Sure, we’re facing the worst market conditions most living people have seen. And compared with almost all its global peers – dead and alive – Macquarie is in an enviable position. But for those of us who have been long-term supporters of this business, its people and its business model, $1.14bn in write-offs – more than 10% of shareholders’ equity – and plenty more to come at current market prices is a slap in the face.
The net effect on shareholders is substantially diluted because staff and the tax man wear most of the pain, but this is Macquarie. Macquarie doesn’t do writedowns, because it doesn’t, or didn’t at least, take risk. Making money with other people’s money has been the true Macquarie model for decades.
The business sailed through the early 1990s recession that brought Westpac to its knees. The Asian Crisis of 1997 and Russian debt default weren’t even speed humps – the only effect on Macquarie being that it picked up ING’s Asian business on the cheap. The dot-com bubble burst in 2000 and brought a few would-be investment banks down with it – but not Macquarie, its exposure was next to nothing. Enron and WorldCom collapsed in 2002 and contributed to a three-year global bear market. Macquarie’s 2003 profit was 33% higher at $333m. The bank’s conservative approach and strong risk management has protected it from the greed and folly that typically brings investment banks unstuck.
During the 12 years between 1991 and 2003, profit grew at a fairly consistent 15% per annum. Towards the middle of this decade, however, profit growth exploded. Macquarie bettered the 2003 number by 48% in 2004, added another 48% in 2005, 29% in 2006 and a whopping 55% in 2007. The 23% increase in the year to 31 March 2008 meant profit had increased almost sixfold in five years, compared with a doubling in the five before that.
Shareholders might have cheered at the time – the share price rose from $20 at the start of 2003 to $98 in 2007 – but they’re not cheering now. Somehow, somewhere, the idea that it’s better to risk others’ money than your own got thrown out the window.
For me, the most disappointing losses were on the US and Italian mortgage books. A former Macquarie colleague bristled when I expressed my disappointment at these exposures. He suggested it was impossible to foresee losses of this magnitude on ‘high quality’ mortgages. I beg to differ. But even if he’s right, this company’s stated strategy is to ‘expand selectively, seeking only to enter markets where our particular skills and expertise deliver real advantage to clients.’ What expertise could Macquarie possibly have been bringing to the US mortgage market – probably the most over-serviced loan market in the world?
And then there’s the $3.8bn invested in its own funds. This is partly a result of fees being paid in securities, but Macquarie has also been buying substantial amounts of Macquarie Infrastructure Group and Macquarie Airports on the market. Using complicated financial models to convince the banks to lend the funds a fortune is one thing. Believing them yourself is another thing altogether. Surely Macquarie already had enough exposure to this boom sector – through base fees, performance fees and advisory fees at risk – without committing billions of dollars of its own capital.
It could have been a whole lot worse. Shareholders can thank US billionaire and hedge fund manager Samuel Heyman for scuttling the Macquarie consortium’s ridiculously optimistic $5.60 bid for Qantas. That would have been a disaster. It would have been a bigger one had Macquarie won the bidding duel with Babcock & Brown for Alinta – a business we labelled Australia’s next Enron. The stupid price paid for this company has done more than anything else to bring the Babcock empire crashing down. It could have conceivably been Macquarie. And the millionaire factory isn’t out of the woods yet.
The 30 September balance sheet still contained $6.7bn of investments in its own listed and unlisted funds and assets held for sale and there remains the risk of further substantial writedowns. In fact, management’s rhetoric about not valuing these assets at current market prices sounds a lot like the mortgage-backed securities rhetoric coming out of US investment banks 12 months ago – more wishful thinking than anything else. But the risk of collapse looks remote. The government guarantee of deposits and interbank lending has removed the potential for a run on the bank. The match between short-term assets and short-term liabilities is the best I’ve seen of any bank.
It’s trading at a discount to book value for the first time since the business listed in 1996 and hopefully the humble pie currently being dished out will herald a return to the more conservative days or yore. But the behaviour of the past few years suggests Macquarie has become much more like a typical investment bank than it once was. Perhaps it’s not possible to maintain that innovative, niche market culture with 13,000 employees. It’s obviously a lot more difficult with $3.4bn in new shareholders’ capital, raised in the past eight years, on which it needs to earn a return. Either way, the days of seemingly low-risk returns on equity in excess of 20% are surely over.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.