COMMENT: How bad is it really at Russia’s VEB?

COMMENT: How bad is it really at Russia’s VEB?
VEB’s HQ in Moscow.
By Mark Adomanis in Philadelphia June 27, 2016

When pulling together the information for this commentary, the very first thing that caught my eye was that VneshEconomBank (more simply, VEB) had recently changed its auditor. After using Ernst & Young for more than nine years, VEB suddenly switched to BDO.

By itself this doesn’t prove anything, of course; companies change auditors all the time for all sorts of reasons, most of which are mundane. But I remember from my accounting classes that if a sudden switch in auditor coincides with public accusations of financial impropriety, then the story is rather different. Companies that switch auditors under these circumstances are, statistically speaking, far more likely to experience various kinds of nasty things like asset impairments, revenue re-statements and re-valuations of liabilities. That’s not a moral judgement about auditor changes, it’s merely the result of regressions run on a lot of companies over a very long period of time.

And VEB’s finances have, to put it mildly, been under just the slightest bit of public scrutiny as of late. Several weeks ago Bloomberg published a scathing overview of the bank’s financial position with the less than subtle title of “Putin’s Once Mighty Bank for Pet Projects Now on Chopping Block”. The article quoted a number of insiders speculating about potential scenarios for the bank’s future. None of them was good and they ranged from the receipt of a large (at least $20bn) bailout from the government to a restructuring/downsizing that would leave the bank in a radically reduced and unrecognizable state.

Due to the bank’s political sensitivity there haven’t been many specifics about precisely what (if anything) it has actually done wrong. But there does appear to be a general acknowledgement that the bank is in trouble. VEB’s financial statements bear this out. It has recorded enormous net losses over the past two years: in 2014 it lost RUB250bn (€3.5bn), while in 2015, if you strip out a RUB330bn infusion of government cash, it lost even more.

Now, on the one hand, VEB is supposed to be a state development bank, so making money isn’t its primary or even secondary goal. It is designed to invest in projects that other commercial lenders would eschew because they are too risky, too costly, or would take too long to pay off. The standards by which it should be judged are rather different than what we would apply to, say, JP Morgan. But even with a relatively loose definition of what we would expect to see from a bank, VEB’s financial statements paint a dire picture. Consider the chart below.

VEB’s balance sheet has grown really quickly over the past decade, from roughly RUB330bn in 2006 to more than RUB4,000bn in 2015. That’s explosive growth, as rapid as that experienced by American banks in even the most crazed periods of the mid-2000’s real estate bubble. Without too much hyperbole, VEB has been loaning out money as quickly as it can.

At the same time VEB’s net income has barely budged. Back in 2006, the bank recorded net income of about RUB8bn. In 2013 it recorded net income of… about RUB8bn. The problem is that in 2013 the bank’s balance sheet was more than ten times larger than it was in 2006. There are, as you might imagine, a great many ways in which a bank’s balance sheet can grow by a factor of ten but throw out the same level of net profits. The problem for VEB’s management, and the Russian government, is that none of them is good. It is evidence (extremely strong evidence) that the quality of the assets on the balance sheet leaves something to be desired.

The question then becomes, “what are VEB’s assets really worth?” When it comes to large, complex financial institutions the question of “real” value can be a surprisingly abstract, almost philosophical one. Matt Levine’s hilarious rumination on Bank of America (“There is no objective reality. At best, there is a probability distribution…”) is a classic of the genre, but the simple fact is that the accounting for an entity like VEB is inevitably going to use a lot of estimation and forward-looking predictions. And even small changes to these estimates can meaningfully improve (or worsen) the bank’s apparent profitability.

VEB discloses the fair value of roughly RUB3.9tn worth of assets and about RUB3.6tn worth of liabilities. “Fair value” is basically an accounting terminology for market price. For some kinds of assets and liabilities that are actively traded in deep, liquid markets (eg. government bonds), determining the “fair value” is as easy as going to the nearest Bloomberg terminal. You don’t need a PhD in statistics to work out how much VEB’s holdings of Russian government debt are “really” worth. You just see which bonds they own and look at the current prices for those bonds.

However, there are many kinds of bank assets and liabilities (customer deposits, loans) that are not traded in deep public markets. Indeed, they aren’t traded at all. The great majority of the assets (77%) and liabilities (71%) for which VEB discloses fair values are in “Level 3”, which is a category where valuations are based upon “significant unobservable inputs”. Even under the best of circumstances, valuing items in Level 3 requires a lot of guesswork and management has a lot of discretion in its estimates.

Given the rapid growth in the size of VEB’s balance sheet over the past decade, it seems safe to assume that management has been relatively aggressive in its valuation methodology. More conservative accounting policies would have limited the extremely rapid headline growth in VEB’s balance sheet.

But while management has substantial discretion for valuing Level 3 assets and liabilities, at a certain point economic reality enters into the picture: the investments are either going to generate cash or they are not. And the cash flows suggest that this is simply not taking place.

Consider the above chart, which shows VEB’s cash flow from operations. The bank has been burning through money at a prodigious rate, a cumulative RUB1.3tn since 2006. Yes, it is true that you would expect that, as it ramped up operations and rapidly increased its lending, VEB would burn through cash for a certain period of time. The investments the bank was making were long term in nature, and would not be expected to generate lots of cash very quickly.

But there is no sign that this has changed, or that it will change at any point in the near future. VEB’s operations are continuing to burn through cash just as rapidly as they did several years ago. Perhaps this will turn around in the near future, but there’s little reason to expect so.

Maybe Russia’s economy will turn around and boost VEB’s fortunes. At the moment, however, it is easy to see why the bank is in the financial press’ crosshairs and very difficult to see how it will resolve very complex (and likely expensive) financing needs.