It hasn't been since Harry Potter that we have seen readers of all ages take to the now hyper-popular Stephenie Meyer's Twilight saga. For those that aren't tuned in to teenage angst, the young adult human-vampire love story is making waves not only in literary circles, but in cultural and financial markets. For example, banks that would have invested in signed (by the author) North Fork High School photographs would now be recognizing a 123% return over the past year - better than any other asset class. Before you laugh at the idea, consider that more than 150 different signed photographs traded last week (just on electronic exchanges alone). That is more volume than perpetual preferred and trust preferred debt traded during the peak of the market back in late 2006.
Of course we are not advocating investing in Twilight memorabilia because it fails one of our 3 market tests for bank investments. To be a suitable, in our opinion, 85% of a bank's portfolio should be 1) Highly liquid; 2) Have a low correlation to the loan portfolio; and, 3) Have a duration that does not exacerbate interest rate risk. For today, we focus on liquidity, as we will come back to the other two points in the near future.
While Twilight memorabilia is a "market," since people come together to buy and sell items, it is not deep enough to allow for price discovery, information transmission, transaction efficiencies or uniformity. Unfortunately, against this definition, the Twilight market is similar to the market for a variety of investment subsectors such as RMBS, CMBS, CDOs, perpetual preferreds, trust preferreds and a whole host of other areas where banks made investments. Large investments (mostly by national banks) in these subsectors is one of the root causes of market problems today. Some of these large financial intuitions had 30% of their investment portfolio in these asset classes. The sheer size caused major problems when liquidity dried up in August of 2008. As a result, banks are stuck with poorly structured, highly credit correlated and extremely illiquid securities. This is driving many Other Than Temporary Impairment (OTTI) / FAS 157 issues.
When it comes to liquidity, we adhere to the rule that no more than 5% of a bank's portfolio should have very low liquidity. We define very low liquidity as a comparable security trades once per day (if it trades less than that the security is illiquid). Further, no more than 10% of the portfolio should be in low liquidity securities, like municipals (where similar securities trade, but not in appreciable enough size to permit an easy exit within a day's notice). We call this our "5 and Dime Rule." In other words, at least 85% of the portfolio should be in highly liquid securities such as agency mortgages, bullet agency debentures and, our favorite, Treasuries.
Investment portfolios should be a compliment to a bank's loan portfolio, not another place to take elevated risk. A bank exists not to leverage capital in extreme fashion (that is the domain of a hedge fund). A properly constructed balance sheet will leverage the investment portfolio primarily to provide liquidity and offset deposit or lending shocks. Moreover, the correlation will be such as to counteract cyclical credit problems.
At Executive Management Conference starting May 3rd in San Francisco (http://www.pcbb.com/2009Conf_Summary.asp), we will be looking at hallmarks of top performing banks and will demonstrate how a liquid investment portfolio equal to 25% of the balance sheet performs better than banks that treat their investment portfolio as a way to drive more yield (or as only a means to gather collateral that can be pledged). This is one of the lessons learned over the past year - Smart banks stay away from illiquid securities and Twilight collectibles - It's hard to justify the risk of owning hard-to-value or thinly-traded items.