Breaking up the banks?

The Citigroup logo since 1999, re-introduced in 2012 with blue lettering.

Sandy Weill, the big banker most associated with breaking down the government barrier between investment and commercial banking to form Citigroup, now says that big banks should be broken up to protect taxpayers.  

Richard Kovacevich, the former CEO of Wells Fargo (full disclosure: my clients and I own shares of Wells Fargo), says banks are safer as big banks.

Who’s right?  Who should voters, legislators, regulators, the Federal Reserve, the executive branch, the press, etc. listen to?

Let’s look at their respective records.

Citigroup was formed by the merger of Travelers group–run by Weill–with Citigroup in 1998.  Citigroup’s split-adjusted stock price was over $300 per share in April 1998, the month its merger occurred. Weill was chairman of Citigroup until he retired as CEO in 2003 (Citigroup: $474 per share) and chairman in 2006 ($500 per share).  Weill hired as his successor Chuck Prince, who later became famous for excusing Citigroup’s participation in the sub-prime meltdown by saying, “as long as the music is playing, you’ve got to get up and dance.” Prince chose to enter early retirement in November 2007 after Citigroup blew up.  Citigroup gladly took $45 billion in assets from the government’s Troubled Asset Relief Program (TARP) in 2008 and 2009 and has paid back only 44% ($20 billion). Citigroup also received $306 billion in asset guarantees as part of the TARP program. Citigroup’s stock price crashed to $15 per share in 2009 (down 97% from May 2007), and is currently around $28 (down 91% since the Citigroup merger, and 94% since Weill retired as CEO and chairman).  

Wells Fargo was formed by the merger of Norwest Corp.–run by Kovacevich–with Wells Fargo in 1998.  Wells Fargo’s split-adjusted stock price was $18 in November 1998, the month its merger occurred. Kovacevich stepped down as CEO in 2007 ($35) and chairman in 2009 ($27). Kovacevich’s successor, John Stump, is still CEO and chairman of Wells Fargo.  Wells Fargo was forced (Kovacevich has been quite vocal in his criticisms of TARP and how he pounded the table–literally–trying not to be forced to take the funds) to take $25 billion in TARP funds and repaid them in full as soon as the government would allow it. Wells Fargo received no asset guarantees as part of TARP. Wells Fargo was strong enough during the financial crisis of 2008 to buy out distressed Wachovia (snatched from Citigroup’s clutches because Citigroup required government loss guarantees to buy Wachovia). Wells Fargo’s stock price fell to $12 per share in 2009 (down 67% from May 2007), and is currently $34 (up 89% since the Wells Fargo merger, and down 3% and up 26% since Kovacevich retired as CEO and chairman, respectively).

Basically, Weill created a Frankenstein’s monster of a bank that, not surprisingly, blew up during the financial crisis of 2008. Weill was a deal-maker that used his political influence and bluster to build an unstable house of cards that collapsed with the first real puff of wind. His bank would have gone under without government guarantees that are outstanding to this day. Not only did his bank fail on almost every measure, it destroyed 90% of shareholder value. Why exactly would anyone want to listen to this “expert’s” opinion?

Kovacevich, on the other hand, built Wells Fargo slowly and stably over time. His bank was sound enough to handle the worse financial crisis since the Great Depression, so much so that he could afford to bail out another large unstable bank without any government assistance. He did it because he understood banking instead of political influence. Under his stewardship and that of his successor’s, Wells Fargo has succeeded on almost every measure and has created value for shareholders. Kovacevich is the type of expert that people should be listening to, and he’s not calling to break up the banks.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Breaking up the banks?

Bad Bank! Now, go to your room!

National Bank Oamaru.jpgAs an occasional investor in banks (I currently own Wells Fargo and would like to buy US Bancorp, M&T and Park National), I have to admit to being somewhat surprised at all the bad press banks have faced recently.

As usual, it seems to be a perception versus reality issue, but I believe there is a willful ignorance on the part of both the press and the general public.  I suppose I should elaborate before the hate-mail gets sent.

First off, not all banks are the same.  Just as you shouldn’t judge a person by their skin or gender, you shouldn’t rush to judge an organization simply because it belongs to a particular group.  There are good banks and bad banks, just like there are good and bad people.  

Several investment banks, like Bear Stearns and Lehman Brothers, were gambling with tax-payer dollars, and they deserved to go bankrupt.  Their shareholders and bondholders should have reaped what they sowed, though, and taxpayers need not have been involved.  Nor should bankers have been allowed to gamble with tax-payer dollars.  I don’t blame a 3-year-old for asking for a full-sugar and caffeine soda 5 minutes before bed; I do, however, blame their parents for giving in.  So it is with banks.  I expect a very small minority of bankers will be vicious (that must be accepted in any society), but the real fault lies with a government that supported and encouraged that vice, not with all bankers as a group.

Most U.S. banks aren’t like that, though.  They are more like the Bailey Building and Loan Association from It’s a Wonderful Life: they take in deposits on which they pay interest and lend those dollars out to borrowers at higher interest.  They don’t gamble with tax-payer dollars.  In fact, they provide the vital life-blood that keeps a modern economy like ours flowing.  Lumping all banks together because we know of a couple of bad ones has parallels with Ku Klux Klan “reasoning.”

Also, just because a bank has been “bailed out” doesn’t mean they are bad, either.  Keep in mind the U.S. Treasury and Federal Reserve didn’t give many banks a choice on taking a “bail-out,” and most of those good banks didn’t need or want it.  Once again, this reasoning is like blaming someone raped or mugged for “giving in” instead of blaming the real perpetrator.  Just because some people are ignorant of these facts does not forgive their avowed but poorly informed conclusions.

Second, a lot of what banks have been blamed for recently is the result of well-meaning politicians that are clueless to the point of being vicious.  Let’s take the recent furor over Bank of America charging $5 per month for debit cards.  

A bunch of politicians have decided, in their infinite wisdom, that banks are charging too much for interchange fees.  Instead of letting customers, banks, networks, merchant acquirers, and merchants decide what’s fair, the Federal Reserve is now inserting itself in the process of free interaction to dictate what fees the participants can charge each other.  

These same politicians also decided they don’t like overdraft fees.  It’s not nice, they say, to charge people for trying to buy things they don’t have the money for.  The bank should say thank you to their unmathematical customers instead of charging them for borrowing money without making prior arrangements. (As a side note, I have paid overdraft fees several times in my life and didn’t enjoy it.  I did not, however, blame the bank or society at large for my mathematical mistakes, I was mad at myself.)  

What is the rational response of an organization that has bondholders, shareholders, employees and more-mathematically-inclined customers to take care of?  Raise the same amount of money elsewhere in the form of additional fees!  Why should some bondholder have to eat that overdraft fee or lost revenue from interchange?  Why should the shareholder, or employee, or customer?  They shouldn’t!

No rational person expects one bus-driver to take a pay cut to support another bus-driver who is too lazy to know how much money they have in their account.  Nor do most people think that politicians should arbitrarily cut a bus driver’s pay because some passengers don’t feel like paying that much.  So, why would it be any different for banks?

Banks are now quite logically raising additional fees and turning away customers it used to accept.  In addition, fewer customers are getting credit and debit cards, fewer merchants can afford to accept the cards, and services that were once free–like checking accounts–now frequently require fees.

This is all quite logical and predictable, even to narrow-minded politicians who wish they could have their cake and eat it, too.  The only surprising thing is that they thought their laws would have no unintended impact!

Third, politicians are crying for banks to lend more money while–at the same time–raising their capital requirements (if banks lent more money, all else equal, they would violate the old capital requirements–let alone meet the new ones).  Politicians are also saying banks aren’t being generous enough in offering credit to those who need it while–at the same time–bemoaning the fact that banks have so much bad debt on their books.  The blatant contradictions in both of these views should be obvious to anyone with knowledge of banking, but that apparently isn’t required for politicians who regulate banks.

We don’t need to send banks to their room for being bad.  We need to unshackle them so they can do their jobs.  I’ve read that banks now need 1.2 employees to keep up with regulatory requirements for each employee taking deposits and making loans.  Perhaps if banks weren’t so busy meeting all these new and old regulatory hurdles, they wouldn’t be gambling with taxpayer dollars, charging high interchange and overdraft fees, and they’d be making more loans, offering more services and getting the economy going again.  

That doesn’t seem very likely, though, given all the shrieking from the press, public and politicians about how bad banks are.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bad Bank! Now, go to your room!

The Fallacy of Too Big To Fail

I’ve tried to stay away from the Too Big to Fail discussion, but after doing research on the banking sector recently, I decided to put in my two cents.

First off, “too big” assumes some standard.  It assumes that something of a certain size is “good,” but when that size becomes “too” much, it becomes “bad.”  (What, like too much health, too much peace, too much prosperity, too much happiness, too much virtue?)  By what standard?  For what goal?  By whose judgment?  No data or references are provided by most of those who make this argument, which makes me suspicious right-off.

Lately, this argument has been made with respect to banks.  “XYZ Bancorp is so large that it can take down the whole financial system” seems to be the implicit line of reasoning behind the Too Big to Fail discussion.  Does that mean breaking XYZ into 10 or 100 or 1000 small banks that all fail at once is better simply because they are each small?  Are lots of small failures good and one large failure bad?  Is smallness somehow an implicit good?  No. 

I guarantee that if you break XYZ into lots of pieces that all have the same debt to equity ratios and loan exposures as XYZ as a whole, they will all fail at the same time.  And, you’ll end up in an even worse situation than if an integrated XYZ bank had failed.  Too big or small isn’t the issue, the real issue is leverage and loan exposure. 

The Too Big to Fail argument assumes that somehow lots of smaller banks will not fail at the same time but one large one will.  Oh, like lots of small banks did so much better than large banks because the housing market can’t possibly crash nationally (note: I’m being sarcastic).  Oops, that argument didn’t float.

The housing sector crashed nationally and that almost took down our financial sector and the rest of the economy for reasons other than large banks.  The banks were a symptom, not a cause. 

If banks weren’t back-stopped by the FDIC and Federal Reserve and driven to hold low equity to capital, they wouldn’t have crashed due to too much leverage. 

If home ownership weren’t explicitly supported by Congress, the Executive branch, tax policy, FHA, GNMA, Fannie Mae and Freddie Mac (government supported enterprises), etc., then all kinds of mortgage derivative instruments would never have been created and crashed.

If the government hadn’t driven the creation of rating agencies and given three of them exclusive control of debt ratings that banks, insurance companies, etc. must use in the purchasing of securities, then risky securities would never have had a huge, captive markets in the first place.

If the Federal Reserve weren’t encouraging speculation with interest rates below free market equilibrium, there never would have been massive mis-allocation of capital to the housing sector all at once.

The only thing that seems too big here is government intervention in banking, housing, debt ratings, and interest rates.

Back when banking was more free (it’s always had lots of government interference), banks carried 40% equity against 60% in liabilities.  With government back-stopping and lots of regulation, that ratio is now 10% equity to 90% liabilities (it was 7%/93% right before the financial crisis).  Perhaps things were safer when banking was more free.

The history of bank failures in the U.S. has smallness written all over it.  Our regulatory structure has long encouraged lots of small banks.  But, a small bank in Iowa is very likely to crash and depositors to be wiped out when an inevitable bad corn crop occurs.  In contrast, a large bank with loans to corn farmers in Iowa, gold miners in Nevada, cotton growers in Mississippi, steel manufacturers in Indiana, orange growers in Florida, cheese producers in Wisconsin, etc. is unlikely to have all loans default at the same time, thus protecting depositors and borrowers.

Unless, of course, speculation is encouraged on a national level, or large banks are driven to hold 10% equity to 90% in liabilities.  That doesn’t happen, though, without national coordination–in other words: without a national regulatory structure that lines up the dominoes to fall at the same time and in the same direction. 

If leverage and loan exposures were the problem, wouldn’t greater regulation of those issues fix the problem?  No.  Not all banks are the same, and so no regulatory body can foresee all the potential business mix issues that might come up (only someone omniscient could).  JPMorgan, with international operations, investment banking services, and proprietary trading operations, has very different risk exposures than U.S. Bancorp’s community banks.  You can’t come up with one-size-fits all prescriptions for either debt ratios or loan exposures.

In addition, any attempt to prevent problems is more likely to create systemic risk, because a bunch of banks marching to the same music are much more likely to fall together than several separate banks marching to their own drummer (each might fall on their own, but not together systemically).  This is the same reason why periodic recessions and small fires that burn the underbrush prevent catastrophic problems.

The road to hell is literally paved with good intentions–which frequently take the form of national (or international) regulation.

I can’t help but point out one other blatant inconsistency of the Too Big to Fail argument.  If bigness is inherently bad, then why have a BIG, super-governmental body to oversee, break-up, regulate and control banks or any other sector of the economy?  Wouldn’t its bigness be an inherent threat? 

Please keep in mind, too, that no markets in the world are as highly regulated as housing and banking, the epi-center of our latest financial crisis.  Big regulation didn’t help there.  In fact, I strongly argue it created the problem. 

When looking at bigness, it’s useful to recognize that the regulatory bodies are already much bigger and more powerful than the regulated. The Federal Reserve made $80.9 billion in “profits” last year (by trashing our currency and punishing savers, no less) compared to the two most profitable non-governmental businesses: Nestle’s $37 billion and ExxonMobil’s $30 billion.  At least Nestle and ExxonMobil produced things people wanted to buy!  I won’t even mention the ridiculous spending power of other federal government branches. 

If bigness is the problem, then banks or any other non-governmental businesses are the wrong target for concern.  But, even there, the concern is not size, per se, but what an organization does.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Fallacy of Too Big To Fail

Is the banking crisis over?

For those of you who want to see my latest quarterly client letter, it’s here.

Banks stocks took a beating over the last several weeks, and it created some wonderful opportunities to buy top-notch banks at rock bottom prices.

Not only was I a buyer, but an eager buyer of certain companies. But, not all banks are equally good, and just because I’m buying specific companies at specific prices is not a statement that banks stocks have hit bottom.

I don’t try to pick bottoms because I don’t know that anyone can. It’s like forecasting the weather, you can get in the ballpark with some guesses, but you never really know exactly what’s going to happen.

If you don’t believe me, look at the annual hurricane forecasts over the last several years. They are pretty far off on an annual basis, but pretty accurate over 5 year time frames. Sounds like the stock market in many ways….

Back to bank stocks. I don’t know if crowd psychology has signaled capitulation in bank stocks in general. I don’t believe so. I think poorly run banks will be announcing significantly worse results as the impacts of a slower economy ripple up into more loan defaults and delinquencies.

I’m buying now because good banks hit very good prices, not because I know when bank stocks will bottom. In fact, I may very well have opportunities to buy the companies I just bought at even lower prices.

As the stock market continues to recognize that the 3rd and 4th quarter won’t be so peachy, I’d expect it to roll over further. It also wouldn’t surprise me that what we’re currently seeing is short covering and mere reactions to short term noise.

When will the market and banks stocks really bottom? I don’t know, but my guess is that people will be talking less about buying bargains at that point, and more about running for the hills.

As Rothschild said, “Buy when there’s blood in the streets.”

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What’s next for the banking sector?

What’s made the stock market so jittery lately? Was it oil prices or commodity run-ups? I don’t think so. I think what’s bugging investors is: will something bad happen in the banking sector?

So far, the banking sector has suffered from defaults on higher risk mortgage investments. Some of these were subprime, some were Alt A (a step up from subprime, but not prime), and some have been home equity loans. All were bad loans and bad investments to begin with.

Because many market participants were buying mortgage investments with other people’s money (read: borrowed money), this part of the market really suffered when it became clear that almost no one knew what the mortgage investments they bought were worth.

But, so far, the banking sector hasn’t really suffered from major defaults on business loans, credit card loans, auto loans, prime mortgages, etc. In other words, the banking problems that started in March of 2007 have almost entirely been an investment phenomenon, not a broader bank lending problem, per se.

The question now is: could that change? Could the problems seen so far be the tip of a broader loan default problem? Could the economy be rolling over into recession and signaling that loan defaults will increase across the board?

If the answers to these questions are yes, the the problems in the banking sector, and the rest of the economy for that matter, may only be getting started.

Can the Federal Reserve fix these problems? Many people believe they can, but some strong dissenting opinions, even from within the Fed, are starting to question the validity of this premise.

The Fed may control interest rates and be able to bail out banks, but not without cost. The cost, in most cases, is higher inflation. With soaring energy and food prices, this will not be welcome news.

The other problem is that Fed actions are creating moral hazard. When you bail out stupid risk takers, they learn a bad lesson: they either make a ton of money making risky bets or they get bailed out. “Heads I win, tails you lose.” This may be leading to even more bad lending and highly levered investing.

What’s next for the banking sector?

It all depends on fundamentals at this point. Either banks have made good loans and have enough reserves to weather tougher times, or they don’t.

If they don’t, then expect the banking sector to hit new lows as more and more news comes out that broader loans–like credit card, auto, business, commercial real estate, prime mortgages–are hitting higher default levels.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.