Regarding Investing In Commercial Banks

This week's European government and financial tumult brings me to once again review the position of large US commercial bank CEOs, led by Chase's Jamie Dimon, that their firms should be allowed to take risks, presumably in order to drive high total returns.

At issue currently are two changes which bank managements despise: the Volcker Rule and higher primary equity capital requirements. The former strips large commercial banks of the ability to pursue riskier profits via proprietary trading, while the latter adds capital, which will depress returns on assets.

It's fair to say that, with recent hindsight, on average, the Volcker Rule will minimize societal costs of banks trying, but usually failing, to earn profits on risky trading with their own capital. The recent financial crisis demonstrated that those financial concerns capable of not losing on such risky trades are small in number, and often privately-held, while the larger US commercial banks carry deposit insurance, and, thus, indirectly, are themselves insured by the US federal government. The Dodd-Frank bill has made such insurance of firms explicit.

After several decades of US commercial money center banks cyclically posting large losses on everything from sovereign lending to credit cards, mortgages, and energy lending, requiring higher capital levels doesn't seem so harsh.  For example, as I noted in this recent post, fund manager Ron Baron declined to invest in Jon Corzine's now-failed MF Global in part because, with capital constituting only 3% of assets, the risk of total loss of equity from trading positions was too great. Today's US money center banks are fighting to avoid capital levels only a little higher, i.e., going from 7% to 9%. It seems like a lot when seen as a percentage of balance sheet assets. But it's trivial when seen as the potential loss in a trading position. What's another 3, 4 or 5 percentage points of loss once a derivative or badly-hedged asset goes wrong? It's rounding error.

But to CEOs of these companies, that means relegating them to a role much more like energy utilities than like investment banks or faster-growth firms.

Which brings me to the central point about this debate over permissible money center bank activities and their primary capital levels.

My now-deceased mentor at Chase Manhattan Bank, Gerry Weiss, observed decades ago that since banking is a derivative industry, it can't, in total, grow faster over time than the economy which it serves. Thus, shorter-term, faster growth typically comes by taking more risks. Which pays off for management when it works, and leaves shareholders with losses when it doesn't. Only, in reality, those losses now become spread to taxpayers, as well.

So long as a bank is allowed access to taxpayer money for insuring deposits, and is allowed to become sufficiently large that its collapse would create counterparty problems for the nation, it has to be restricted to a role as a financial utility. Much as CEOs like Dimon want to have the latitude to chase total returns that match the US equity market's best, doing so as a money center bank simply isn't in society's interest.

Time and again over the past several decades, US money center banks and their managements have exhibited poor judgement and incompetence at avoiding bank-collapsing risks. When enough commercial bank assets pursue similar risks, which typically occurs, the resulting systemic risk endangers the US economy.

Dimon and his fellow CEOs like Vik Pandit at Citi or Brian Moynihan at BofA may grouse about being shackled and prohibited from pursuing brisk income growth which outstrips that of their markets. But to allow them to talk their way out of both measures- restraint of proprietary trading and higher equity capital requirements- will more quickly and certainly lead to the occasion of another taxpayer-rescue of a US money center bank.

Mike Mayo's Book & Essay In The Weekend WSJ

I read Mike Mayo's extended article/book excerpt in this past weekend's edition of the Wall Street Journal. Sad to say, I was underwhelmed.

My memory of Mayo as a capable bank analyst goes back to my days with Chase Manhattan Bank in the the early 1980s. Back when Dick Bove, Bob Albertson, Tom Brown and Sally Pope were frequently on page one of the daily American Banker.

Despite taking two pages to write it, Mayo's point boils down to one he doesn't actually state, and apparently doesn't choose to acknowledge, i.e., equity research shouldn't be housed in the same firm as underwriting or other services bought by the banks and non-bank financial firms being evaluated by the analysts.

We already learned this in the late 1900s when technology analysts fawned over the companies that their firms brought to market via IPOs. It's not a new revelation.

Mayo tells the same story over and over. How he virtuously made tough 'sell' calls, only to be reprimanded, gagged, taken aside and 'talked to,' cut off from contact with management of the firms he followed, etc.

I don't doubt that Mike made those tough calls. Somehow, I don't think he's so naive as to be ignorant of what would happen when he did. He is evidently still and MD these days, but now has slipped to being one at Credit Agricole Securities.

Perhaps he should note that Tom Brown and Meredith Whitney finally just struck out on their own. Brown runs a financial sector portfolio, and, thus, is suspect every time he opens his mouth to tout the shares his fund owns. Whitney went the pure research route, and appears to be keeping her firm afloat.

It's no secret that analysts who truly have conviction eventually want to, or ought to, run portfolios. Mayo would have been able to have achieved legendary status, according to the article, had he shorted massively in late 2007, when he went on CNBC to predict the coming financial crisis.

Of course, one problem with the transition from analyst to portfolio manager is that the former are industry-focused. So when they run sector portfolios, they necessarily are exposed to sector cycles, which I would think could make for some pretty lean times. Not to mention the tendency to hype positions which are losing money, as Tom Brown now does with sickening regularity concerning BofA.

Still, I expected more, and better, from Mike Mayo. If all he has to tell us is whining about a conflict of interest that's existed since the dawn of sell-side analysis, well, that's not news.

Holman Jenkins On Bank Bashing

Holman Jenkins, Jr., of the Wall Street Journal wrote a thoughtful, if somewhat murky piece in this past weekend's edition of the paper.

Entitled Why We Aren't Bashing Banks, Mr. Jenkins seemed to attempt to address a number of specific topics related to the Greek and European debt/bank crisis, including responding to left-wing economist Paul Krugman.

What interested me about Jenkins' article, however, were two of his contentions.

The first is that

"politicians find no upside in bashing bankers right now for good reason, since the whole game- 100%- is maneuvering the European Central Bank and its chief Jean-Claude Trichet into a more pliant mood so they will prop up Europe's banking system to permit sovereign debt restructuring to go ahead."

In effect, Jenkins, along with others, alleges that the truth is that bankers bought now-nearly-worthless Greek sovereign debt which, if carried at its correct value, would result in insolvent banks, a severely damaged European banking system, and, for good measure, no more private banking institutions to roll over and hold more of the rotten paper while the European Union figures out what to do about the mounting financial problems of larger EU countries, such as Ireland and Spain.

Thus, despite criticisms of cronyism, the regulators and central bankers are seen to be bailing out Greece, in order to bail out Europe's banks. And right now, that more or less equates to Germany bailing out the EU's banking sector.

My own fascination with this situation is how twisted and selective our international central banking and regulating authorities have become, such that they implicitly suspend the need for banks to recognize losses in value of assets they hold, so soon after the recent financial crises which involved precisely this sort of phenomenon.

Ask yourself why anyone in his right mind would own equities of large banks when such flagrant misstatement of asset values is allowed. If it weren't sanctioned by regulators, it would be called what it is- fraud.

Jenkins' second topic of interest was this passage,

"Here's guessing that a world without too-big-to-fail banks would not be bereft of financial innovation or diversified services aimed at every kind of customer."

He's probably right. My original research on consistent total return performance took place when I headed the research function at then-independent Oliver, Wyman & Co, revealed that the worst-performing financial institutions were the broadly-diversified banks. They hit every financial pothole which occurred- credit cards, mortgage lending, third-world debt, etc. The most consistently-superior performing firms were the more focused asset managers, credit card lenders and mortgage banking firms.

When income from diversified business mixes isn't used to prop up ailing units and mask weaknesses, firms tend to either succeed or fail rather dramatically.

Whether that would happen again, or not, I can't say. It may well be that we've had more financial innovation than any global economy can stand for a while. But, as Jenkins implies, with smaller, more nimble and focused financial institutions, profitable innovations would succeed, others would not, and investors in and lenders to such enterprises, rather than taxpayers, would enjoy the appropriate consequences.

Banks, Capital Requirements & The S&P500

CEOs of large US banks have raised an alarm recently due to the recommendations by several regulators, including members of the Fed and FDIC, for higher capital requirements. Some have suggested an extra 3%, bringing the large-bank level to around 10% of risk assets, while others have mentioned 14%.

Predictably, the CEO of at least one large bank, Chase, has warned that higher capital levels will result in higher lending rates and overall operating costs, as well as lower profit levels. These comments are meant to scare regulators away from imposing higher risk capital levels.

However, Chase' Jamie Dimon, aside from having an obvious interest in lower capital requirements, also lacks perspective. He spent the bulk of his career assisting his one-time mentor, Sandy Weill, in the brokerage industry. The sorts of retail brokers at which Dimon cut his teeth didn't engage in much risk-taking activity, so they were highly-levered.

But a more appropriate perspective on the current debate involving large US commercial bank capital levels should take us back to the 1920s. The events of the 1930s, in which then-integrated commercial and investment banks, such as the forerunners of today's Citi and Chase, improperly sold questionable investments from one side of their bank to customers on the commercial side of the bank, resulted in the Glass-Steagal Act. The Act broke up banking into its investment and commercial pieces.

Up until the 1970s, commercial banks, the retail deposits of which were FDIC-insured, didn't typically engage in much risky activity outside of conventional lending. Even that resulted in the occasional large regional bank failure, such as First Pennsylvania, Seattle First and the like.

However, with the complete removal of Glass-Steagal, commercial banks were allowed to function as investment banks, but retained federal deposit insurance. This oversight effectively resulted in the federal government subsidizing, via deposit insurance, the risky activities of trading and underwriting in the investment banking side of these newly-integrated large US banks.

Earlier this week, I saw an analysis on Bloomberg predicting that as commercial banks divested or closed newly-prohibited trading businesses, their profits would fall, bringing down equity indices of which they comprise something in the neighborhood of 20%. This sort of statistic, combined with the specter of higher capital levels and resulting lower profits, is being trumpeted as the reason to reject such calls for more bank capital.

However, I believe this is incorrect reasoning. What I believe is correct is to ask why equity indices such as the S&P500 allocate so much weight to financials. As integrated, risky companies, financials may well have merited such weight.

But now, the large US commercial banks are more properly viewed as financial utilities. As such, they don't merit a large presence in the S&P, nor should they be expected to be engines of high and consistent total return delivery for their shareholders.

This may not be to the liking of Jamie Dimon and the CEOs of Citi, Wells Fargo or BofA. But it's reality.

After the tremendous cost to taxpayers of the financial crisis of 2007-08, in which large US commercial banks with insured deposits played a corresponding major part, even if they didn't initiate the crisis, it's understandable that capital requirements would be increased and risky activities prohibited.

As I have written in prior posts, the basic business of lending and safekeeping money, plus some ancillary trust and processing businesses, are the core of what large US financial utilities, a/k/a large commercial banks, perform. Those aren't a huge part of the American economy, nor should they be. Such businesses aren't high growth businesses, either.

Regarding interest rate levels, who's to say they should not be higher? Large bank profits rise with interest rates- why didn't Dimon mention that? Further, we didn't have a crisis three years ago because rates were too high- it was because they were too low. And still are.

Cries of 'foul' by large bank CEOs and analysts stem from a refusal to acknowledge reality- both recent past, current and future. The days in which banks such as Citi, Chase, Wells Fargo and BofA may be expected to rival Google or Apple as consistently high total return performers are over. They are now meant to be fairly safe, unexciting basic financial services firms which don't engage in overly-risky activities.

That's the reality of the new financial landscape. And it's consistent with such an environment that those large banks should carry more capital, the better to avoid needing taxpayer funds to rescue them from insolvency in the future.

The Fed's Proposed Large Bank Regulatory Capital Increase

The banking community is shocked- shocked!- at the Fed's proposal to add about 3% to required regulatory capital for the 'too big to fail' crowd.

One large bank CEO, Jaime Dimon of Chase, went so far as to try to embarrass Helicopter Ben during the Q&A after his speech in Atlanta yesterday. I just saw Bernanke's reply on CNBC a few minutes ago, after having to endure senior economic idiot Steve Liesman's attempt to restate Dimon's comments. Fortunately, though, there was audio of the native New Yorker's signature accent delivering his diatribe.

Much was made of how great Chase was, how it was a lower-risk bank during the financial crisis, and how important a CEO Dimon is. The implication being that since Jaime asked these questions and pointed out various facts, well, they must be important.

What Dimon asked, to summarize, was why, with SIVs gone, CDOs moribund, some banks gone, and most housing finance excess gone, there was now a need to raise capital requirements on large banks? And did anyone study the potential effects of such increased regulatory capital on interest rates, loan volumes, economic activity and- hold your breath, because Dimon gets positively statesmanlike on this next one- JOB GROWTH!

My God! Raising capital requirements must be un-American!

Well, not quite.

I've written in a post some years ago that banks want to portray themselves as competitive companies in terms of equity values and growth, even though the business in which they are in doesn't lend itself- no pun intended- to such dynamics. And the traditional nosebleed level of regulatory capital/risk assets doesn't really matter once risk becomes loss. Which happens in as little as one or two days, if not overnight. Ask the former executives of Bear Stearns.

Although banks like Chase have been forced to lessen their proprietary equity trading, their business is to hold financial assets, some of which have values which can change rapidly and, at times, in unexpected directions.

Current capital levels don't begin to cover what can occur on a large bank's balance sheet. Never mind, now that Dodd-Frank is law, what the geniuses at the banks will invent next, now that they have a fixed regulatory target around which to maneuver to evade capital requirements and other nettlesome regulations.

Former Goldman banking analyst Bob Albertson was on CNBC as a follow-up to the Bernanke-Dimon exchange to shill for the banks. He sagely intoned that nobody in government knows what the effects of their regulations will be.

True enough. And Dimon's question regarding research into said effects was simply theatrical. Everyone knows that such research wasn't and won't be undertaken. From a statistical sense, it's likely far too complicated, with too many variables for which to control, and too many to study, to ever develop sufficient data to draw conclusions.

But after you get by Dimon's- and Albertson's- smoke and mirrors, remember that this sector ran amok only a few years ago, with the help of Congress, sleepy Fed and FDIC regulators, and Fannie and Freddie buying off overseers and most of Congress. Collectively, the American taxpayer and the economy footed the bill for these excesses, next to which an added 3% of risk assets is a pittance.

Will BofA's equity be diluted nearly 50%? Maybe so. And maybe Tom Brown will have second thoughts. He was on Bloomberg yesterday morning singing Dimon's praises- no surprise there, eh?

The reality of large bank equities, however, is that they are timing plays. These companies don't typically exhibit consistent behavior. So once you acknowledge that to buy and sell them is to engage in market or sector or even company timing, surprises like added capital requirements are just part of the risk of playing that game.

From a historical perspective, however, it's hard to argue that having large, nearly-unmanageable and uncontrollable financial institutions which are slated to be taken over by the government after their next series of lethal mistakes, hold some added capital, is indefensible.

The Folly of Sector Focus: "The Case for Bank Stocks"

Randall Smith of the Wall Street Journal wrote a weekend edition column entitled The Case for Bank Stocks. It's a fine example of why you should be wary of people who write columns on investing in media for which you pay. I don't follow Smith's writing in the Journal, so I don't know if his piece was a one-off piece that represents his big break in writing at the Journal, or a frequently-appearing column. It doesn't have a clever heading, so Smith probably hasn't yet attained the status of his fellow Journal investment columnist whom I also find dangerously naive and narrow-minded, James Stewart.

Now that I think of it, the only two routinely-appearing Journal writers in the Money & Investing section which I find generally sound and interesting are Kelly Evans and Dennis Berman. Neither is confined to a single sector or topic.

Just like their actual kindred spirits in sell-side analysis or sector portfolio management, journalists who focus solely on either investing, or a sector, have a recurring problem. They must publish tantalizing pieces on a fixed schedule, and the pieces must at least appear to provide some fresh insight or value, regardless of whether, for sector-focused analysts and portfolio managers, it's just a bad time to be in that sector.

But this flies in the face of legendary Vanguard Group founder John Bogle's dictum,

'Don't just do something- stand there,' which captures his well-regarded and  empirically-proven contention that passive index investing will provide most retail investors with comparatively better returns at lower risks for the long term.

However, in keeping with why I originally began this blog, I decided to read and dissect Smith's article to see what sort of sense it makes. Passages from his piece are in italics.

Bank stocks rocketed out of the financial crisis in 2009, helping to ignite a bull market that has lasted more than two years.


This sort of anthropomorphizing of "the market" is an old journalist's trick to get you to regard equities emotionally, and actually believe they possess some sort of animus of their own. They don't. It's also an attempt to portray what may be simple correlation as causation, which also takes much more work to prove.

But in the past year, they have lagged the broader U.S. market. While the Standard & Poor's 500-stock index has risen 15.6%, a widely watched measure of bank stocks, the KBW Bank Index, has fallen 10%.


Now, as the economy moves from recovery mode to full-fledged expansion, some market strategists and advisers say bank stocks should outperform once again.

Christ, is it me, or does Smith sound like the pitchmen on the frequently-appearing 'invest in gold' ads on cable business channels? Does it get more hackneyed than "some....strategists...say banks stocks should outperform once again?"

"As the economy improves, we're seeing capital-markets activity picking up, credit trends improving dramatically, problem loans and delinquencies falling, and loan demand picking up—all the classic signs of an early-stage recovery," says William Tanona, a bank-stock analyst at UBS AG.

Wow, I'm impressed with Tanona's insights. But, wait....he's a bank-stock analyst! At UBS. Which really means he's a bank-stock sales support publicist at UBS. If bank stocks become uninteresting, Tanona's going hungry. So I'm sure his remarks are always totally objective.


The case for bank stocks has three main prongs. First and foremost, banks look cheap. On average, bank stocks trade at just 0.9 times their book value per share, while their average for the seven years before the meltdown of 2008 was about two times, Mr. Tanona says.


While current valuations reflect investors' fears about new regulations and higher capital requirements, Mr. Tanona says multiples should rise "once asset quality normalizes and firms adjust for all the regulatory, legal and capital requirements."

Seriously, I had to stop laughing at this point before continuing my comments. First, we have the old 'they sure look cheap historically' argument. Meaning past is prologue. Except that all investment literature must state that prior performance is no guarantee of future performance, etc. Then that second paragraph, which essentially disguises the truth that nobody knows how Dodd-Frank will hobble these leviathans.

My longtime financial business colleague B, and I, both believe that the largest remaining US banks are now slow-moving utilities incapable of surprising growth for extended periods of time. They are essentially heavily-regulated, quasi-governmental finance arms which are so heavily insured and regulated as to be pointless as investments.


J.J. Schenkelberg, an investment adviser at CLS Investments LLC in Omaha, Neb., says her firm has put about $50 million of its $8 billion of client assets into an exchange-traded fund tracking the KBW Bank Index because the stocks are "quite attractively valued" based on their price-to-book ratio. "With these types of valuations, they are still overly punished" for the financial system's near-meltdown, she says.

I love it when sell-side, or even buy-side analysts stumping as sales people for their funds, use P/E ratios as causal, rather than consequential. My proprietary research found P/E ratios to be meaningless and unrelated statistically to consistently superior performing companies as measured by total return.


The prospect of rising interest rates in the next few years also bodes well for banks, say some strategists. In that scenario, banks' so-called net interest margin, a measure of the money banks earn by making loans, would increase, says analyst Chris Kotowski of Oppenheimer & Co. That's because, in a rising-rate environment, banks can usually raise the rate on their loans faster than they have to raise the rates on their deposits.


Some banks also say they can reinvest some of their assets more profitably once rates rise and regulators loosen controls over their reserves. Two of the largest banks by assets, Bank of America Corp. and J.P. Morgan Chase & Co., "are both positively positioned for rising rates," Mr. Tanona says. Others say Citigroup Inc. is, too.


At Wells Fargo & Co., redeploying just half of a $100 billion short-term cash trove could boost pretax profits by $880 million a year, analyst Chris Mutascio of Stifel Financial Corp. told Wells executives on a conference call last month. "I would not disagree with your math," replied Wells Chief Financial Officer Tim Sloan.


Other potential beneficiaries of rising rates include Bank of New York Mellon Corp., Charles Schwab Corp., and Federated Investors Inc., all of which would be able to recapture fees waived due to rock-bottom interest yields on money-market funds. "These companies automatically get a benefit when rates go up," says Frederick Cannon, director of research at Keefe, Bruyette & Woods.


As profits improve, banks are likely to boost their dividend payments, say analysts. Banks slashed their payments during the financial crisis to preserve capital. Now that the crisis has ebbed, regulators are allowing banks to return more cash to shareholders. Nineteen banks have raised their payouts so far in the second quarter, on top of the 39 that did so earlier in the year. Among those that did so after regulators approved their capital plans: J.P. Morgan Chase, Wells Fargo and U.S. Bancorp.


As a result, while the KBW Bank Stock Index currently yields about 0.9%, KBW's Mr. Cannon expects it to increase to 1.9% over the next year. He says that, in turn, should attract buyers to the stocks.


Not all banks are likely to boost their payments at the same time. Investors were surprised in March when one bank, BofA, saw its dividend plan rejected by regulators.

It's true, and I've written about this in prior posts, from my own knowledge as a Chase Manhattan officer years ago, that most people don't realize banks generally benefit from higher rate environments. But this is the sort of thing that the thousands of sell-side and buy-side bank analysts all spend their time estimating. So it's not on the order of, say, surprise growth at Apple or Priceline. And you'd be basically, according to Smith and his sources, buying now, to hope that, sometime after Helicopter Ben raises rates, or things go wrong in the US economy and nervous investors cause risk-free Treasury rates to soar as they shun debt auctions, these large banks will benefit from some liquid assets redeployed at higher rates.

Never mind that, in this economic environment, those higher rates might actually choke off economic growth and demand for loans. A trivial concern, I am sure.


The banking sector isn't a cakewalk these days. Some analysts warn that banks must adjust to a new lending reality that includes a retreat from the wild-west days of mortgages with zero down payments, no income documentation and other loose lending standards.


"It will take banks years to adapt" to an environment of mortgages with 20% down payments, says bank analyst Nancy Bush, a consultant with SNL Financial Corp.

I'm old enough to remember Nancy Bush as a young sell-side analyst, along with Tom Brown and Mike Mayo. She's seen a lot, and her cautionary words are appropriate. By the way, if it does take banks "years to adapt" to this new environment, doesn't that suggest that resulting profits could be lower and later than the (smirk) totally objective sell-side analysts contend?


One drag on banks' loan growth in recent years has been the need to shed legacy portfolios of toxic assets they either inherited from previous management, in the case of Citigroup, or acquired in acquisitions, in the case of J.P. Morgan Chase, Wells Fargo and BofA. One bank with a big slug of for-sale assets, Citigroup, is only about halfway through that runoff.

Ah, yes. Those pesky "legacy portfolios." That's what sell-side analysts and bank managements like to call the resulting toxic relics of their last big errors in judgement. But don't worry. Really. They've learned all their lessons and nothing remotely like those mistakes will ever happen again. Really. Everybody agrees- the sell-side analysts, the bank managements, the regulators caught napping lasting. Everyone! Even Randall Smith!

So, go ahead, invest already!


Still, Todd Green, chief investment officer at Alesco Advisors LLC in Rochester, N.Y., which owns $15 million of the same KBW bank fund, the SPDR KBW Bank ETF, expects bank stocks to rally as lenders reinstate or raise their dividends, mergers pick up and valuations bounce off their recent lows.


Bank stocks, he says, represent "an attractive opportunity in this market to buy high-quality companies at low prices, in an industry that's essential to the functioning of capitalism in the U.S."


Let's see....Todd Green's funds own a big chunk of bank ETFs. Todd would like you to believe, as he does, that banks will be hot. So Todd's investments, bought at lower values, will benefit from your stampede into, well, hopefully the very same ETFs that Todd's firm bought for its clients.

No lack of objectivity there, huh?

Mind you, these so-called "high quality" companies are the same ones which accepted government bailouts and heavy consequent oversight. Are these low prices? Why?

If the prices rise due to equity index rises, maybe the S&P500 is safer.

Then there's the real proposition that would likely infuriate John Bogle.

This entire article, and all the supportive material, argue for market timing. Pure and simple. But market timing is notoriously unreliable and largely the province, when successful, of seasoned professionals who also have the benefit of legal market intelligence that retail investors lack.

It's always curious to me that analysts expect people to buy and hold in hopes of some future gains, while they know that what investors want is gains now...and in the future. I know of no professional fund managers who believe that telling investors to just wait through poor or negative returns now for future better returns will retain their capital. Market timing propositions, which is what Smith's piece is, fly in the face of seeking consistently good investment performance.


Finally, Green engages in a bit of suspect logic. Banks may be "essential to the functioning of capitalism in the U.S.," but that does not mean they will provide consistently superior returns.


Airlines are "essential to the functioning of ....the U.S." Would you like to buy and hold one? Or are they, too, market-timing equities?
 
Railroads were "essential" for the opening of the West, yet British investors lost nearly all their capital lending to and investing in them in the late 1800s.
 
Just because a sector is essential for something doesn't mean it's a worthwhile investment, when other alternatives are available.
 
In its totality, Randall Smith's piece displays, in one place, many errors of logic and biases which tend to characterize this type of investment journalism.
 
Proving to me, once again, why the financial sector's continuing insistence on sector-based analysis and investment provides such a helpful confusion to many investors. Meanwhile, other investors, like me, focus on firms of any sector which simply have prospects of providing consistently superior total returns now and in the near future.

Investing In US Money Center Banks- The Recent Track Record

It's earnings season, and already two of the nation's largest money center banks- Chase and BofA- have reported disappointing results.

It's also just a little over two years since the post-financial crisis market bottom of March 2009.

So how have the largest US commercial banks- Chase, Citi, BofA, Wells Fargo- performed, relative to the broad US equity market, as represented by the S&P500 Index?

Not so well. The first three have underperformed the index on an absolute basis. Wells has done a bit better, but not sufficiently so for the relative risk of a single equity to the broader index.

I had lunch with a long time business colleague on Tuesday of last week. Neither Chase nor BofA had, at that point, reported earnings. Still, we laughed at how many pundits had recommended bank stocks over the past few years. While I can't cite specific dates, I'm pretty sure both Jim Cramer and Dick Bove have gushed over Chase or Citi in the past two years.

Despite the many years which have passed since my friend and I both worked at Chase, the basic character of each of the nation's largest banks has not changed materially.

Citigroup's risky business strategies should have resulted in its dissolution, except for the general financial crisis in which it luckily happened to occur. Once upon a time, long ago, I suggested to colleagues that the way for Chase to have been better-valued was for the whole sector to become as mediocre as our bank was. Citi took the idea to new lows, and survived.

BofA continues to labor, as the nation's bank with the largest consumer business, under the burden of being more or less tied to that sector's fortunes. With high unemployment, stagnant wages and rising prices for ordinary consumer purchases, being the country's largest consumer banker is no picnic, as last week's BofA earnings report proved.

Chase remains the sluggish, less-well-defined bank which just never seems to either soar, or crash. As my friend reminded me, it was Chase's genetic inability to do anything quickly which allowed Jamie Dimon to avoid the worst of the mortgage-related disasters and therefore be relatively better positioned to scoop up some failed large commercial banks, such as Washington Mutual, as well as a government-insured bid to takeover failing Bear Stearns.

Wells Fargo continues to be a bit nimbler and better-managed than its eastern counterparts, but its attempts to bulk up have ensnared it in continuing mortgage problems. By swallowing Wachovia, which had purchased California's Golden West S&L, Wells inadvertently exposed itself to more losses and trouble than it probably expected.

It's been years since a commercial bank was selected by for one of my equity portfolios, and the appearances, even then, were few and brief.

I can't see anyone who seeks to consistently outperform the S&P500 using large US commercial banks to do so- now, or anytime soon.

US Commercial Banking, Evolution & Commoditization

My years with the Chase Manhattan Bank were spent under the tutelage of Gerry Weiss, SVP of Corporate Planning & Development. It was a privilege to work for such a bright, secure and gifted strategist.

Gerry didn't win a lot of new friends among his senior executive colleagues at the bank for holding the view that banking was one of the most commodity-like businesses in existence. With a few exceptions, most of the businesses at Chase were extremely difficult to differentiate because, at the end of the day, you were either borrowing, lending or processing money. Not exactly a patentable good.

Further, as technology became more important in more banking businesses, any single bank's ability to maintain a competitive edge for very long became increasingly difficult.

With all this in mind, I read a piece in the Wall Street Journal last week regarding federal arm-twisting of the major US banks on mortgage foreclosures. Leaving aside the subject of that article, which was the unwise attempt to force banks to forgive negative equity for borrowers, I was struck by the pedigrees of the few banks mentioned- Chase, Wells Fargo and BofA, and the one absent bank- Citicorp.

I realized, as pondered these names, how few people today probably recall that these, including Citi, are no longer the banks which originally had those names.

For example, Wells Fargo is really just the name of a former San Francisco-based bank acquired by what was once a staid Midwestern outfit- Norwest Bank of Minnesota. If I'm not mistaken, Norwest itself was acquired by a one-time rival, First Bank System. Along the way, it hoovered up the crippled Wachovia during the recent financial crisis, giving it, ironically, the old Golden West S&L, too. That was a product of Ken Thompson's wrong-headed mortgage bank acquisition at the peak of the real estate bubble. It cost him his job.

Meanwhile, BofA is just the surviving name of another San Francisco-based bank that took too many risks and became the prey of another regional US bank- Nationsbank, the renamed North Carolina National Bank. Hugh McColl busily assembled a large group of basic banking franchises beginning in the 1980s. The drive to aggregate assets and relationships culminated in the takeover of the once-proud BofA. McColl's successor, Ken Lewis, overreached when he bought Countrywide and Merrill Lynch during the recent financial crisis. That latter deal's murky details sent Lewis packing early from his CEO job at BofA.

Chase, as we know it today, is simply the name hung on the agglomeration of assets of most of the old money center banks of New York City, except for Citi and Bankers Trust. Back when I worked for Gerry Weiss, he once referred to Chase Manhattan, Chemical and Manufacturers Hanover Trust as three fairly interchangeable, mediocre banks. When asked about merging them, he snorted derisively,

'All you'd get is a much bigger mediocre bank that would be even more difficult to manage than what we've already got.'

Never the less, Chemical took over MannyHanny, then the two picked off Chase after its CEO, Tom Labrecque, finally ran the latter into the ground and attracted the unwanted attentions of fund manager Michael Price. In time, the CEO job went to Jamie Dimon, who had fled New York City to run the remaining Midwest regional commercial bank, Banc One- by then a product of a merger of the Ohio company of that name and the old First Chicago.

Citicorp wasn't mentioned among those in the foreclosure-related article because it essentially died, only to be resuscitated as a ward of the federal government after 2008. Before that, however, it was taken over from outside banking, when Sandy Weill prevailed upon then-Treasury Secretary Bob Rubin to allow him to 'merge' with John Reed's Citibank. Weill then hip-checked Reed out of the C-suite, hired Bob Rubin, and proceeded to build the most unwieldy, unmanageable financial supermarket ever attempted in the US.




My point is that if you were to have surveyed the national and regional banking field in the mid-1980s, as my colleagues and I did as part of our jobs as corporate and business strategists at Chase Manhattan, you'd have classified BofA, Chase Manhattan and Citicorp as the nation's three most important international money center banks. Chicago had just lost Continental Bank, but still had First Chicago. Bankers Trust and JP Morgan were smaller, more focused money center banks. All of these had senior management which felt and behaved as if their banks were special, different, and able to take risks which other US banks couldn't handle.

Fast forward almost 30 years, and you can see how wrong they were. The three premier US money center banks all lost their managements via takeovers.

In truth, the managements of what we now know as the leading US banks are products of duller, less-ambitious banks. Less ambitious in terms of scope, though, rather than size. And the businesses which are now part of these banking companies which aren't historic mainline banking units- brokerage, underwriting and merger and acquisition advisory- have become, as my old boss Gerry Weiss predicted, less lucrative due to the commoditization of them by the large commercial bank entrants.

In true Schumpeterian form, most of large commercial banking has become commoditized amidst growing competition. Thus, their equity price performances are, for the most part, anemic. Only Wells Fargo has a 35-year price performance which eclipses the S&P500 Index. Chase, BofA and Citi all trail it substantially.

What's different about Wells? Notice, first, that its outperformance slackened significantly around 2000. So it's not a function of recent management skill.

More likely, its earlier outperforming of the S&P resulted from its having avoided combining with any of the leading money center banks- ever. A host of old mid-sized California banking franchises- First Interstate, Crocker, and Security Pacific- if I recall, comprised the Wells Fargo that Norwest snared. As such, while predecessor banks got into some troubles, they tended not to be on the gigantic scale of the messes into which the three largest US money centers stepped throughout the past three decades.

Of the other banks, Chase managed to about match the S&P, while the Citi and BofA plunged noticeably.

So, from a perspective of over thirty years of large US commercial bank performance, it's evident that the risk-taking of the old international money center banking companies didn't result in their consistently superior performance. Rather, to the contrary, that strategy failed, as evidenced by the managements of more cautious, smaller commercial banks ultimately owning the marquees previously associated with their larger one-time rivals.

Now, no matter what you hear on CNBC or read in the Wall Street Journal, for the most part, the four major US commercial banks have become financial utilities which will, for the most part, fail to consistently outperform the S&P500 for any significant period of time. They've become large, slow-moving purveyors of financial commodities.

Investing In US Financial Companies

I continue to find remarks on CNBC regarding investing in the equities of US banks to be suspect.

Consider, for example, the nearby price chart for BankAmerica, Chase, Citi, Wells Fargo, Goldman Sachs, Morgan Stanley and the S&P500 Index.

Despite what you may believe from the daily cheerleading by CNBC equities reporter Bob Pisani, simply holding a basket of these largest six (surviving) equities for the past five years was worse than holding the anemic S&P index.

Yes, Pisani is largely valueless as a reporter, because he's really just an equity markets shill. But it's a deeper issue than that.

First, as I noted, there's the survivor bias. Wachovia acquired itself out of business, while Bear Stearns just imploded. Merrill Lynch and Countrywide are gone, now part of BofA.

Even if you knew in advance which large financial institutions would survive, you'd have to be pretty fortunate to randomly pick the winner- Goldman Sachs. Chase and Wells Fargo basically tied the S&P with no price appreciation over the period. It's difficult to credit those latter two CEOs with being paid handsomely for simply tying the index. If they were hedge fund managers, they'd be pilloried on Capitol Hill.

Citi and BofA remain, of course, unholy messes. The former should have been allowed to fail, so that better management could have gained access to that large asset base. Morgan Stanley continues to limp along, performing like a badly-managed commercial bank, but with the business mix of Goldman Sachs.

If you look back just about a year, you see that, in general, prices have either flattened or actually dropped. So timing didn't really get you much in a year when the S&P rose 15%.

Then there's the sector's prospects for 2011. Here, Goldman is again probably the best-advantaged of a mediocre bunch. With no asset base like a true commercial bank, it doesn't own mortgage portfolio valuation risks and, if it behaves as it has in the past, may even bet on further declines in related assets. For the commercial banks, recent housing price weakness, noted recently in posts here and here, portend another round of punishing valuation plunges reminiscent of late 2007.

Between that imminent risk, and the uncertainty of rebuilding fee income in the wake of the Dodd-Frank bill, commercial bank revenues are not so, well, bankable. Plus there's the reality that bank profitability historically rises with rates...which are ultra-low and show no particular sign of rising.

Unless you feel lucky about timing financial equities, there's not really much positive in the outlook for financial equities.

All of which leaves me critical of CNBC's ceaseless pumping of financial equities. At least Kelly Evan's recent Journal piece on the upcoming earnings season cautions on financial sector equities.

Low-Rate Environments & Bank Profitability

Yesterday's Wall Street Journal finally published an article detailing how low interest rate environments hurt bank profitability.

My banking education dates from my first days at Chase Manhattan Bank in the early 1980s. Schooled on asset-liability management and repricing, I recall quite clearly that low-rate environments are worse for bank lending and asset management profitability than higher-rate environments.

Evidently, that hasn't changed in thirty years.

Thus, since 2008, banks already pressured by bad mortgage-related loans, securities and derivatives began to be squeezed by the Fed's lower interest rate policy.

The Journal story provides details of various banks and asset managers coping with slimmer margins. What the piece doesn't discuss is two other important phenomena which add to lower overall profitability of this environment.

One is, obviously, the greater probability of asset bubbles, against which loans may be made, in low-rate environments. We just saw this over the last seven years. Now rates continue to hover at record lows.

The second aspect involves risks versus rates. At ultra-low rates, projects of marginal merit appear to be worthwhile and may be funded. Yet they are precisely the most vulnerable loans, once rates begin to move upwards towards more normal, sustainable levels.

This will leave banks holding more problem delinquent and/or defaulted loans. It's a major reason why so many banks reportedly aren't lending now in the first place.

Of course, idle capital which is unlent is employed in money markets, which now is about the same as cash, i.e., the classic Keynesian liquidity trap.

Welcome to the world of low-profit banking so long as Helicopter Ben continues to hold rates near zero.

Old News: We Have Too Much US Financial Services Capacity

In a recent Wall Street Journal editorial, frequent, if often misguided contributor Andy Kessler proclaimed,

"There are too many traders, bankers and salesmen to support the new level of business. Thanks to Dodd-Frank, the shrinking of finance will continue."

Duh.

Sorry to break the news, but, as I've written in prior posts on this blog over the past few years, US financial capacity has been excessive, and shrinking, since the 1990s. Even before, really.

In part, the simple applications of computer technology began to create excess capacity as long ago as the 1960s. It hasn't stopped since.

Kessler evidently thinks his insight is a surprise, or at least news.

It isn't.

He's right about the old retail brokerages and investment banks shamelessly inventing new, less efficient, higher-margin products for decades since the Big Bang deregulation of stock commissions in the 1970s. And among the consequences of the recent regulatory legislation will certainly be the elimination of prohibited activities at publicly-owned commercial banks.

But the much larger, more important trends in the sector have been the continuing growth of excess capacity, depressing margins and causing riskier trading and underwriting behavior, coupled with the exit of the best talent to hedge funds and private equity groups.

Put the two together, as Kessler failed to do, and you have your recipe for the recent financial disaster.

Forget "What's the Matter With Wall Street," the title of Kessler's editorial. There's really no Wall Street left, with Goldman Sachs' and Morgan Stanley's conversion to commercial banks.

It's more a matter of US financial services, generally, being over-supplied with capacity that simply can't be afforded. The sooner the capacity is taken out, the better for the nation and its competitive financial institutions.

What To Expect from the Bureau of Consumer Financial Protection

Much has been made of Elizabeth Warren's rather tortured, strangely-handled appointment to head the federal government's new Bureau of Consumer Financial Protection. I've written about that aspect of her long-awaited appointment here on my companion political blog.

In this post, though, I'd like to consider what this new agency is likely to do to and for US financial consumers.

According to a Wall Street Journal article on the subject, Warren is to oversee a staff which will now commence writing hundreds of pages of new rules and policies governing practices at financial firms.

Warren is now attempting to spin her efforts as being "willing to cooperate with business leaders."

Unlikely.

Anyone who's seen Warren's scolding, imperious, inquisitorial manner during her TARP Oversight Committee will find it hard to believe that statement.

Instead, Warren has spoken of "tricks and traps" that consumer lenders employ, and of calling for "fundamental changes to the way rules are written in Washington." According to the Journal article, Warren wants two-pages contracts for mortgages and credit cards. It's not clear how that would offer more protection to consumers, unless the language is so sweeping as to provide for nearly-unlimited lender liability.

You don't really have to know just what new regulations will be written to understand the effects they are likely to have on consumer lending. Rather than allocate credit according to a consumer's ability to pay, new regulations are more likely to result in no access to credit whatsoever for borderline borrowers.

If consumer lending documents truly become distilled to one or two pages, it's reasonable to assume that only the safest credits will be funded. The fewer terms and conditions are allowed, the more assured lenders will want to be that their customers, and their loans to them, are very low-risk.

Just stepping back and considering Warren's overall belief that lenders have behaved predatorily, and consumers need to be 'protected,' it's a good bet that the price of credit will rise, when it's available.

Perhaps a good example of this likelihood was Warren's reaction to a question from Jack Welch on CNBC's morning program yesterday. When Welch asked Warren if she thought her efforts would increase the price of credit, she replied,

'That's the wrong question to ask.'

Amazing, isn't she? Simply ruling an inconvenient question off limits, out of bounds, to be ignored. Which she did.

She went on to claim, without any examples, that whole companies existed simply to take advantage of consumers with 'tricks' to make them pay exhorbitant fees and rates. Then resorted to the hoary old references to 'families' to contend that all was amiss in the finance industry. Not just a few bad apples, according to Warren, because she never actually admitted that there were honest lenders out there.

Instead, Warren painted a picture of poor, uneducated, stupid consumers waiting to be fleeced by sharp lenders. In her world, consumers sign loan agreements they don't read or understand, despite being adults and understanding that nobody is making them borrow money. For a glimpse of this, go find and watch CNBC's House of Cards documentary. The scene with the large California woman who knew she couldn't afford her mortgage, but figured that 'if they want to give me the money, they must believe it's okay and I can afford it.'

That woman is the prime example of the average consumer in Elizabeth Warren's world. In reality, of course, no amount of regulation or protection will prevent such a person from making mistakes, borrowing too much money, at unaffordable rates. But don't try to tell that to Warren.

Thus, as with most regulatory overkill, the results of her efforts will, typically, be the opposite of intentions. In this case, it will not facilitate borrowing for lower-income borrowers, but probably eliminate them from qualifying for loans at all.

New Fed Rules & Commercial Bank Presidents: Does It Even Matter?

Sometimes it's worth considering the output of a system, before getting excited about changes to its inputs.

In this case, I'm referring to a recent Wall Street Journal article professing concern that Chase's Jamie Dimon doesn't feel he can "perform his duties on the Fed board" because of recent financial regulatory reform legislation.

Is the the same Fed which has been reduced to a 0% interest rate policy and quantitative easing in order to effect monetary policy in the US? The Fed which is dominated by its chairman, currently known for throwing liquidity at any crisis, rather than let natural systemic reactions help to right the nation's economy?

Having work with several CEOs of large US banks in my past, I'm wondering just what it is for which Dimon is required on a regional Fed board. Even that of New York.

I'm one of those people who doesn't believe that large company CEOs magically become omniscient and smarter, i.e., someone they never were before, just by being anointed with the title.

In Dimon's case, he was never considered a monetary or economic policy savant when he carried Sandy Weill's bags for years at Shearson, American Express, Travelers or Citigroup. Why should he have such wisdom now?

The gritty, operational details of banking, the expertise with which might be a necessity on a regional Fed board, aren't generally possessed by bank CEOs, either.

In short, I wonder just what a bank CEO can provide to a Fed board that reports and analysis from his/her bank's various functions can't, with greater specificity?

The most important element of the Journal article to me was the potential conflict now created by new legislation and the existing Federal Reserve. It could well be that the recently-passed law improperly and illegally infringes upon Fed powers. Or maybe it's a legal curtailment that constitutes a sort of 'back door' curbing of Fed powers which has been threatened by Congress, but never implemented, for decades.

That would seem to be the real story. Not just whether a certain bank CEO on a certain regional Fed board is no longer able to "perform his duties."

A Reminder On The Ineffectiveness of Basel Capital Requirements

George Melloan, a former Wall Street Journal staffer, made a useful point in his editorial which appeared in Tuesday's edition.

Entitled Basel's Capital Illusion, Melloan notes that, while more capital certainly won't be a bad thing for US and other large banks, nobody should infer that the new capital requirements will prevent any further financial sector problems.

That's because, as Melloan points out, the US financial meltdown was caused by government policies aimed at "affordable housing" beginning twenty years ago.

Though many in the federal government are loathe to acknowledge this fact, the private sector banks only followed the lead of Fannie Mae, Freddie Mac and numerous CRA threats in lending to questionable borrowers. Mortgage banks such as Countrywide, too, only followed in the wake of the GSEs' securitization of low-quality mortgages.

Melloan reminds us that none other than Bill Clinton waived the Basel requirements for Freddie and Fannie because they were engaged in implementing federal policies to encourage more people with lower incomes to become homeowners. He writes,

"This was a laudable goal that ultimately wrecked the housing and banking industries."

Between Alan Greenspan's Fed reducing interest rates to absurdly low levels, and holding them there, while the GSEs revved up the private financial sector's institutions to originate mortgages, upstream them to Fannie and Freddie, then distribute them as private-labeled MBSs, large volumes of toxic, low-quality mortgages came to pollute global investment markets.

New Basel accords won't prevent any of that sort of governmental policy mistakes from tanking our financial sector in the future.

Those Pesky Bank-Held Mortgages

Andy Kessler, a periodically-published editorialist in the Wall Street Journal and former hedge fund manager, wrote a piece at the end of August entitled TARP and the Continuing Problem of Toxic Assets.

Leaving aside recent better-than-expected housing data, and Kessler's own wacky, unworkable ideas for handling the problem assets, he did a service by reminding readers that the problem remains with us.

In his editorial, he wrote,


"Home sales dropped 27% from a year ago July to a 3.83 million annual rate, which was blamed on the May expiration of the $8,000 home buyer's tax credit. Dig deeper and its even scarier. Existing home inventory (the number of homes for sale) now stands at four million units- that's a 12.5-month supply versus the average 6.2-month supply since 1999. As late as 2005, home inventory was just 2.5 million. Using that as a baseline or normal number, there are now around 1.5 million "extra" homes on the market that are not selling and either empty or soon to be foreclosed.


And those toxic mortgage assets? As far as I can tell, most are still there, valued at "mark to wish" since the Financial Accounting Standards Board's relaxation of "mark to market" accounting rules. Who knows what they're really worth? The stock market is guessing not much, sending finance stocks like Bank of America, Wells Fargo and even J.P.Morgan down close to 52-week lows.


...without a housing turnaround, jobs in construction, decoration, mortgage banking, auto sales and finance will stay in the doldrums. Delinquency rates, which are a leading indicator of foreclosures, are on the rise. According to the latest Mortgage Bankers Association survey, in the second quarter, prime adjustable-rate mortgage (ARM) delinquency rates rose to 9.3%, with prime fixed-rate mortgages seeing delinquencies up 4.75%. On the subprime side, ARM delinquencies hit 30.9% with fixed at 22.5%.


This is not good for banks that still own toxic assets of any type of mortgage, subprime or not. If home prices fall further, and I can't see too many scenarios where they won't, these toxic assets are all set to drop in value. At some point, buyers of bank debt will get nervous. If this toxic sludge were sitting on a shelf at the Treasury or Fed, it really wouldn't matter. But, instead, even a small uptick in foreclosures could take down the banking system- again."

Let's recall that major banks halted foreclosures in early 2009 due to coercion by the incoming administration. Having been forced to take TARP funds only months earlier, all the major money center banks were pretty much vulnerable to such intimidation.

That doesn't mean they don't still hold the toxic stuff, as Kessler reminds us. And that, with a continuing weak housing market, the toxic mortgages remain impaired, and could easily become worse.

At this point, I don't really think there are any better solutions than forcing banks back to "mark to market" valuations. None of Kessler's various sleight-of-hand suggestions for fixing the problem seem reasonable or feasible.

To me, this all leads back to employment. Not the construction- and housing-related employment to which Kessler referred, but the simple notion that, without an imminent, healthy expansion of non-government, non-stimulus-sourced, genuine private sector jobs, the housing sector, and toxic mortgages, will continue to ail, then grow worse.

Eventually, if that happens, it's going to affect equity values- again.

There's no long term substitute for letting asset values find their own, real, un-manipulated value. Nearly two years' worth of government subsidies, coercion and other actions to try to wave a magic wand over housing prices and related mortgage values have all failed to fix anything. For that, we'll finally have to just let housing values and their associated mortgages find real, market-based values. Until then, nobody will really believe current 'values' anyway. Certainly not as a basis for long term investments.

About Those Basel Accords & The Financial Crisis

George Melloan, a former Wall Street Journal columnist and editor, wrote a thought-provoking editorial in last weekend's edition of the paper.

Entitled "The Lesson of Basel's Bean Counters," Melloan's piece is a timely reminder that Basel's various accords afforded exactly zero systemic protection in the event of the actual financial dislocations of the past several years.

Melloan points out that Japanese banks, well-capitalized by Basel standards in 1990, never the less led the Japanese financial sector and economic collapse.

Lehman Brothers, he notes, had "close to triple the core capital required by the Basel standards when it crashed."

Mr. Melloan ends his piece with these passages,

"An assessment of Basel III is provided on the Web site of a London based organization called the Asymmetric Threats Contingency Alliance (ATCA), which came into being in 2001 to promote online discussion of global issues. It concludes, quite plausibly, that "Despite promises that regulators will be vigilant and central bankers more watchful, banks are certain to get into trouble again, as they always have throughout history. The way to protect taxpayers, the Basel III argument goes, is to compel banks to have buffers thick enough to withstand higher losses and longer periods of extreme volatility in financial markets before they call for government intervention."

As the ATCA paper notes, in the days before banks could rely on governments to save them they carried large capital buffers, with core capital sometimes as much as 15% to 25% of assets, as opposed to as little as 2% under current rule. Of course, that made banking more expensive, and bankers were choosier about risks than in today's world, where the U.S. government has chosen to treat some banks as worthy of taxpayer help because they are "too big to fail."

One thing seems certain, the promise of bailouts and better regulation is unlikely to restore better risk judgment to the profession of banking. The opposite is more likely."

Perhaps, before the US Senate and House pass FINREG, or anything like it, with its 1,336 current pages, cooler, wiser heads should consider Melloan's points. Even the decades-long Basel I, II and III accords have been unable to prevent a near-total, global financial meltdown.

If you were to ask me, I'd say less regulation and higher core capital levels on the order of 20% would do a great deal more to avoid, or mitigate, the next, inevitable financial crisis.

Sure, this will make banks less 'hot' in the sense of total return growth. But, in reality, banking has never been the kind of business which lends itself- pun intended- to the sorts of total return performances over time of an Apple, Google or even Home Depot.

Banking is a derivative business. It facilitates societal transaction, wealth transfers and accumulations. But it doesn't exist as and for itself.

I'm not sure banks should ever have become publicly-listed and -traded equities. But, having become so, they really should function and perform more like energy utilities, less like high-flying growth companies.

On Risk & Capital Allocation In Commercial Banking

Most people have little notion of how capital is treated inside a commercial bank. While regulators and those concerned with systemic risk want banks to hold as much capital as possible, those inside the bank want to operate on as little capital, especially equity, as possible.

Like every other business, banks are sensitive to the costs of capital, and, following basic economics, which is about rationing scarce resources, their managements want to use the absolute minimum to do their business.

Back in the late 1980s, RAROC (Risk Adjusted Return On Capital) was developed at Bankers Trust's. It is, or was, the original risk management tool for bank capital allocation. From it, and its design team, flowed many of the modern variants of VAR-style risk metric systems in financial services firms.


While working on resource allocation and productivity at Chase Manhattan, it was necessary to address risk capital. Thus, I retained the developer of Bankers Trust's famous RAROC model, Philippe Geneste, as a consultant to assist us in introducing the concepts into resource allocation at Chase, as well as to better understand its likely ramifications on business unit operating decisions and overall bank profitability.


There were, and are, fundamentally two methods to internally adjust for risk. One is to raise required rates of return for businesses, on notionally-allocated capital. The other is to use some variance-based approach to allocate more capital to riskier businesses, where risk is defined by greater variances in returns, or losses, of the business.


When dealing with risk, internal capital and allocation, one rapidly runs into a conundrum. It was on display yesterday morning on CNBC, where a guest, no less than Bill Gross of PIMCO, was opining on the need to make banks carry as much capital as possible to mitigate risk.


Here's the problem.


Internally, business units decline to accept capital allocations. They will claim to not need as much as is allocated. But, from a corporate viewpoint, the regulatory-mandated capital has to be allocated. Otherwise, one is in the position of having unallocated, in effect fallow capital. Capital that has been raised and is being paid for, whether through interest or implied total return to shareholders.


In the normal course of business, probably 95% of the time, that added regulatory capital buffer is unnecessary. It constitutes a drag on bank earnings and returns to shareholders.


Of course, in rare circumstances, like those of late 2008, losses in various units of a bank can skyrocket. But, when those so-called black swans appear, even the excess regulatorily-mandated capital levels are unlikely to be sufficient to absorb the losses.

If you look closely at a commercial bank, such as Chase, you'll see that even today, it's common equity/total assets ratio is only about 8%. An incredibly thin wedge of pure equity is in that ratio, as preferred equity outweighs common by about 10:1.

It doesn't take a genius to see how fast a commercial bank can lose substantial equity and become insolvent from a particularly big valuation hit in one or two businesses.

Yet, if regulators force a commercial bank to carry more equity, they inevitably depress profitability and returns. Bank CEOs want to believe their institutions can offer total returns which are competitive with industrial firms. But, if regulators have their way, this can't and won't be true.

Like it or not, fractional reserve banking systems and commercial banks' participation in modern capital markets as publicly-owned entities virtually guarantees that big risk mistakes on their part will quickly lead to insolvency. The banks won't carry more capital than they are forced to, yet, given the risks they take, they are occasionally going to burn through that thin wedge of equity.

Debating about a few percentage points of capital won't really change that.

About The New Bank Tax

The newly-proposed tax on banks, ostensibly to recoup TARP losses, is surely one of the worst ideas to come out of any administration and Congress.


There are so many flaws in the tax it's hard to know where to begin. But I'll try.


First, it seems the wrong way for Congress to now decide how not to have lost money on the bill they so hastily passed over a year ago. Why didn't they, or the Treasury which pushed the legislation, prescribe a method, ex ante, to recoup losses before banks and all other TARP recipients were allowed to operate normally?

To now, after some banks have met the bill's conditions and repaid forced borrowings, with interest, toss in an added tax just because the TARP was badly conceived and administered, is hardly fair.

By the way, is it even Constitutional to force a bank which did not want TARP money to take it, demand onerous repayment terms, and then also tax its profits because the TARP wasn't well-planned from the outset?

Why exempt GM and Chrsyler? They took TARP funds. And why exempt Fannie and Freddie, which were actually the prime movers in the recent financial sector meltdown?

None of it would have occurred had Democrat Representative Barney Frank, Conneticut Democrat Chris Dodd, and others in Congress, forced, and allowed, the two GSEs to underwrite ever-more marginal mortgage loans to risky borrowers. Once securitized by Fannie and Freddie, what investment and commercial banks did was tame by comparison.

If the new tax is supposed to be a "Financial Responsibility" tax, then Fannie and Freddie should be paying a disproportionately high share of it.

Finally, this tax won't fall, ultimately, on any institutions.

Apparently the current administration's economists were all absent the day their long-ago professors taught the economic theory of tax incidence.

Taxes are never paid by companies, only collected. Consumers will pay this tax through reduced access to financial services, or more expensive services, or added fees and penalties.

But be assured, no bank will actually pay the tax on its own.

And, thus, the entire notion of the tax, and its arrogant name, a “financial crisis responsibility fee,” is phony.

As always, its the consumers that will pay this tax and, thus, ultimately for losses from a poorly-designed and implemented TARP program.

Mort Zuckerman On "Too Big To Fail"

Mort Zuckerman wrote a good editorial in Wednesday's Wall Street Journal addressing the "too big to fail" phenomenon in US banking.

He lays out the situation that fostered super-sized financial institutions in the beginning of his piece,

"It is also true that the wisdom that led to the Glass-Steagall Act, which separated commercial banks from investment banking during the Great Depression, was discarded. In 1999, President Bill Clinton and Congress revoked the act, thereby accelerating financial consolidation through mergers and acquisitions. So we got huge firms whose failure would bring down the whole house of cards. The too-big-to-fail phenomenon led to bailouts with taxpayer money, provoking a deep-seated public anger that has been further aggravated by the recent pile of executive bonuses.
The too-big-to-fail firms, in short, lie at the heart of the current crisis. Some are now even bigger, in part because the government had to sponsor and support several mergers that made them larger. The presumption was that big meant diversified and sophisticated and, therefore, less risky. That presumption proved false.

The dangers posed by a too-big-to-fail financial firm surely must be dealt with by new legislation, and one change needed is that the price large banks pay for the privilege of size should be significantly increased. If they benefit from explicit or implicit protection from the government, they should not be able to ride free on the backs of taxpayers.

Their risk of failure should be reduced one of two ways: by increasing capital requirements or by providing the option for the banks to be smaller or less systemic. This can be done either by narrowing what businesses they can be in or by making them less interconnected. In the worst-case scenario, the final backstop has to be bankruptcy or dissolution through a series of well-ordered procedures that do not imperil the whole economy or adversely affect our market-based system of credit."

I think Zuckerman is correct. His recommendation echoes that of my friend B, who first, among people I know, or what I have read, first predicted the rise of financial utilities in a conversation with me in 1996. That is, the driving force has to be to refuse implicit government deposit guarantees to large, risk-taking financial service firms.

Since really large banks have to be in many businesses, there should be some sort of firewalls between any government-insured businesses, and the riskier ones, or, at such sizes, government insurance should simply be priced for the added risk.

What puzzled me, though, was Zuckerman's contentions regarding such large financial institutions,

"Moreover, it must be remembered that the size of many of our financial institutions, despite its role in bringing on the crisis, has also greatly benefited the U.S. economy. Size, for example, enables our big financial firms to compete against others in Europe and Asia.

The too-big-to-fail institutions operate around the world, participating with similarly large financial partners to execute diverse and large transactions. They offer a full range of products and services, from loan underwriting and risk management to local lines of credit, providing financing to states and municipalities as well as firms of all sizes.

Should we fragment and constrain the system and cap the size of banks, it would undoubtedly limit the competitive level of service, breadth of products, and speed of execution. Clients could turn to foreign banks that don't face the same restrictions. Ill-judged reform could undermine one of the most important ingredients of American global power: our financial know-how, intellectual firepower, and size."

I must say that I emphatically disagree with Zuckerman on this point. He may have been correct in the 1960s and 1970s. But certainly by the 1980s, when I was at Chase Manhattan Bank, the evolution of deep, broad global financial markets had pretty much negated the advantages of banks with global reach, offsetting the declining advantages with the headaches of managing such sprawling, multi-business entities.

How does Zuckerman explain the rise of standalone mortgage banking, M&A and credit card companies in the 1980s?

Further, those very financial utilities were the ones which required such expensive cleanup and, in the case of Citigroup, Wachovia and WaMu, went bust.

If these financial titans created such value, how did they manage to self-destruct? That's a rhetorical question. The answers are, they were either too complex to safely and profitably manage, or didn't really provide extra benefits, or both. And I think it's "both."

The capital markets and technology of the past two decades have given smaller financial firms with better people advantages over the Citigroups, Chases and Goldman Sachs.' The new breed of excellent financial service firms are, once more, privately held, i.e., the better hedge funds and private equity shops.

For some reason, many people, including Mr. Zuckerman, behave as if the latter don't exist, and only focus on publicly-held financial institutions. But the mere fact that such successful hedge funds and private equity shops exist ought to be evidence to intelligent observers that the financial utilities simply aren't so valuable and uniquely important, after all. The really good people already left those cattle pens for the greener, more flexible fields of privately-held financial companies.

Finally, Mr. Zuckerman ends his piece with lavish praise for helicopter Ben and his Fed,

"The central bank may have fumbled a bit in the evolution of the bubble economy. But once the crisis hit, it was the Fed, under Chairman Ben Bernanke, whose innovative, imaginative response to the crisis literally saved the financial world.

Should Congress undermine the Fed, we could face a world-wide collapse of confidence in the dollar that would inevitably lead to higher interest rates. Congress is always playing the blame game, but it would be irresponsible to undermine the Fed and its capacity to handle the new financial world that we will all be living in."

Again, I respectfully disagree. I continue to believe that Anna Kagan Schwartz was correct in diagnosing last year's financial panic as one of solvency, not liquidity. Because so many bondholders were rescued, real consequences for the failure to appropriately measure risk were never felt. Instead, global interest rates have fallen back to levels which engendered the crisis in the first place.

Were insolvent banks simply closed and merged, the system would have automatically stabilized. The US, and, for that matter, the globe, was over-banked. The reason such financial junk as mortgage-backed CDOs were pumped out is that profit margins on conventional financial instruments were so thin, due too excess capacity and competition. Fewer, more solvent remaining financial institutions would have been a better result, with any legitimate needs for financial services being filled by the remaining institutions, both publicly- and privately-held.

The only thing that would have truly vanished was excessive leverage. Instead, the Fed replaced that with publicly-supplied leverage, and we are suffering the consequence of that now- a suspect economic "recovery."

Mr. Zuckerman then, in my opinion, reasons incorrectly, opining that an undermined Fed would lead to higher interest rates. That's the reverse of what most believe, i.e., that a Congressionally-compromised Fed would be forced to hold rates too low in perpetuity.

But we already have that, as David Rosenberg recently noted. Bernanke, in his quest for renomination, opened the monetary floodgates, and we have zero interest rates and an unprecedented rise in the monetary base as a consequence.

How much worse could it get under another regime?

In sum, I believe Mr. Zuckerman, whose editorials I generally find well-reasoned and sensible, only got this partially right. He is correct to call for risk-based pricing of any sort of government-provided insurance to financial institutions, particularly large ones. But his estimation of the value of financial utilities, and the correctness of the Fed's actions last year, are, I believe, widely off the mark.