What About Those Banks & Mortgage Loans?

My friend B is a banker and mortgage banker of many years and great wisdom. A few days ago, he sent me the following email, as part of an exchange regarding the turmoil at Freddie and Fannie, and my recent post about them,

"I don't know what a "best option" is in the longer-term. Too much is unknown and seen through a political fog. We have not dealt with the consequences of moving towards the "financial utility" (or "supermarket" take your choice) dominated banking system without the constraints of a Glass-Steagle-like control for the transition. Some of the consequences of this are playing themselves out, e.g. the placing of investment banking under the sway of the Fed. The problems at Fannie and Freddie resulted at least in part from the excesses of firms controlled by incompetent and management and regulators, the blur between banking and investment banking, greed, housing policy, real estate cycles, ignorance and huge, highly concentrated risky holdings and murky politics, not securitization, standardization , etc.

In the short-run the U.S. government needs to assure bond (mortgage-backed and debentures) holders that the credits in the holdings are secure (I am far less concerned about share holders). Too much is at risk in pension funds, banks (commercial and thrifts), governments (foreign and domestic) , insurance companies, etc. The current means being adopted are probably OK in the short-run but should not be a surrogate for a longer-term solution. In the longer-run we need to come to grips with the world of the financial utility and its mechanisms.

As to the Indy Mac's (arguably a creature of the housing bubble) of the world, it seems that the market and the regulators are properly handling things.

I believe we are into a very long process of "hunt & peck" solutions, driven at least as much by political as economic motives. Giving Americans a piece of the rock has been a core philosophy of our society for quite some time. It is a bedrock (no pun intended) of an enlightened capitalism and a protective edifice against unsettled populaces. The governments at the Federal and local levels have been intimately involved in facilitating home ownership and Fannie and Freddie are just pieces of this environment.

Perhaps the inertia resident in the world of banking has been impacted by a outside forces great enough to change things, but to what end?"

B makes a great point as to why our government has the goal of home ownership. It tends to keep citizens viewing society as owners and participants with something to protect, rather than a mobile rabble prone to discontent. And it fosters healthy values along the lines of community welfare.

But the much, much larger picture seems to me to be, as always, B's focus on 'financial utilities.' B is the guy who, to my knowledge, first used the term in a phone call with me back in 1996, when I was the (first) Director of Research for the then-independent financial consultancy, Oliver, Wyman & Co.

Today's Wall Street Journal added perspective to this mess when it reported on Chase posting losses for last quarter that were 'not as bad as expected.'

It then went on to note that PNC's net income actually rose for the quarter, because it had never strayed from its simple, regional focus on traditional commercial banking.

Therein, I believe, lies the lesson regarding B's 'financial utilities.'

Banking is a derivative business. Unlike, say, Google or Intel, banks don't really 'create' value, beyond some simple, liquidity- and time-shifting aspects of financial management. And, if done properly, by some risk-sharing which diminishes overall financial risks of lending, a/k/a diversification of portfolios.

That being said, how can banking ever really be, as a sector, a long-term, consistent growth business?

It cannot. Pure and simple. It cannot.

Thus, B's comment that regulators have some good short-term fixes working, but a long term solution is, as yet, undetermined.

I believe this is because of human nature and the effects of technology on banking. As I wrote late last year, regarding Henry Kaufman's comments on financial services sector regulation in this post,

"In the process of their evolution, various financial systems came to increasingly on technology. This reliance, as it has in other industries, drove two important structural changes. First, the rising costs of technology made size profitable, driving consolidation in businesses such as credit card issuance and processing, as well as mortgage loan origination and servicing. Second, concurrent with this consolidation came lower fees for the same services.

In business after business, save, perhaps, for boutique services such as high-end private banking and investment banking M&A activities, scale has become important for driving costs down and making financial services ubiquitous to those who need them, be they retail consumers, investors, or institutional investors or credit customers.

In the decade since, commercial banks, contrary to accepted financial theory that an investor can diversify his/her own holdings better than a company can do it for him/her, sought these types of businesses to attenuate variation in their reported earnings, as well as pursue the mythical 'cross sell' opportunity amongst various retail businesses.

The results have not been impressive, as I noted in this post two months ago.

My point is that, over time, financial conglomeration does not, in fact, lead to consistently superior shareholder total returns. In fact, the only currently, or, for that matter, historically frequently-appearing large financial institution in my equity portfolio is Goldman Sachs. It's not a widely-diversified financial services company. Rather, it tends to specialize in two areas- institutional businesses, such as underwriting and trading, in which superior knowledge, modeling and risk management matter, and asset management, which shares the same salient characteristics.

The price that US consumers have paid for financial services innovation and cost reductions over the past five decades has been the concentration of many financial services into fewer, larger entities, which concentration has increased risks to the banking and credit system.

In fact, one of the few benefits, besides technological innovation, that recent consolidation affords is larger capital bases with which to absorb the effects of mistakes.

Looking back over nearly 50 years of US financial system innovation and evolution, I think one could fairly say that the benefits we have enjoyed have far outweighed the realized risks that have accompanied such changes. "

But what we now face is the problem of name CEOs of very large banks- Chase, BofA, Wachovia, Citi, Lehman, Morgan Stanley, Merrill Lynch- who wanted to attain star status through asset and profit growth way beyond the natural limits of the financing needs of the population.

My proprietary research on what factors drive consistently superior total returns in companies vary markedly between higher-growth and lower-growth companies.

The former group, to which banks, over longer terms than, say, three years, belong, succeed by managing ROE and expenses, not by investment in growth.

I hate to say it, but Jamie Dimon is probably the right kind of CEO for Chase. He is not very skilled in anything but taking out expenses and micro-managing his managers. A chip off of his old mentor Sandy Weill's now-discredited block.

But ironically, whereas Sandy came a cropper trying to gun for growth with a hybrid of insurance, investment banking, brokerage and commercial banking, Dimon has only to squeeze down on businesses at the typically-staid and slow-moving Chase.

I'm not saying Dimon will ever make Chase a consistently superior total return company. But I do think he has the potential to manage the financial utility, now, according to the Journal, the largest US commercial bank by assets, in a manner that avoids catastrophic losses.

And that, frankly, is just about what my friend B prophesied to me back in 1996. A few very large financial behmoths which would be incapable of fast growth or nimbleness, but would dominate share in the conventional, everlasting banking businesses of: deposits, revolving credit, mortgage finance, various service/processing businesses and basic asset management.

Which brings me to my conclusion for this post.

What about those banks and mortgage loans?

Well, the loans were made by inept bankers, allowed by their CEOs, in hopes of attaining unattainable consistent long-term revenue, profit growth and total returns. Eventually, the shareholders of the companies which made those loans must foot the bill.

And the banks?

Well, this morning's Wall Street Journal announced that Freddie is contemplating selling new equity.

Who, honestly, would be so stupid as to buy any, short of a pure political/regulatory play?

I believe that the financial utilities will rarely be investments that can consistently outperform the S&P500. As such, they won't be candidates for my equity or options portfolios. The nearby, two-year price chart for Wells Fargo, Chase, Citi, Wachovia, BofA and the S&P500 Index clearly demonstrates my point.

Not one of these banks beat the index.

I suppose if you want a bond-like return in a necessary enterprise, you could do worse than owning a less-ineptly-managed large financial services conglomerate.

But why would any intelligent person hold a money-center or large publicly-owned investment bank as a long term asset anymore?