On April 9, 2009 Eric Dash reported in The New York Times on the progress of the federal bank examiners' stress tests. The purpose of those tests is to determine how the nation’s biggest banks would hold up under simulated worst-case conditions. The good news is these banks are in better shape than many think, but:
… the tests, which are expected to be completed by the end of this month, are being conducted out of public view. Federal law prohibits the unauthorized disclosure of the results of any bank examination, including the stress tests. Some investors wonder if the new tests are rigorous enough, given the potential problems lurking inside the banking industry.
The bad news is the Treasury’s stress tests will be inconclusive and the results will not be made public. As an alternative I introduced the bank Asset Quality Index [AQI] in Which Banks Are Holding Those “Hard-to-Value” Assets? This index defines the probability that a bank is holding significant hard-to-value assets on its balance sheet. In that article I applied the AQI in a cross-sectional analysis of leading U.S. banks. This analysis operates on the normalized difference between each firm’s share of market value and share of total revenue in a group of eight banks covering the 36 quarters ending in 2008.
To the surprise of no one, it turned out that Citigroup (C) and Bank of America (BAC) respectively registered a 0.98 and 0.99 probability of holding hard-to-value assets. The probability that American Express (AXP) was holding some of these assets was 0.35, while Wells Fargo (WFC) and The Mellon Bank of New York (BK) both had less than a 1 in 100 chance of holding them. The purpose of this post is to show how the AQI tracks the surprisingly risky history of the three remaining banks: Goldman Sachs (GS), JP Morgan Chase & Company (JPM), and Morgan Stanley (MS).
THE ASSET QUALITY INDEX
Since banks don’t sell products their revenues are dependent on fees for investment banking services and the interest they earn on performing assets. When investor’s price a bank’s stock they lean heavily on the quality of those assets. Unlike retailers (and manufacturers) that carry inventories and sell products, there is a more direct link between the quality of a bank’s assets and its market cap. I designed the AQI to capture the implications this link.
Technically, the AQI is a normally distributed variable with mean zero and standard deviation one. As a result, it may be interpreted as a probability by looking up any given AQI in the student t-distribution. The higher the AQI value, the less chance a bank has a significant proportion of hard-to-value assets in its portfolio. The lower the index the more likely the bank is to have a significant proportion of these assets in its portfolio.
GOLDMAN’S INCREASINGLY RISKY BETS
The following chart tracks the AQI of Goldman Sachs over the period from February 29, 2000 through November 30, 2008. The index numbers in red indicate increasingly higher probabilities that GS held hard-to-value assets in its portfolio from November 2002 through August 2007.
This chart documents almost five years of ever more risky bets by Goldman Sachs. Its AQI was -0.2 in November 2002 indicating a 0.58 probability the company was holding significant hard-to-value assets. By August 2007 Goldman’s AQI had declined to -3.9. In that quarter GS was virtually certain to be holding a damaging proportion of those pesky assets.
Apparently management then discovered their long run of risky bets and jumped into action. Within months GS cleaned its portfolio of those assets and reported an AQI of +1.6 in November 2008. By that time the probability that Goldman was holding such assets had plunged to 0.07.
MORGAN STANLEY’S INCREASINGLY RISKY BETS
In August 2000 Morgan Stanley’s AQI was +2.0, which indicated a probability of just 0.03 that is was holding hard-to-value assets. When in November of 2000 the AQI fell to -0.7 this set the stage for a long series of increasingly risky bets. The company’s AQI reached a low of -3.7 in February 2008. At that point MS was virtually certain to be holding a significant proportion of those assets on its balance sheet.
Like Goldman Sachs did earlier, Morgan Stanley management began to clean up the mess, reaching an Asset Quality Index of -0.9 by November 2008 indicating about a 50/50 chance it was still stuck with a bunch of those hard-to-value assets.
JP MORGAN’S EARLY CLEAN-UP
Morgan management was ahead of the game in cleaning up its balance sheet. In September of 2002 JPM posted an AQI of -2.6, which at that time appeared to put its balance sheet much deeper in the toxic asset pool than either GS or MS.
Perhaps this motivated management to begin the early and systematic clean-up that reached a high point of +2.7 in September 2008 following its purchase of the Bear Stearns Companies (BSC) at a fire-sale price. The deal closed on June 30, 2008 and JPM’s balance sheet remained clean as a whistle after absorbing BSC. In September 2008 the probability it contained a significant proportion of hard-to-value assets was 0.0053.
In his Seeking Alpha article on March 17, 2009 Mark McQueen gave BSC a net value of -$4.3 billion. By the close of the 4th quarter 2008 the market apparently detected there were more of those hard to value assets in the BSC balance sheet than they had recognized – the AQI of the combined companies dropped to zero implying a 50/50 chance a significant proportion of those assets were still present.
THE VALUE OF THE AQI
The Asset Quality Index provides early warnings about the presence of hard-to-value assets on a bank’s balance sheet. It's a very handy way to sort the good from the bad and the in-betweens. It's also based on public data that can be updated every quarter. What do you think?
Thank you for visiting. As always, your comments are welcome.
~V
