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The truth about bank accounting: the Royal ‘Berg of Scotland

Shareholder group PIRC discovers £40 billion of unrealised losses in UK banks – yet bonuses keep flowing on the back of fake profits

Last summer I attended an open day by RBS for A-Level students. It was an “insight day” to look at what it was like to work at their investment banking division. They paid the travel expenses and my naive self thought that investment banking was something I later wanted to work in – so I went to London for the day.

After arriving, I got chatting with a chap who had come down from Bradford. “They paid me train fare – 250 quid, put me int ‘otel overnight, and paid me for’ taxi.” That’s a lot of money, I thought, for just one person, for just a single day. At that point I pondered – if RBS were willing to spend that much on today, surely they must value it, think it is important, and make it really useful. But how wrong I was.

For the first half hour we had a “communications guru” who spent the best part of an hour telling us that smiling makes you come across as a nicer person. You don’t need to be Benedict Cumberbatch to work that out.

Then we had another woman who was awfully nice, and smiled a lot, but didn’t really tell us anything useful. She told us about RBS’ Moneysense program that would teach us how to make a budget at university. Surely if you did not know how to budget at university, you should not be later working with other people’s money in an investment bank. But no, not at RBS!

This was followed by tasks of minimal educational value – putting velcro-backed company logos onto a board with Retail Bank, Investment Bank, Hedge Fund and Building Society on it. A trip to the trading floor for literally 30 seconds (for informational security reasons) – before we were told about their wonderful “insight week” (more of the same), internships and other opportunities. At which point many of us just rolled our eyes.

The reason I mention this day is because it illustrates a culture in which money is thrown around left, right and centre for spurious purposes – regardless of the fact it is owned by the UK taxpayer. This approach may have been acceptable before the crisis – but they should not be so reckless with money now, given that without the UK government they would no longer exist.

In the context of the recent report by PIRC, a shareholder group who revealed that RBS have undeclared losses of £18 billion, it would seem RBS have been equally liberal with their accounting.

The problem with bank accounting is that – from an outsider’s perspective – it’s very easy to fudge the numbers. You can report your losses during one quarter, or announce them later. You can mark-to-market (record your assets at their real market prices) or not. What this means is the top brass at a bank can record large profits and consequently pay themselves huge bonuses, despite the reality of creating a big loss.

A little while later, losses have to be reported, the bank’s capital buffer is wiped out, and guess who will have to pay again? You guessed it – the taxpayer!

Many would argue that RBS should have been allowed to fail in the 2007/8 crisis – but it was propped up. Billions of pounds have been dispersed in bonuses whilst they have milked moral hazard mentality (tails we win, heads you lose) – leaving the bank to be little more than a decrepit shell.

In my humble opinion – RBS is taking took much risk and is willing to let the taxpayer take the hit when defaults on their loan books ultimately occur. In the meantime, they are paying out most of their (short term) “profits” out in bonuses. Therefore, I would recommend a short-selling of it with a stop-loss at 250p a share.

Granted, the shares have fallen 50% over the past year – they are not at their cheapest and a bit of volatility could make us hit the stop loss. However, with the saga of Europe rumbling on – I would argue they are already technically insolvent.

One last thing, if you’re not convinced that it is a basket-case already… just read what The Slog said about it.

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Posted by on June 6, 2012 in Trading Ideas

 

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INTERVIEW: How monkeys are better than fund managers – Pete Comley on his new book

Pete Comley was on his allotment last year listening to David Kuo’s podcast for the Motley Fool. The host was discussing a share trading competition for schools, and how 61 of the 72 teams had failed to beat the index.

David: “Do you know what? In the wider industry, in the professional fund management industry, these statistics are almost identical to what happens. Out of all the funds that are available for people to buy, approximately 15% of professional fund managers will beat the market, and 85% of them will not.”

As I forked over my vegetable plot, those words went round in my head. I then stopped and listened to it again. Had I heard it right – that virtually all professional fund managers, that were paid millions in bonuses – couldn’t beat the market. Surely it wasn’t true?

Over the next few months, Pete researched the industry and wrote a book about it. Indeed it was true. A monkey with a pin who picked and held stocks at random beat the majority of investment ‘experts’. Furthermore he argues that most people would be better of they just kept their money in the bank, rather than investing in funds.

Here follows an interview with Pete – you can download his book, Monkey With a Pin, FOR FREE at his website monkeywithapin.com

Meet your new financial advisor

Some people will read the book and think, isn’t this a bit grim? Because if they’re in cash they are going to be ‘financially repressed’ by inflation and if they are in shares many will pay large fees. Is there an optimistic view of what you’ve discovered?

Yes, I think there are two optimistic views on it. The first is that once you understand what all your potential pitfalls are in a trading system, you can then effectively game the system. You know where not to lose your money so you can actually be a much better trader. For example if you had just bought passive ETFs [Electronic Traded Funds which follow the stock market], and you buy and hold them, and you were confident enough that the ETF will still be around in ten years, and you picked a low-fee platform – you could keep your costs down to maybe 0.5% a year. But you have to be actively thinking about the markets and have a strategy.

The other reason to be positive, which is something I hadn’t really appreciated until I did the research, was all this stuff about cycles in the market – which I had never really sort of twigged before. Should have done, but haven’t. But I think it is quite likely that there will be some point in the next two years when the market declines to something worth buying, like the FTSE down to 4,000.

If the FTSE goes near or below 4,000 I’m just going to convert all my cash into shares somewhere, because that – if you look into history there are usually 2 or 3 significant lows in a corrective, secular bear market – and if it were to do that one [4,000], it would be the last low before we start a huge bull run over the next decade or so. I want to be fully invested at that point.

It seems as though individual investors are having to spend more time doing research into the shares to achieve better returns. Do you think there is a new gap in the market for fund managers, and people who do the research and do the legwork?

The simple answer is I don’t think there is a gap in the market. If you read the stories about a company and do the research, you will probably make the wrong decision. You remember in the book I talked about the ‘turtle traders’, the guys taught to be a bit like Eddie Murphy in ‘Trading Places’ where they took 14 people off the street and taught them to trade – and they made, whatever it was, half a billion pounds in a couple of years.

One of the key things they were taught was to effectively never read a paper. Never read a news story. Everything you need to know is in the price already, in the graph, and you just need to trade the breakouts. You just look at it and you trade the breakouts, and don’t read.

I pick up my Investors Chronicle or Shares magazine – in fact I won’t even read Shares magazine again – there’s no point, because all it will tell me is something which it is too late to invest in.

So is there a role for those fund managers [who just buy the news stories]? No, of course there isn’t. I think they will just disappear really – when eventually people realise that.

There are some people out there who are some quite clever traders – and if you want to spend a lot of time, I think you can do something and get some positive returns. But for the average Joe Bloggs in the street, it’s a waste of time. So they should go for a simple thing like passive index trackers if they want to dabble in the stock market.

But if you’re going to dabble, you still have to think about whether you should get in here or there?

I think the answer is, like Buffett, you should buy when the stock market is cheap.  I think my strategy in the future will be one of being a bit like a panther. Just sitting there in the long grass, sleeping, and when some kind of injured animal comes along, I’ll jump out and kill it and I’ll eat it and then I won’t bother to eat for a week or two. Wait for the injured prey to come by.

I agree though, timing is the difficulty – that is where you need a set of rules. For me, I see that FTSE below 4,000 and I don’t know at what point it is going to stop, but if I can get in anywhere below 4,000, I am going to be a happy bunny, long term. In the short term, I might be thinking, I could have got it cheaper, but I’ll still be happy long term, because the potential to go lower isn’t very likely. I might get my darts out as well, and pick ten shares at random – because I know how well that strategy works [i.e. the monkey with the pin]. Some of them will be dogs, but some of them will be stars. I will buy the monkey another banana.

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At this point, I talked to Pete about the effect of benchmarking on fund managers portfolios – how benchmarking encourages fund managers to strive towards mediocrity, and to not take risks. The implicit mentality is: “if we fail, we will fail together”. The net effect is that everyone holds similar portfolios and the performance is very closely aligned. No one stands out for brilliance, nor does anyone stand out for shoddiness. For the second version of his book, Pete plans to add another section on this.

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You said managers can’t really perform consistently, so should they exist?

Well, I think that whole industry will get disintermediated. I’ve seen it in my industry, I’m a market researcher, in fact I partly helped disintermediate it. I was one of the first people doing online surveys in this country. The industry tried to take me to Professional Standards, for bringing the industry into disrepute by running an online survey. They really were fearing what it would do to their business. They didn’t in the end. Since then the industry has radically changed and the same is going to happen in the fund management industry. People have realised we don’t need most of them.

What I am expecting is that the number of fund managers will shrink substantially, I think we both agree on this, but presumably there will still be a place for good fund managers.

I think there are genuinely people out there who are better than the average and it would be great to know who they are. They are never going to be perfect all the time, but even if they can only do it better than chance, they are worth following. At the moment though there probably aren’t the incentives in the system for them to be able to follow their own real style because of the reasons you were saying. They are being benchmarked all the time. They might have a personal style like mine where they hold cash for a while, and invest at the right time. If you had that kind of style as a fund manager you couldn’t survive the system. But it probably is a more successful strategy.

You make an important point about incentives and I think that it what this industry boils down to. Because if you are an average fund manager, you just need to have an average portfolio, make it similar to your peers – then you get paid your management fee. Is the solution to this to say – you may not charge an annual fee and you can only charge based on your performance?

I agree – the incentives aren’t right. I think there is a lot of logic to that because at the moment the system doesn’t work. If they fail, the punter pays, and if the thing succeeds, the punter pays and is also charged an extra performance fee. It’s not very equal is it? They should only receive a payment if they beat the average – that would wipe out most of them.

The other point is to avoid drawdowns. For example, if a fund manager loses 50% of your portfolio like many did in 2007/8, then you need to have 100% return just to get even again. There needs to be an incentive there to limit the downside risk of these portfolios. Say, if the managers lost you money they would have to make it good themselves.

That would be nice. But wasn’t that the concept of with-profits policies? The life insurers used to sell them a decade or two ago, they said they would smooth out the returns so that if the markets turned down they would chip in some reserves. They weren’t as generous as thought because they were just pocketing most of the profits during good years – so they had big reserves to chip into during the bad years. There’s something unequal about it.

That rounded off our interview and I’d just like to thank Pete for his time and for writing his brilliant FREE book, Monkey with a Pin

 
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Posted by on May 6, 2012 in Trading Ideas

 

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