Remember those complex financial products that helped touch off the financial crisis in 2008 -- the ones with impenetrable names like “collateralized debt obligations”?
They’re back in vogue, according to my Bloomberg News colleagues. Anchorage Financial Group, a New York-based investment manager, used them recently to magically transform a collection of corporate junk bonds and loans into a AAA-rated investment. Yet S&P downgraded the U.S. government’s credit rating from AAA to AA+ in 2011, where it remains today.
That’s right - there are investments stuffed with junk bonds that are more highly rated than U.S. government bonds. While this smacks of some of the financial crisis’s wackier moments, there’s a key difference: This time it’s investors, rather than big banks, that are taking high-octane risks.
After all, banks and investors have charted completely different paths since the financial crisis. Many risk assets such as U.S. stocks, real estate investment trusts and high-yield bonds have nearly doubled or even tripled in value since then, but the big banks have largely sat out the party. (Though, as my Gadfly colleague Rani Molla noted in her column yesterday, smaller regional and local banks have become big players in the sometimes perilous commercial real estate market.)
It now seems like a lifetime ago when Chuck Prince, former chairman and chief executive of Citigroup, famously quipped in 2007 that “As long as the music is playing, you’ve got to get up and dance.” Whether due to hard-learned wisdom or tougher regulations (or both), banks have become more circumspect, and some have gone so far as to shun traditionally lucrative businesses such as currency hedging. (Obviously, Wells Fargo’s armada of fake accounts appears to be a notable exception to all of this.)
The banks’ financial statements tell you almost everything you need to know about what’s happened to their appetite for risk. The debt-to-equity ratio of the S&P 500 financial sector was 5.6 when 2008 began; it has since shrunk to just 1.5. Similarly, the financial sector’s debt-to-assets ratio was 0.43 just before the financial crisis, and it is now 0.2.
Less risk translates into smaller profits, of course. The financial sector’s return on common equity and return on assets averaged 15.9 percent and 1.2 per cent, respectively, during the swashbuckling days from 2003 to 2006. By comparison, the financial sector’s ROE and ROA have averaged just of 7.2 per cent and 0.8 per cent, respectively, since 2009.
Looking at those financial results, it seems to me that the banks’ views on risk have swung to an extreme that isn’t good for their franchises. (I also fear that the banks’ reluctance to lend is a drag on economic growth, but that’s another column.)
Still, investors could learn something from the banks’ newfound conservatism. If banks have become too cautious, I think investors have become too eager to chase every incremental basis point above the ultra-low yields offered by government bonds. And it’s not just investors’ flirtation with crisis-era products like CDOs that worries me; the data on more traditional assets also shows how enthusiastically investors have embraced risk over the last several years.
Let’s start with U.S. stocks, where soaring stock prices have depressed earnings yields. The S&P 500’s earnings yield (based on ten-year trailing average earnings) was 6.8 per cent when 2009 began. Today that same earnings yield is just 4.2 per cent. You can find this same dynamic in other asset classes.
Take a look at real estate. The FTSE NAREIT Equity REIT Index –- an index of real estate investment trusts –- offered a dividend yield of 7.6 per cent when 2009 began. The yield has since been cut in half to 3.7 per cent. High yield bonds are yet another example. The Bloomberg Barclays U.S. Corporate High Yield Bond Index yielded 13.2 per cent when 2009 began. Today that yield is 7.8 per cent.
None of this means that investors’ bets on U.S. stocks or REITs or high yield bonds will necessarily leave them poorer (most likely not if they have the discipline to hang on), or that they should avoid risk to the same degree that the banks currently do (they almost certainly should not).
But investors would do well to internalize the lesson learned by banks eight years ago. Namely, that risk always -- always -- can come back to bite you.
Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.Report Typo/Error