A virtual interview with the WSJ and the FT

Part 1

WSJ: We read with interest your views on the origin of the financial crisis we went
through: In a recent article you were indicating that you would prefer to be short instead
of long the banking sector: why?

M&B: The crisis that started in August 2007 is the abrupt adjustment to 20
years of over-indebtedness: over indebtedness by governments, individuals and
corporations (to a lesser extent), thanks to central banks having provided plenty of
liquidity, particularly in the US. Each time we had a crisis, the liquidity ticked up, and we
had such crises more often over the past two decades and they became more acute and
important in size. No decision was made to go to the root of these crises: over-liquidity
leading to the misallocation of resources. Besides a loose monetary policy, these crises
were also spurred by bad political decisions.

Is there anything new? No. The G20 in London focused on tax havens and in Pittsburgh on
traders’ bonuses. Wrong, these are meaningless vis-à-vis the current crisis and its causes
even if they do the front page of media and are talked up by politicians. These are pure
scapegoats to deflect the attention of the public from the real roots of the problems and
solutions that will be painful.

Regarding the banking industry, I do not believe that problems are healed.
True, a collapse has been avoided and this is fine; we gained time, very important in
troubled times. Many banks received public money, and many have repaid it. However so
called toxic and non-performing assets are still in their balance sheets (or off balance
sheets) and their value has
not improved (home values
not really increasing, credit
card delinquencies on the
rise, commercial real estate
starting to hit, to name a
few). Bank’s lending
continues to go down, so the
real economy is not getting
the financing it needs,
particularly small and
medium businesses (loosing
50k jobs 10.000 small
business is politically and

1
journalistically irrelevant, loosing the 10k jobs via GM is important, this is the power of
communication and making “events”).

Many banks have returned to profits, but a lot has to do being financed at close to 0%
whilst investing the proceeds in Treasuries yielding +/-3 % - a no brainer to make money
by the way. The core business of banks (or what it should be) is not improving at
all.

Look at Q3 results at JP Morgan Chase in details – one of the best managed banks. Net
profit $ 3.6 billion: 7X Q3 2008 and +32 % / Q2 2009. Great! But hold on, look at the
details. Over 50% are coming from investment banking (and over 2/3 of Investment
banking revenues coming from trading profits). Retail financial services are
hardly making any money ($ 7 million profits) and the situation is deteriorating
compared to previous quarters with provision increasing (nearly $4 billion representing
nearly 50% of net revenue). Card services losses are mounting: $ 700 million (close
to $5 billion provisions) vs. a Q2 $ 672 million loss and a Q3 2008 $ 292 million profit (if I
however do not dismiss the ability of the management to "overcharge" provisions to
reduce the effective tax rate and create a cushion for the future and smooth results, in this
case I believe the assessment is real). The rest of business lines is more or less flat.

And what about Goldman Sachs – the best fully-fledge investment bank – where 70%
of its net revenues are derived from trading at $ 8.8 billion during Q3? Net
common equity stand at more or less the value of level 3 assets (the illiquid difficult to
value assets). From what I read, Goldman Sachs is also back to the happy days of
leveraging (15X from my rough calculation of common equity/total assets - it is beyond the
purpose of this interview, but I would be quite interested to know the ratio with off balance
sheet items...). We are back to a Return on Equity (ROE) above 20%: I thought we were in
a new world... Never mind, the tax payer bails out, and management retains their position
with no financial sanction (the only one that really matters, besides jail).

A final word on commercial banks and subprime mortgages. A recent study published by
the US FED showed subprime borrowers represented 20% of all new mortgages in 2006 to
zoom down to zero in Q1 2008 to reach... 20% currently in an environment where net
lending is negative for the first time since 1970.

All this led me not to be optimistic about the banking sector, bearing in mind that
deleveraging will translate into lower ROE and lower valuations (just look at the collapse
in private banking valuations that went from 6-8% of AUM some years ago to 1-3% now).

2
Sources:

Goldman Sachs
http://www2.goldmansachs.com/our-firm/press/press-releases/current/pdfs/2009-q3-
earnings.pdf

JP Morgan Chase
http://investor.shareholder.com/jpmorganchase/press/releases.cfm?type=

Federal Reserve Bank of St Louis

https://research.stlouisfed.org/fred2/series/TOTLL?cid=100

Federal Reserve Bank of San Francisco

Economic Letter: Recent Developments in Mortgage Finance
http://www.frbsf.org/publications/economics/letter/2009/el2009-33.pdf