In late 2002, a book made its way through the publishing offices of Doubleday. The publishers and editors thought it was a really good book, but the author had previously published three novels with Doubleday that were really good books and none of them sold well. The previous works had been marketed heavily by Doubleday but none earned any recognition or commercial success and none sold more than 10,000 copies. So when the author's new book hit the bookshelves in March 2003 and once again failed to sell, nobody at Doubleday was really surprised. After all, the "failure" business is the business Doubleday is in and "failing" is a built-in part of their business model. Nearly 85% of Doubleday’s books fail to earn a profit and most sell less than 10,000 copies, but Doubleday keeps printing thousands of new titles every year, hoping that a few will break the losing streak and become million-copy-selling blockbusters. Predicting which titles will sell and which ones won't, has proven to be nearly an impossibility for the publishing houses, however. After all, if Doubleday could do it with any real measure of accuracy their success rates would be much higher than 15%.
The massive investment bank, Bear Stearns, went down in flames last week, and what shouldn’t be a surprise to anybody is that it happened. Bankers lead professional lives almost perfectly negatively-correlated to the professional lives of book publishers. The banking business model is predicated on "winning". Banks lend money out and earn it back (with interest) with few failures. Their success rates with loans are usually 95%. They expect most of their loans to come back, but when lending money there’s always a chance it won’t come back at all.
The Bear Stearns case is exactly the kind of bank failure the FDIC has been seeing more and more often over the last 25 years; namely, banks failing less frequently, but the size of the banks that DO fail are growing larger. I recently called and spoke to FDIC spokesman David Barr (under the guise of an MBA student writing a finance report) to ask him about this. Barr pointed out that banks have been consolidating and growing to humongous sizes the likes of which have never been seen before. There are currently three banks in the U.S. with more than $1 trillion in deposits (Citibank, Bank of America, JPMorgan Chase) and there are another 1,750 banks operating with at least $1 billion in deposits. Contrast this to the banking scene just 25-years ago, when only a handful of banks operated with more than $1 billion in deposits.
So what happened at Bear Stearns? Why did the bank fail? Well, lending money to anyone, save the federal government (and even that can be suspect on some levels), carries a certain level of risk. Any banker or Wall Street investment guru who tells you otherwise is lying… by the way, witness Jim Cramer (of Mad Money fame) at the end of this Daily Show clip, telling viewers a week before Bear Stearns’ collapse to not worry about the company’s stock.
Barr noted that the risks in the subprime and mortgage markets were actually foreseeable. The FDIC saw our current financial woes coming and started preparing for possible failures as early as 2004, by increasing the carrying level of cash they might need to start bailing out failed banks. But, as Barr mentioned before, bank failures are usually much tougher to predict. Banks fail for a variety of reasons; fraud, mismanagement, economic downturns or downturns in regional economic sectors all have been culprits at one point or another for bank failures.
There are also a host of issues that can derail a bank’s earnings. Being in the investment business also means they're in the “prediction” business, and trying to predict which businesses will succeed or what the economy will look like next week, let alone in 10-years is flat-out impossible. The sheer size of the global economy and the gazillion different factors that influence it daily make it a impossible to accurately predict. For instance, can you do an economic forecast for how much longer cars in the United States will be running on gasoline? To answer this question, you could do an analysis of how slowly current carmakers are converting to alternative fuels and how available those fuels are, and then come up with a number (say, anywhere from 5-50 years), but the reality is, you don’t know. It could be tomorrow, it could be 100-years. Investors in the steam-powered engines of the railroad certainly didn’t see how quickly the internal combustion engine would destroy their businesses. Newspapers have been around for more than 200-years. The newspaper business survived radio and television, but how could anyone see how rapidly the internet would completely ruin them (when the last of the WWII generation departs, they’ll take the last newspapers with them).
See how hairy it gets? Imagine being a lender that sunk a $1 billion investment loan into a newspaper company on a 30-year loan in 1995? Is that still a good investment? Do you think the newspaper might default on the loan or struggle to pay it back between now and 2025? Being in the economic and financial "prediction" business means a lending "forecaster" also has to predict the weather and make sure their investment in, let’s say Idaho mortgages, isn’t suddenly ruined by a massive, completely unforeseen tornado or by a natural gas geyser that rises out of the ground, pollutes the state and makes it unhealthy to live in. These examples, though random, and perhaps out-of-left-field are no less random or out-of-left-field than what happens every day in the lending business.
Lending money to the subprime market from 2001-2005 seemed like a good idea at the time and a good prediction. The economy was flying, real-estate prices were skyrocketing and the subprime borrower could use built-up equity in their house to pay back their high-interest, subprime loans. Could anyone have predicted that everything would collapse as quickly as it did? Maybe. But it might not have been as big a problem for the U.S. economy if only a handful of banks had loaned to subprime borrowers. But, obviously, when a lot of banks do it, it can create economic ripples. Or if the handful of banks that engaged in subprime lending included the three biggest banks in the country, all with similar lending practices, then it creates massive economic ripples that can create or cause recessions... which affects all of us.
Trying to accurately predict the future of the economy (or a company's future earnings) while weighing millions of external variables still doesn’t factor in the internal variables (the human element) that can also ruin predictions. Calculating internal variables means trying to predict something like which CEO will be a fraudulent crook, and which one won’t. There is mounting evidence of fraud in the executive suites of the banking institutions currently under the credit crunch and that’s just as upsetting as the bad predictions made by their lending teams. What do Merrill Lynch, Countrywide Financial, Citibank and Lehman Brothers have in common? From 2006-2008 all four of the institutions lost tons of money (Lehman Brothers is rumored to be in as much trouble right now as Bear Stearns) and all four banking institutions cost their shareholders billions. But all four banks gave out massive bonuses, raises or severance packages to their CEO's. How much, you ask?
Stanley O’Neal at Merrill Lynch -- $161 Million
Angelo Mozilo at Countrywide -- $77 Million
Charles Prince at Citibank -- $68 Million
Richard Fuld at Lehman Brothers -- $36 Million and counting
This kind of fraud isn’t as directly visible as Jerome Kerviel stealing $7.1 Billion from French Bank, Societe Generale, but it hurts the average investor just the same. And, as banks become more and more consolidated, and trillions of dollars of deposits are retained at just one institution, it means that a single person is now more capable of defrauding massive amounts of money from large numbers of people.
Altogether this illustrates how traumatic a lending prediction error can be when it's an error made on a massive loan (or a collective group of loans). Nobody can predict the future and anyone arrogant enough to try usually eats their lunch (The U.S. Dept of Energy was so arrogant that they released a 1996 prediction stating “oil prices will remain steady for a long time... the price of a barrel will remain under $25 through 2015.” Well, we’re at $111 and rising with seven years left until 2015!!!)
Prediction errors are part-and-parcel of the banking business, however, and most people aren’t concerned (and shouldn't be concerned), because when banks lend money, and lose that money, the trusty FDIC is there to protect the depositors. But bank consolidation is starting to look like a problematic issue for the Federal Deposit Insurance Corpoation to deal with. The FDIC disbursed more than $21 Billion to cover lost deposits in 1991 and that was their largest year ever. The largest bank they’ve ever disbursed for, The Bank of New England’s failure in 1992, required $10 Billion, but the total amount of money in the FDIC’s entire insurance fund is only $51 billion. Weigh that against $1 trillion in deposits at Bank of America and that $51 billion starts to look piddling. It looks microscopic against the $4.2 trillion in total bank deposits in the U.S. -- the numbers show that the FDIC can currently insure only 1.2% of all U.S. deposits.
Barr was not concerned about this small percentage when I pressed him however. He noted that during the S&L crisis in the 1980’s, congress approved taxpayer monies to foot the bill to cover what the FDIC didn’t have reserves for. But with our economy currently heading into a recession, how happy would you be if congress had to approve $1 trillion in taxpayer money to cover the failure of Bank of America due to executive fraud? Probably not very happy at all.
Let’s go back to that Doubleday book. By the end of 2003, the book hadn’t sold more than 10,000 copies. After nine months on the shelves it was doing little more than collecting dust and serving as a doorstop. But as 2003 rounded into 2004 something strange happened – the book caught fire (Malcolm Gladwell would say it reached its Tipping Point) and in 2004 it flew off the bookshelves at a blistering pace and ended up selling 30 million copies that year. The book was The Da Vinci Code and it is a perfect model of what Doubleday hopes happens – they publish a lot of books and pray that one or two break the ceiling. This is the book-publishing business model in a nutshell. Take chances with a lot of titles, expect most of them lose money, but hope a tiny percentage bring in record profits and keep the overall business sustainable. Nobody upon nobody at Doubleday (or even Dan Brown himself) could have predicted WHICH (if any) of their book titles that year would become a potential worldwide phenomenon and sell 30 million copies. This is what is called, a “positive” prediction error.
Now imagine some fantastic new fuel source is invented. Let’s say it runs on garbage and produces oxygen and water. All three of the banks with $1 trillion in deposits decide to invest in the project. But would you fault them for it? Cars running on garbage and producing clean air and fresh water sounds like a great idea!!!
But now imagine that just five years later a new fuel source surpasses it… one that captures subatomic particles flying through the solar system and just hitches a ride on them as they pass through the Earth on their way out into the rest of the galaxy. This fuel source needs NO fuel and produces NO byproducts. But why would we need this one instead of the first radical, new fuel source? Well, producing oxygen and water would eventually be bad as (like your mother always told you), too much of ANYTHING is a bad thing. If cars constantly spewed water into the atmosphere, we’d turn the world into a rainforest pretty quickly, not to mention any other unforeseen side effects of over-oxygenating the atmosphere.
So the new "subatomic particle" fuel source would, within a few years, completely surpass the old one, bankrupting the lending institutions along the way and plunge the economy not just into a recession, but likely into a full-scale depression (depending on the level of cash the banks invested). And yes, I’m well aware of the economic offset that any radical new fuel-source invention would give to the economy, but this is just an example I'm using to illustrate a point... that huge, consolidated banks are no better at avoiding random predicition errors than anybody else.
Would the bankrupting of our three biggest banks matter in the long-run? Would the country and the world survive if Citibank or Bank of America went under tomorrow? Yes, of course we'd survive. But we’d also be in a depression. Now go ask your grandparents and great-grandparents just how much fun the Great Depression was.
I "predict" they'll say it wasn't that much fun at all.