Hubbis Opinion - Where are We Now? Same old Song? Or Can Greater Harmony be Ahead for Wealth Management?
May 15, 2020
The sombre and seemingly prophetic lyrics to David Bowie’s very last hit ‘single’ asks “Where are we now, where are we now?” and the reply comes in the refrain as “The moment you know, you know, you know”. The reality of this global pandemic and the havoc it is wreaking on all aspects of our lives is that we have not reached the moment that ‘we know’. In fact, we know we do not know. But for the world of private banking and wealth management, perhaps this is a time to reflect on what we do know of the past, and to re-calibrate both expectations and behaviour. Will lessons actually be learned, or will the world of investments still keep spinning, perhaps even faster, towards the next Tulip Mania, towards the next global financial crisis, with investors constantly battered by wave after wave of excess, and all too often jumping into seas they are ill-equipped to swim? Hubbis sought some insights from our friends in the wealth management community. Like them, we can reach no conclusions yet – we simply do not know, you know – but we can plant some flags in the ground, perhaps even as pointers for the future.
A leading independent wealth management firm executive we recently canvassed for his views commented in the aftermath of the worst of the recent Covid-19 financial markets rout that those investors with leveraged positions were the most dramatically impacted, across almost all markets and all asset classes, even seemingly ‘safer’ segments of fixed income. No investor, from professional to retail, was immune to the market’s ills, but those worst afflicted were, as usual, those whose greed, or excessive optimism, or ignorance had put them in the position of becoming forced sellers. And those whose banks or advisers had led them into various investment minefields.
Across the board
“We saw many quality assets sold off during the worst of the market falls, with a considerable amount due to forced sales determined by margin accounts and excess leverage,” this particular independent wealth management professional commented. “We even saw gold selling off for some days after its initial hike; people were selling whatever they could sell to stop the boat from sinking. Whatever had a price tag, and that had been pledged as collateral for leveraged accounts or for margin positions was potentially up for sale.”
The worry amongst the more cautious wealth management professionals we know – especially the independent players and some of the more vigilant boutique private banks - is that the big banks have, yet again as they did in the years leading to the global financial crisis (GFC), in many cases encouraged investors to take derivative or complex structured product positions that perhaps they never fully understood, or perhaps ‘encouraged’ them to take on considerable leverage, rather in direct contradiction to the lessons they and investors should have learned during the GFC.
Little altruism…yet again
“The banks have encouraged leverage, for sure,” said another expert. “This is how they make money when commissions and fees are falling, as they have been. Leverage can be manageable, until drops of 20% or 30% plus in prices, leading to margin calls; it all has to be managed very much more cautiously in the future.”
Another expert we canvassed, someone with a direct line to the second-by-second market trading activity, also pointed to how much leverage the banks themselves had as the crisis set in. “We saw banks themselves that were aggressively leveraged, and which needed to urgently redress their balance sheets for fear of weakened capital ratios,” he reported.
Such types of selling by the banks often do not show up through the normal trading channels, he noted, as they can be disguised by working privately through market-makers rather than putting assets onto the market publicly, which would signal a fire sale and cause greater alarm.
“Instead of a Bloomberg trade,” this expert noted, “there are plenty of backchannels still being used by the private banks and other banks looking to sell their own inventory. Margin calls and structured products falling over, lots of distressed portfolios, all these were suddenly driving the market down during the worst of the market collapse, and to some extent are still playing out and will be for some time. It will be interesting to see what happen in the next three to nine months in terms of how clients will ultimately react to all this.”
The wealth model exposed
Another wealth management professional commented that ultimately this might all play out to some extent in favour of the independent wealth management community.
“The private banks’ incentives for their RMs are still devised in such a way as to encourage RMs to encourage their clients to take overt risks that they do not need to take; but wealth management should surely be more about preserving wealth and taking only very modest risk in order to accumulate more in as risk-mitigated a manner as possible.”
And of course, it was rampant greed of the institutions themselves and of their commission or bonus-hungry sales teams that helped conspire to create the perfect storm that was the GFC.
This same professional added that when he was at a major global bank before the GFC and as it erupted, the bank suffered a vast number of margin calls. “People got wiped out, and negative equity in leveraged accounts meant customers ended up owing the bank money, even when the underlying asset had not performed so badly, but of course dramatically so if they had leverage against complex, risky and highly illiquid assets, as many had.”
He worries that the most susceptible segment of the HNW market has been those clients with USD2-5 million, where the banks could offer them sophisticated products and solutions, with those clients sucked in by thinking they are getting some sort of institutional style structure, often even telling those clients that the risks are very low, whereas these clients do not truly understand what they are buying into and do not have the market skills to offset their risks, and are therefore in fact totally unsuitable for what the banks have been offering them.
“This is why the EAMs offer a more reliable approach,” came another view. “They are not able to directly offer leverage, they tend in general to be more cautious about complex and derivative structures, and they perhaps act more in the best interests of these types of clients, whom they value and nurture more.” They certainly do not have access to the mass affluent market, which in Asia has been growing apace, and therefore losing a HNW client of that type of size highly significant for many of the boutique independent firms, whereas for the major private banks it is far less of a negative.
Rounding up the cowboys
This same expert also worries that too many of what he describes as the ‘cowboy’ RMs around prior to the GFC, those that had encouraged such risky portfolios and products, are still around today.
“Not that much has changed, frankly,” he warned, “and we have yet again seen the significant dangers of being sucked into complex products that can collapse under severe market stresses, and also the dangers of seemingly cheap loans at very high LTVs designed apparently to boost returns.” But which, when a Black Swan event such as the current global pandemic occurs – and this is always a possibility, however remote – can result in the exact opposite, and turbo-charge losses, often deep into negative equity territory.
The virus knows no borders
A major issue highlighted by this crisis is the sheer complexity of outlook. We simply do not know how long the pandemic will afflict the planet and what the ramifications are. And this has major implications for risk assessment in the future. Another of those we canvassed commented that while leveraged positions in forex, for example, are prone to margin calls when unforeseen events take place relating to certain countries or one-off, more isolated events, an across the board global market stampede across every asset class – as happened this time around - is far, far rarer.
Look also at the usually more stable and low volatility dividend stocks, which in the major markets have also been hit hard, as investors realised that the pandemic would almost inevitably lead to both weaker cash flows and also as corporations rapidly opted to retain more cash than they had for many years. Combined with the global oil price collapse, this has battered even the long-reliable dividends of the oil majors.
Estimates cited by market professionals in the UK press, for example, indicate that the historically relatively high-dividend UK market will see dividends down at least 40% this year, with the outlook for robust payouts returning in the foreseeable future diminishing day by day.
Moreover, stock buybacks, which have been literally rampant for the past decade, especially in the US, are suffering a dramatic reverse. Accordingly, on this occasion, that segment of demand in a falling market has also collapsed, as again many boards of directors sitting on cash opt to hold those funds and wait things out.
Safe? Let’s redefine that…
In the mainstream world of equities and fixed income, people have therefore found out that asset classes they thought would have been relatively safe, with low volatility, have sometimes proven to be highly susceptible, and the impact is even more dramatic if aggressive leveraged positions had been taken against some of these traditionally resilient, bluer-chip assets.
And leverage against less than blue-chip assets can create an even more critical meltdown. For example, one market insider told us how a basket of fixed income paper issued by Indian corporates, albeit the best credits available there, crashed from around par to 70 cents in the blink of an eye during the market rout. Add leverage to that, and margin call fire sales were of course inevitable. Selling into a falling market with little liquidity is like being sucked into a whirlpool.
Moreover, leverage against more complex structures, for example, derivatives, can be even more destructive, as evidenced in the abysmal performance of a Bank of China product sold to Chinese investors.
Without getting into detail here, Bank of China in April was at the centre of what the SCMP called a “USD1 billion hole from plunging oil”, with the Hong Kong paper indicating that some 60000 Chinese retail investors had been caught in the product, many suffering calamitous losses.
They had apparently bought into Bank of China’s Crude Oil Treasure, a structured financial product, which then suffered catastrophic price falls as the crude oil price moved into negative territory, with the benchmark US West Texas Intermediate Futures on April 21 quoted at a devastating minus USD40.32 as market traders became desperate to avoid delivery of the crude, which for anyone holding such a contract would have been due on April 22.
SCMP reported that as those Chinese investors in the Bank of China product awoke on April 21, they were appalled to see their investments, linked apparently to those WTI futures, immersed deep in negative territory. For those investors that had also leveraged up to buy into the product, the losses were even more disturbing, or “beyond any normal person’s comprehension” as SCMP quoted one investor as stating. Bloomberg reported that the losses for those who had bought into the product soon racked up to USD1 billion, and later reports indicate considerable worse numbers.
Far from a rarity
The media also reported that other leading Chinese state-owned banking giants, such as Industrial and Commercial Bank of China, China Construction Bank, Communication Bank of China, and Shanghai Pudong Development Bank, had all been selling what one newswire called “variations of the same structured financial product” for their retail customers.
The SCMP reported that Bank of China made a statement on April 24 that indicated it had alerted investors with warnings about the volatility and the impending expiry of contracts every day since April 15 via text messages, phone calls, and social media posts. The investors have reportedly been attempting to pressure the authorities and the bank to make good some or all of their appalling losses.
The SCMP reported that the Bank of China had stated that the bank was reviewing the design of its financial products as well as its risk management process, and had stated it would “shoulder its due responsibilities under Chinese law to protect clients’ lawful interests”, and that the bank had barred customers from taking new positions on all financial products related to the price of crude oil, including those linked to Brent International – the benchmark used in the UK – from April 22. But critics were reported as stating unequivocally that had Bank of China acted only one or two days earlier, the losses would not have ballooned to such a magnitude.
SCMP quoted Lin Boqiang, director of Xiamen University’s Centre for China Energy Economics Research as stating that other banks had not had “the same degree of problem” as they forced settlement of the products earlier. Other critics implied that due to the packaging of the product, investors had not properly understood the complexity of the derivatives contracts underlying the products, and others indicated the bank had not acted within the law by issuing such products.
Whatever the facts of this and other similar cases – and lawsuits are already underway, apparently - it is very clear that China’s nascent wealth management market needs a far tighter control by the regulators and self-control by the leading banks, as even sophisticated investors would struggle to fully understand such derivative instruments, and would be highly unlikely to read, or fully understand, the fine print on any such products.
Risk disclosure, suitability and ultimately potential liability are all in question in this, and other similar cautionary tales from China.
China’s vast oceans of savings
But, as the SCMP reported that Chinese households are sitting on an estimated USD10 trillion in savings, it is fairly easy to predict that this type of event will not be the last, and possibly not even the worst, especially as the Chinese authorities have been driving banks towards lower lending margins and pushing them towards generating higher fee and other income.
The investors who went into the Bank of China product might have, very reasonably and fairly, assumed that the oil price, while historically volatile, would never move into negative territory. In other more mundane structures, for example fixed income baskets based on underlying stocks that are considered robust and stolid – REITs for example - underlying assets might appear fairly solid, but add structures and leverage on top and the pack of cards can topple very rapidly indeed.
“Just like in 2008,” said one ex-private banker we spoke to, “there is a litany of sins out there. A key problem is leverage; if you can weather the volatility and not become a forced seller, and if you can retain a long enough time horizon, you can sustain positions, but for those with poorer quality, riskier holdings, and especially those with leverage against such holdings, things would have been remarkably bad again this time. It is really simple - too much greed and leverage and you can find yourself in a really bad place.”
Will we ever learn?
The major questions now are whether people will learn from these events, or whether this pandemic and its effects are game-changers for the foreseeable future. Investors and companies will likely want to hold onto cash, but on the other hand, rates are now so low, and likely to stay low for many years, that we might see demand for equities and risk appetite in general recover when there is more stability and greater visibility on the future.
The final word goes to an expert who cautions that the Fed and other central institutions have been buying wholesale to support the markets, but that neither they, nor anyone else, knows where this pandemic will leave planet earth and all those who spin around on her.
“You would imagine we have probably seen the bottom of this particular crisis in terms of the markets,” he said, “but the fallout will be seen over months and years ahead. And if there are second and third waves of the virus and markets lose hope, then we could see new post-coronavirus lows tested in the equity markets. The market has rallied on hope, but not necessarily on reason. Even Warren Buffett appears not to be buying.”
In five to 10 years, will the wealth management community and the clients have become more cautious, more professional, or more measured as a result of this debacle? We can but hope, but perhaps the reality, to paraphrase David Bowie, is that until we know, we will not know.
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