Warren Buffett says in an interview with CNBC that the collapses of the big banks we have seen this year are not the end of the story. According to him, we can expect further troubles in the banking sector and even more bankruptcies. Buffet has removed some shares from his portfolio, however, claiming that shareholders, not deposit holders, may lose the most from the coming turmoil. Let's take a closer look at what the root of the problem might be.
Change in Berkshire Hathaway's portfolio exposure to the banking sector
The only bank in which the Oracle of Omaha’s trust has retained a large stake is Bank of America. He has completely dropped JP Morgan, Goldman Sachs, M&T Bank, and PNC Financial over the past three years. Furthermore, he has significantly reduced his stakes in BNY Mellon and US Bank. On the other hand, he added other banks to the portfolio, such as Citigroup, Ally Financial, Jefferies, and NuBank. In addition, he has further increased his already large stake in the Bank of America. Buffett justifies that he got a very lucrative offer when he first invested in it in 2011, and holds the current CEO of Bank of America in high regard. The total amount of capital invested by Buffett in the banking sector over the past three reporting years has fallen from just under $70 billion to nearly $40 billion. The diversification of the portfolio in this regard has also declined. The portfolio is now almost entirely occupied by Bank of America, which is endowed by Buffett with a high degree of trust and affection.
Source: Market Insider
What is the reason for Buffett's lack of confidence in banks?
It seems insufficient to assume that the only or main reason for placing tens of billions of dollars of capital in Bank of America is personal affection for its CEO. Therefore, it is worth leaning into the business and financial practices that may have convinced Buffett to make such an assessment of the banking sector today. Buffett's general opinion of the banks he seems to dislike is that they take imprudent risks and manipulate accounting to make it look better on paper than in reality, and this would have serious consequences for them sooner or later. Buffet specifies in his opinion that this manipulation in accounting is the valuation of assets at cost, rather than at market value, which in case of being lower than the purchase price would artificially inflate their position on the balance sheet.
What is the situation that may have prompted the banks to behave this way, and what assets are involved? The situation seems quite similar to what happened with Silicon Valley Bank. Namely, in the case of assets such as bonds, they can be valued in several ways, depending on what someone expects about them and what the intentions are towards them. You can value them at cost, meaning they are worth what you paid for them, you can value them at face value, and you can also value them at market value. Valuation at market value applies to such assets that are intended for trading and you want to sell them. However, if a buy-and-hold strategy is envisioned for some bonds, this prompts other valuation methods. Since there has been a recent interest rate hike in the United States, this means that existing bonds with fixed or floating (but dependent on another factor) coupon payments can be sold for less than before, since the market will demand a higher rate of return from them. In short, an increase in interest rates makes the market value of such bonds fall. Since the banks wanted to show the highest possible value for their assets, they had to adopt a different valuation method than the market, such as the aforementioned incurred cost/acquisition method. Someone could afford to do this assuming that these bonds would be held until maturity with a high degree of certainty. The problem may be the realism of this assumption, because a realistic forecast may suggest that such bonds would have to be liquidated in the near future. The answer to this dilemma could be sought precisely in Warren Buffett's second objection to “dumb” risk, which he specifies as a mismatch between assets and liabilities.
This refers to the types of deposits offered by banks to their customers. If there is a large number of deposits that can be immediately withdrawn and they exceed available cash and other liquid assets valued at market value, in the event of increased customer withdrawal requests, there would be a need to sell the remaining assets to satisfy customer claims. Such assets are, for example, the previously mentioned bonds, which are valued at acquisition cost, but in reality, may be sold at a considerably lower price incurring losses for the financial institution. This is what the asset-liability mismatch mentioned by Buffett is all about. It's about taking customer deposits, which can be immediately withdrawn and used to buy long-maturity government bonds and mortgage-backed securities, whose sudden liquidation at an undesirable moment requires a large discount. As for the mortgages themselves, it is worth noting that there is a clearly noticeable drop in real estate prices in the United States just like bonds. Mortgage receivables, like bonds, are among the most common long-term investments of banks.
Is Bank of America better in this regard? Apparently, based on Buffett's actions, someone could conclude that probably it is. Perhaps it is a bank that uses different valuation methods and values many assets using the market value method. However, it should be noted that in terms of indicators specific to banks (e.g. tiers), it does not perform significantly differently from others, or at least those that Buffett has sold. The balance sheet items at the end of 2022 do not have significantly different proportions when we compare Bank of America with JP Morgan, Goldman Sachs, PNC, and M&T. For example, the Bank of America’s, liquidity ratio is around 0.78, while JP Morgan's is around 0.84 - even higher than Bank of America, similarly to Goldman Sachs (0.90). It should be noted, however, that they fall far short of what is needed for analysis in the case of the banks. This is because there is a significant amount of off-balance sheet items, the operation of fractional reserve (i.e., lending money that is not there) and specific ties to the central bank. Perhaps a prudent accounting practice would be to discount the long-term investments by some percentage depending on the market environment or simply use only the valuation method based on the market value.
Paweł Szarmach, MPW, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73.18% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Trade this news from Conotoxia Ltd. platforms
Go to your account
