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?

Big bad banks?

Just a quick note: the U.S. Federal Reserve made $78.9 billion in 2011, second only to its 2010 record haul of $81.7 billion.

Feeling curious, I decided to look up how much money the U.S. big four banks made in their peak years.  Combining their best, Bank of America (2006), Citigroup (2006), JPMorgan (2007) and Wells Fargo (2010) had combined peak earnings of only $70.1 billion (full disclosure: my clients and I own shares of Wells Fargo).

In other words, the banks that are supposedly the cause of all our earthly problems didn’t together, looking at their peak earning years(!), match what the Federal Reserve made by itself in either of the last two years.

The bozos of Occupy Wall Street and everyone else who believes all our problems are due to the greedy, too powerful big banks need a reality check.

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.

Big bad banks?

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