Monday, September 29, 2008

Financial Sector Self Healing? WaMu & Wachovia

A lot has transpired in the financial sector in just the last five days.

With lightning speed, the OTS sold WaMu to Chase, while Wachovia, one of the five largest banks, and seemingly healthy only last year, desperately seeks a buyer to keep it from insolvency.

So, let's review the past month or so.

Treasury finally seized the badly-run, bloated and badly-designed Fannie Mae and Freddie Mac, after their ability to raise capital to continue operations became doubtful. Then Lehman Brothers was allowed to fail when its capital-raising abilities fell short of its needs.

AIG was taken over with 80% ownership by Treasury, to avoid a Chapter 11 filing which would have thrown into doubt the firm's insurance and asset management's units ability to function normally.

Merrill Lynch sold itself to BofA just shy of also being forced to go Chapter 11, due to capital shortfalls and it being the next logical target, after Lehman's exit.

A week later, Goldman Sachs and Morgan Stanley both applied for Federal bank charters, completing the exit of the last large, publicly-held investment banks from the US financial services sector.

Does it not appear that, with Schumpeterian certainty, excess capacity among the weakest, worst-managed financial service competitors is being removed without massive, excess Federal intervention?

I don't count Fannie and Freddie because, to be honest, these two mistakes were Congressional piggy banks to start with. Their excesses were purely Congressionally-sourced, so their takeover is, if anything, merely a recognition of the reality that they were an organizational fiction when considered 'publicly-held.'

AIG was a takeover, to be sure. I do not fully understand why the insurance and asset management units were not bundled together and spun into a separate unit, allowing the other, riskier part to fail. Probably a matter of time available to avoid various debt covenant defaults.

Since insurance in America is a state-regulated business, there was no pre-existing Federal authority to handle the AIG mess.

Still, seen from a distance, because of the nature of short-term lending, counterparty risk management, and confidence, the rapid consolidation of this over-capacity sector was really not all that surprising. Unlike sectors such as energy, metals, or transportation, which consolidate over months or years, financial services tends to consolidate due to some institutions' failures, and, thus, happens much more rapidly.

Does this still require a Federal outlay of hundreds of billions of dollars?

I'm actually not so sure. The consolidation of Merrill Lynch, WaMu and Wachovia will already remove quite a bit of excess capacity, while also allowing some significant bad-asset writedowns. In just a week, the size of publicly-held, face-value held CDOs have plummeted. And will fall by more when Wachovia is bought.

What's left to worry about? The badly-run investment banks are gone. The remaining two- one well-run, the other mediocre- are temporarily independent commercial banks, pending their sale to banks with actual branch networks. The remaining large US banks are healthier than the ones that have gone under.

It's fairly comical that Citigroup could be seen as a potential rescuer of Wachovia. With so many lingering, serious problems of its own, Citigroup would only be adding to its inability to create value for its shareholders.

As I am writing this paragraph, at 8:30AM, the news on the wire is that Citigroup is, indeed, buying Wachovia's retail banking operations. Wells Fargo dropped out of the running. Citigroup has its writedowns capped at $42B, with the FDIC apparently on the hook for anything north of that, in consideration for Citigroup agreeing to raise more capital.

Thus, in just a few weeks, my friend B's 1996 prediction of the evolution of US financial services to a point at which only 3 commercial bank 'utilities' would exist has come true. Citigroup, Chase and Bank of America, the original three money center banks with international networks, are, at least in name, the survivors.

The first of two nearby Yahoo-sourced price charts for the past three months for Chase, Citigroup, BofA and the S&P500 Index show the old money center institutions gaining as the riskier financial services players have exited the scene.

As I am writing this section, my friend B emailed me with the press release on the Citi-Wachovia purchase, noting,

"The inevitable agglomeration accelerates. The separation of the bank market into the three major components is becoming more stark, yet the proper business models and their regulatory, etc. environment have not been resolved. We run the risk of the financial utilities becoming government entities. They will most likely behave that way regardless of whether they remain private or not. Innovation departs "Wall Street", which has quite a while ago become more a symbol than a location for innovation, and moves to the ether and its various nodes around the globe."

Over the past five years, however, the same three banks underperform the index. Expect more of the same going forward.

As B predicts, these banks will behave like government-run institutions, if they don't actually have the Treasury as a major shareholder.

B is an extremely smart financial services veteran with a PhD in finance.

He correctly predicted, over a decade ago, that this agglomeration would occur, resulting in hulking, musclebound financial utilities which are incapable of being managed to outperform the equity markets. In effect, he prophesied, they will be the repository for 'safe' banking businesses- deposit taking, basic lending and transaction processing.

Financial innovation, such as it will exist, has departed to private equity firms and, to some extent, their organizational brother, the hedge fund.

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