Response to Australian Financial Review, Friday 6 May 2016
Sydney, 06 May 2016
http://www.macquarie.com/za/about/newsroom/2016/afr-response-6-may
Macquarie notes an article which appeared in today’s Australian Financial Review (AFR), 6 May 2016, about its Corporate and Asset Finance (CAF) Lending business which, like a previous AFR article on the business, was deliberately inaccurate and sensationalist.
Following publication of today’s article, Macquarie contacted the offices of the Shadow Treasurer and the Shadow Assistant Treasurer. Macquarie was advised by them that contrary to an AFR assertion, a bank Royal Commission terms of reference would not single out any particular bank but rather look at systemic and cultural issues across the sector. They advised that the terms of reference have not yet been set and also advised that if it comes to pass that a Royal Commission looks at this or any other issue, this will be decided by the Royal Commission.
Prior to publication of today’s article, Macquarie repeatedly offered the AFR a detailed briefing on CAF Lending with Macquarie’s Chief Financial Officer. These offers were not accepted. Macquarie also provided the following responses – prior to publication - in relation to a series of allegations made by the AFR.
― The AFR’s claims about Macquarie having a privileged position as a “government-backed bank” (which also appeared in the first AFR stories on CAF Lending), are incorrect. The Government Guarantee was part of a co-ordinated response to the onset of the global financial crisis by G20 countries.
- In Australia more than 200 financial institutions were covered by the Government Guarantee. Those that used the Government Guarantee were required to pay a fee for doing so. Macquarie has not received, and does not receive “government backing” and is no different from any other Authorised Deposit Taking Institution in Australia, and no different in that respect, to any of our its international banking competitors.
― The AFR’s implied criticism of sub-investment grade lending is a misunderstanding of the business of banking which has always included the provision of credit to non “investment grade” borrowers, including many corporates, small to medium sized enterprises (SMEs) and individuals.
- This lending has always been fundamental to the banking sector – a significant proportion of Australian (and global) bank lending is to non investment grade borrowers. In corporate debt alone, each of Australia’s largest banks’ non investment grade lending portfolios are many times the size of the CAF Lending portfolio.
- Importantly, the quality of a loan is determined not just by whether the borrower is investment grade but also by the quality of the security and covenants over the loan. Successful banking business requires this judgement, rather than only following public ratings.
― Suggesting the large global banks are not competing fiercely for sub-investment grade financing and have left a gap in the market for Macquarie is demonstrably untrue.
- The large global banks are very active competitors to CAF Lending. They provide considerably more sub-investment grade financing and have much larger sub-investment grade portfolios than CAF Lending’s – often by large multiples.
- CAF Lending’s assets are frequently held jointly with other banks or have been originated by other banks which have a substantially larger market presence than Macquarie.
- Macquarie is regulated by APRA and 190 other regulators around the globe. APRA standards are generally viewed to be among the most rigorous globally and are no less “tough” than those applicable in the US and Europe. Suggesting Macquarie has an advantage from more lenient regulation cannot be supported.
― Regarding the AFR’s comments about accounting treatment of the (CAF Lending) portfolio, Macquarie properly accounts for the portfolio as required under international accounting standards. Under these standards, where the intention is to hold an asset over its life, it should be accounted for on an accruals basis rather than mark to market. Macquarie follows this approach in its audited accounts and also funds the CAF Lending loan book with long term debt on this basis. Since inception, around 85% of the loans have been realised through repayment – clearly evidencing the appropriateness of this accounting approach. In addition, the standards require regular testing for credit quality and where there is a deterioration, that appropriate provisions be taken.
― Regarding the comment that Macquarie was “desperate” to use capital during the financial crisis, even a cursory review of (Macquarie’s) financial results at the time shows that (its) balance sheet footings did not alter.
Macquarie Group's dangerous spin
6 May 2016
Christopher Joye
http://www.afr.com/personal-finance/macquaries-dangerous-spin-20160505-gon4bm
While Labor's proposed Royal Commission into the banks is unnecessary, I'm sympathetic with shadow assistant treasurer Andrew Leigh's desire to investigate whether Macquarie Group's decision to use its government-guaranteed domestic borrowings to become one of the largest and most leveraged investors in the global "high-yield" market is consistent with its banking (and social) licence. Recall that these are the unrated, sub-investment grade and distressed debts that have driven Macquarie's reported default rates to five times the average of the major banks. Macquarie retorts that the "suggestion that [it] 'speculates' in debt is wrong" and maintains it doesn't need to "mark-to-market" these volatile assets because they are normal bank loans that can treated on a "hold-to-maturity" basis that only recognises the ultra-high interest rates Macquarie earns.
Yet the truth is Macquarie has acquired 60 per cent of the $33 billion in high-yield debt it has put on its balance sheet since 2009 in secondary "trading" markets. This was not, therefore, originated by Macquarie like banks ordinarily extend finance. Instead, it has scoured the earth for the cheapest securities it can find and picked them up like you would shares on the stockmarket. This is absolutely and emphatically "speculation": Macquarie is punting on the expectation its guess as to what the junk debt is worth proves correct. More remarkably, Macquarie has the audacity to allege that "the AFR's claims about Macquarie having a privileged position as a 'government-backed bank'…are incorrect". "Macquarie has not received, and does not receive 'government backing'," a spokesperson said.
That must rank as one of the most misleading statements I have ever heard from a bank. Macquarie's $43 billion in customer deposits are explicitly government-guaranteed for free. The taxpayer-owned Reserve Bank of Australia has given Macquarie a $5 billion emergency line of credit to draw down on during a crisis when nobody else will lend to it at a subsidised cost of just 0.4 per cent above the cash rate. Rating agencies lift Macquarie Bank's run-of-the-mill "BBB+" credit rating two notches higher to a strong "A", which lowers its cost of funding, on the assumption Macquarie (and the four majors) are "too big to fail" and will receive "extraordinary government support" if something goes wrong. Finally, Macquarie raised more government-guaranteed deposits and bonds than any other Australian bank in the early stages of the crisis – some $25 billion of taxpayer-insured money by April 2009.
Maybe Macquarie's spinners should listen to NAB's chairman Ken Henry, who recently declared that "were we to have a repeat of the funding and liquidity stresses that precipitated the GFC, our regulators would have no option but once again look to use the public sector balance sheet to underwrite funding guarantees".
Stevens duds savers
After a year sitting on the sidelines, relevance deprivation syndrome has once again compelled the RBA's outgoing governor Glenn Stevens to predictably pull his itchy trigger finger. And so savers have been dudded with a new record low 1.75 per cent cash rate to encourage borrowers to extend their cheap-money binge in the name of fuelling a flawed growth model predicated on ever-increasing debt. It's a sad state of affairs. The RBA has given us the most stimulatory monetary policy in history at a time when fiscal policy is racking up the largest cumulative deficits in living memory. And yet there is no recession in sight. The economy has been growing at a slightly above-trend pace, the jobless rate has fallen to an historically below-average 5.7 per cent and our globally expensive house prices continue to soar. Indeed, RP Data's indices indicate that the RBA-inflated housing boom-cum-bubble has been expanding with renewed vigour: capital city home values have exploded at a 10.9 per cent annualised pace over the three months to May 5.
After the savage 1991 recession when the jobless rate hit 11 per cent, the Commonwealth's gross government debt-to-GDP ratio rose to 23 per cent on the back of understandable budget deficits. The government's persistent inability to size spending to revenues since 2009 has seen the sharpest deterioration in Australia's creditworthiness in post-war history with the gross government debt-to-GDP ratio jumping from 5 per cent in 2007 to 29 per cent in 2016-2017. Ken Henry, previously secretary of the Treasury, is spot on when he says "governments have not matched the improvement in the strength of bank balance sheets that has occurred since the crisis".
Beyond animating zombie businesses and destroying the economy's productive capacity, the problem with zero-to-negative "real" interest rates that leave savers going backwards after tax and inflation is that they force them into dysfunctional decisions. In the search for absolute returns that can furnish adequate retirement incomes in a world where asset prices are being distorted by politicians and policymakers, savers are inevitably going to be assuming excessively high risks of loss.
Performance puzzle
In theory the most attractive solution to mitigating these hazards is focusing portfolios on "active" strategies that produce bona fide "alpha": that is, risk-adjusted excess returns that are unrelated to "beta" or the day-to-day movements in mispriced markets as represented by "passive" indices (the ASX/S&P200, for example). This is akin to finding a very cheap house – perhaps offered by a vendor who has to sell quickly because he or she has committed elsewhere—that rewards you with capital gains that have nothing to do with general house price inflation.
One of the most informationally "inefficient" asset classes in Australia that should lend itself to active management is investment-grade fixed income. This encompasses the $1.4 trillion in high-quality bonds issued by governments, corporates, banks, insurers, foreign companies (like Apple) and asset-backed securities which is almost the same size as the sharemarket. And yet the typical super fund has little exposure to domestic fixed-income compared with enormous Aussie equities holdings, which have massively underperformed bonds on a risk-adjusted basis.
Whereas stocks are traded on an extremely transparent exchange that instantly publishes the prices and volumes of all transactions, bonds are bought and sold in an astonishingly "dark" over-the-counter (OTC) market. This is because the Australian Securities & Investment Commission has not historically required the prices and volumes of fixed-income transactions settled through the ASX-owned Austraclear to be publicly reported like they are in the US. This produces an unusually inefficient price discovery process wherein bond values are slower to incorporate new information and can remain far removed from intrinsic worth (or stale) for extended periods.
It is also manifest in anomalies like the bond "market-makers" who intermediate buyers and sellers presenting bids and offers that "cross". That means sophisticated banks are giving investors the opportunity to make risk-free arbitrage profits, which cannot happen on an exchange. It would be like one guy saying he will buy CBA shares off you at $75 and another offering to sell them at $72.50. Inefficient markets should be manna from heaven for smart active managers that can employ rigorous valuation models to exploit pricing errors to find alpha that is unrelated to the market's beta factors, including credit risk, interest rate duration risk and illiquidity risk. Blind Freddy can boost returns through taking on greater risk of loss by buying bonds with higher probabilities of default, longer loan terms and/or inferior liquidity. One needs skill to figure out that a bond spread is cheap by, say, 0.40 percentage points, which can deliver hundreds of percentage points in capital gains if it reverts to fair value.
This brings me to a profound puzzle. When I examined the performance of 54 active Australian fixed-income funds over the last three and five years relative to their benchmark (the AusBond Composite Bond Index), I found that almost 90 per cent underperformed after fees. This is statistically bizarre because even if you assume that none of these guys have any skill, you would expect some sort of random distribution of returns above and below the index as the lucky ones win and the less fortunate lose.
In the more informationally efficient Australian equities asset class, which is contested by a larger pool of institutional investors, I found that a significantly lower proportion of active managers (only two-thirds) underperformed the ASX/200 index after fees. This amplifies the performance puzzle: you would think that it is easier for active managers to beat their benchmarks in less efficient markets like fixed income.
There are two possible explanations. The fact that almost all Australian bond funds are systematically underperforming implies they are not active at all and just buying assets on a hold-to-maturity basis, which makes them closet index huggers. After fees they have to underperform. A related possibility is that the quality of human capital in equities is higher, which makes sense given equities managers charge fees that are multiples of those levied by their fixed-income brethren. Talent will tend to gravitate to those areas offering the best incentives. This is also borne out in the resources employed in each asset class: the typical $5 to $10 billion-plus equities shop has three to seven times more analysts than similarly sized fixed-income funds.