Milken, Capital Structure, and The Future Of Banking ~ Steve Blitz Morning Notes
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Tuesday, April 21, 2009

Milken, Capital Structure, and The Future Of Banking

In today's WSJ, Mike Milken discusses how proper management of a firm's capital structure through a business cycle sharply raises the odds of survival. In discussing the evolution of capital raising options since the mid 1970s he writes (italics mine) --

"The accessibility of capital markets has grown continuously since 1974. Businesses are not as dependent on banks, which now own less than a third of the loans they originate. In the first quarter of 2009, many corporations took advantage of low absolute levels of interest rates to raise $840 billion in the global bond market. That's 100% more than in the first quarter of 2008, and is a typical increase at this stage of a market cycle. Just as in the 1974 recession, investment-grade companies have started to reliquify."

Since the mid 1970s banks have been financially innovated into a marginal existence when it comes to supplying capital to premier corporations. A good many of these innovations arose out of the need for firms to have continued access to capital when regulatory restraints shut down banks as an avenue for funds. As the prime rate began to mean something less than prime when classifying the borrowers the overall credit quality of any given bank's clientele declined as well. Most of the restructuring moves made by banks since then have been to 1) Attempt to recapture these premier clients by breaking down the regulations that kept them out of the capital markets as direct players; 2) Replace C&I loans with mortgage lending; 3) Increase lending to leveraged players in the capital markets such as hedge funds and dealer desks.

The Government is chastising the banking system for its transgressions and rightfully so in many regards. To me, the bank's biggest faults lie not in the businesses they went into, they seemed like rational choices at the time, but how they managed these forays. Quality of bank executives aside, the point is that lest banks become permanent wards of the state so that ROE is forever less important than sustaining a liquid balance sheet, the government should be careful about the regulatory restraints they are creating. Those that need to borrow capital will find a place, in this country or elsewhere, and a way -- regardless of the regulations in place.

Given the results, we should resurrect Glass-Stegall and again prevent commercial banking and investment banking from operating under one roof. This is better than the good bank / bad bank splitting being proposed. If these institutions are split into commercial bank and investment bank and either fails, so be it, because neither will be too big to do so. As for the future role of commercial banks, management will have a choice. A boring, steady ROE or they can opt to become investment banks instead and chase riskier profits. But now if they do, they must know that they are no longer playing with a net.

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