Kessler's Views On Banks

Andy Kessler wrote an editorial in Thursday's Wall Street Journal entitled, "What's Next for the Banks?" I must admit, as someone with experience in and observing the sector, I found his piece difficult to comprehend. By this, I don't mean its difficult to understand the text or ideas. Rather, it's difficult for me to understand why he wrote it, and why the Journal bothered to waste space publishing it.

Kessler, if memory serves me correctly, was a hedge fund manager turned venture capitalist. A bio of Kessler appears here, for what it's worth. Much is made of his beginning as a Bell Labs engineer and subsequent Wall Street sell-side analyst in the technology and communications sector- not banking.

The first half of Kessler's editorial sums of financial sector activity for the past half decade or so. He covers the expected landscape- CDOs, SIVs, subprime mortgages, etc. Nothing surprising there.

For instance, Kessler writes,

"First, no one, and I mean no one, is going to buy a package of loans without knowing what each and every one of them is, what the risk of default is, etc. Rating agencies can no longer be trusted. The good news is that the same computer technology used to create CDOs can easily be extended to offer this needed transparency, loan by loan. But the bad news for investment banks: The packaging game just won't be as profitable."

Well, duh! Thanks for that, Andy. I'd never have guessed that the failure of CDOs to even have a market anymore would imply that people may not buy them anymore without detailed knowledge of their constituent securities.

Kessler then writes,

"So who has the strong hand? As always, it's a capital game, whoever accumulates the most will be best positioned for what's next."

I disagree. Capital accumulation certainly matters, but I don't think it's a "most" sort of thing. If anything, Kessler misses the point that having so much- too much, actually- capital is precisely what has gotten many financial firms into trouble. They fail to diligently allocate it, and the result is what we see in recent months. Failed risk controls, sloppy capital allocations and wastes of funding.

After cursorily tossing off predictions of what will happen with banks, investment banks, private equity and hedge fund shops, Kessler then states,

"My view is that firms that successfully combine banking and investment banking will walk away with the prize, by being able to offer a full range of services to clients -- short-term loans against assets or receivables as well as bonds and equity for long-term projects, the kind of underwriting and trading that requires large amounts of capital. The inevitable consolidation that should have occurred after Glass-Steagall (the 1933 law that separated banks and investment banks) was repealed in 1999 had been on hold while everyone chased easy profits. But now the shakeout is here.

I can't be sure what Kessler means by "walk away with the prize." If he means that some institutions(s) will enjoy short-term share gains and profits, he may be right. If he means what I mean, though, i.e., earning consistently superior total returns for shareholders, then I think he's completely in error.

First, he misses the salient fact that Sandy Weill merged Citigroup and Travelers while forcing the rescission of Glass-Steagall. It's simply not true that "everyone chased easy profits." The era's penultimate combination failed.

Second, it failed because, as I noted above, attempting to manage too many assets at once typically leads to one, or both, of two mistakes. Either a firm pumps growth in its narrow business lines until they blow up from taking on too much risk. Or the firm spreads into many businesses, bringing cultural clashes and allocation conflicts that eventually make the firm entirely too difficult and complex to manage, a la Citigroup.

Kessler's next contention is,

Goldman Sachs will own a bank, maybe even Citigroup (Goldman's $85 billion market capitalization might be able to swallow Citi's $125 billion value) and strip it down to what it needs. JP Morgan should reunite the House of Morgan by merging with Morgan Stanley, and become a full-service powerhouse. But JP Morgan could buy Merrill or Lehman or Bear Stearns instead. Bank of America will merge with who's left. But don't count out others who have done well with capital. Fortress Investment Group, despite a rocky IPO a year ago, has a powerful real estate arm that could own loan origination and servicing and enough assets to buy its way into the banking or investment banking business. Same for the Blackstone Group."

What would Goldman possibly "need" from Citigroup? The former travels fast and hits hard. Commercial banks are ponderous and can't pay enough to truly attract, nor compete with, the best investment bank, hedge fund or private equity talent. Further, "buy(ing) its way into the banking or investment banking business," as he writes of Fortress or Blackstone, is exactly how firms lost billions. If all they can do is bring money to the party, they're likely to lose a fortune. Witness Merrill and Citigroup.

Further, in the wake of the past several years' financial stumbles, it's unlikely that regulators want or will tolerate even more concentration of risk assets among a few financial mega-utilities.

Additionally, there are fairly arcane rules governing the maximum market share of various deposits that a single bank may hold. Further concentration among the larger commercial banks is unlikely. Cross-business mergers will only give us another complicated financial titan, like Citigroup, which will promptly become confused by its own management agenda. Most commercial bankers simply aren't sufficiently smart to handle an institution like that. Most non-commercial financial wizards are smart enough to know better.

Kessler concludes,

"Capital flows a lot more fluidly around the globe these days. Expect consolidation to start now. The real winners on Wall Street will be the ones with huge stockpiles of capital who listen to the market, and who are fleet of foot enough to smell out and deploy their capital creating instruments that global growth companies need, rather than false profits from eating their own sausage."

I don't think so. See my comments above regarding further consolidation. Kessler states an oxymoron, "winners on Wall Street will be the ones....with huge stockpiles of capital who...are fleet of foot." That's more or less an empty set there. At this juncture, the smart set running Goldman, Fortress and Blackstone probably realize the cultural problems of buying anything large and meaningful. More likely, they'll simply watch and wait to use their existing capital to exploit opportunities for which they are well positioned.

In my opinion, Kessler sees a major sector reshuffling and consolidation that just isn't in the cards, for a multitude of reasons, some of which I have expressed. Such consolidation, if it does occur, is more likely fated to result in more large-scale losses and risk management failures.