructed. "Mr. Berkowitz and Mr. Paulson -- who both declined to comment for this article -- base their faith on financial stocks on a recovery that has been postponed, not canceled. 'One day our banks will be considered the safest investment in the stock market. They are the financial system of the US,' Berkowitz told the Financial Times in July." Still, in reaching for a more cosmic conclusion, the FT offers the following eternal truth, which the piece describes -- inaccurately -- as a paradox: "However, the question of whether big name fund managers can bounce back points to a paradox at the heart of investing: patches of dire performance can be a feature of smart investors. 'The best managers have clear and consistent investment philosophies to which they adhere fairly strictly, even when this philosophy leads them to investments that are out of favour in the market,' says David Sukis of Cambridge Associates, a US investment consultancy."

That "paradox" is revealing. It's a paradox only if you really believe that anyone can consistently and significantly beat the market over a long period of time, which reams of studies suggest can't be done. Otherwise it's more evidence of the deep uncertainty of any predictive enterprise and, to get all high-falutin', the imperfections of humanity generally.

It's an unavoidable outgrowth of these kinds of investing stories to bemoan the sad plight of these investors, as if the world is somehow out of joint. The fact is, these banks -- both the large predominately commercial banks and their Wall Street cousins -- have absorbed a number of blows: the euro-zone crisis, the tightening of regulations and the need for more capital, the reduced opportunities for trading profits to a generally anemic economy and, in some cases, continued losses from mortgages or mortgage litigation. Leverage has begun to be reined in, and capital is being raised, which does impair returns on equity. As Guerrera writes, "In the 1990s and even part of 2000s, some investment banks boosted returns on equity -- a measure of profitability -- of more than 30%. Today they are struggling to reach low double-digits."

A few thoughts here, which apply to the larger economy. First, all these stories suggest that something is wrong, while in fact the reduction of returns, the fall of trading profits, the increase in capital exemplify exactly how the banking system is supposed to return to health. It's a good sign, not a bad one, at least for the longer term, exactly as the fall of household debt, which may reduce consumer spending, is a necessary step toward a real recovery. The surprise suggests a deeper belief in a free lunch. One might guess that both Berkowitz and Paulson were betting on banks not just as part of a larger recovery, but in the belief that they could block many of the return-sapping reforms; that's implied in the Berkowitz quote about the "safest investment." He clearly was placing his money on the possibility that the government would go easy on too-big-to-fail banks. Second, ROE clearly remains a key metric of bank performance, contrary to the arguments of some of academics and pundits in favor of greater bank capital levies. Those academics insisted that ROE is a sort of retrograde and meaningless measure of bank performance and should be abandoned. Not surprisingly, it hasn't. As long as investors care about ROE, so too will bankers and boards. And the overall erosion of return figures will be characterized as a "crisis" and a "decline," no matter if the system is arguably safer or not. That will incentivize the big banks to jack up their ROEs by taking on more risk.

Lastly, what these stories also suggest is that the implicit, if rarely overtly stated, identification of investing -- or in some case, superstar investors -- with the social good, remains intact. This is an assumption that quietly began with the great New Deal reforms; but it took on vastly greater heft with the rise of the institutions and the advent of shareholder democracy. Now obviously, the investing class is a key ingredient of however we define the social good. But it's not the only one: There are any number of other groups -- consumers, jobholders, even corporations -- for whom the alignment of interest with investors is less than perfect. And, of course, it goes without saying that the investor interest is far from monolithic; in fact, it's riven with differences between retail and institutions, hedge funds, mutual funds and bond funds.

In short, trying to view a key systemic sector like banking through the lens of investors can be dangerously deceptive. But it also cannot be denied that that's how we've operated for many decades. To pretend otherwise is also to make a large mistake.

Robert Teitelman is editor in chief of The Deal. For more from Robert Teitelman, check out The Deal Economy.