Ken Lewis' Oversized Appetite

Yesterday's Wall Street Journal had a brief article on the back page of the Money & Investing section entitled "Bank of America's Hefty Dowry for Merrill."

One passage well into the piece caught my eye,

"But Mr. Lewis is still giving roughly one-quarter of his bank to bet on Merrill's recovery.....And executives declined to quantify likely write-downs on Merrill's $60 billion of residential- and commercial-mortgage assets."

Lewis has offered a stunning 70% premium for an investment bank that was perilously close- probably only days- from following Lehman into Chapter 11. If anything, I'm surprised John Gutfreund only clucked at Lewis' "greed," and did not suggest the likelihood of shareholder lawsuits.

Just what has Ken Lewis bought? His grinning countenance during the press conference with John Thain announcing the purchase seemed to indicate a sort of dunce's lack of understanding of what he'd done, rather than the cool, confident demeanor of a shrewd buyer of distressed assets.

Let's review, once again, what Ken Lewis bought, and why.

First, his motives. With Merrill Lynch and Countrywide, Lewis has, as I mentioned to my friend B in a phone conversation yesterday, assembled at least the second financial utility in America. One may argue that Citigroup is the first.

But Lewis may well have built the first true financial 'utility' in the sense that he bought two huge, if nearly-dead giants in their respective fields- mortgage finance (Countrywide) and retail brokerage (Merrill). Sandy Weill assembled a financial conglomerate, but it has always been a much more widely-diversified and complex corporate entity than BofA will be.

That said, as Gutfreund also noted, Lewis wants to be the predominant financial institution to every middle- and lower-income American. Sounds wonderful, doesn't it? That's what Lewis, grinning ear to ear, kept repeating in the news conference.

But here's the problem. Ken Lewis just made BofA's equity into a bond. Aside from occasional days or weeks of occasional, unpredictable spurts up or down, BofA's total return performance will now attenuate to that of a safe, low-growth corporate bond.

As my original financial services research, conducted while I was director of research at then-independent consultancy Oliver, Wyman & Co., made clear, no money center, investment or other multi-line bank ever broke into the ranks of consistently superior total return performance for over a decade. As I like to say,

"When you're a big bank, commercial or investment, with multiple businesses, you're much more likely to hit every pothole in the road of financial services."

These "potholes" occur with distressing regularity every decade. It's human nature in financial services, about which I have written before, in posts labeled 'risk management.'

Real estate in the 1980s, sovereign debt writeoffs in the 1980s, energy lending in the early 1980s, credit card weakness, mortgage finance and securitization in this decade. It's always something.

Expect Ken Lewis' new omni-bank to slowly grind down to a GDP-like revenue and earnings growth rate. Top talent will, with the next economic upturn, leave to become bigger fish in new, smaller financial service ponds. The large corporate infrastructure will levy an overhead tax on each business, eventually pricing some out of profitable growth in their own markets.

Then you have the traditional commercial bank risk-averse overlay on growth-oriented businesses like residential mortgage and investment banking.

The prospects of BofA being anyone's go-to equity investment to routinely beat the S&P500 is close to zero.

Ken Lewis bought Countrywide and Merrill to fulfill his, and his regionally-rooted commercial bank's dream of becoming the largest, by asset-size and number of relationships, financial institution in America. Not to become the best-performing equity in America. Not to consistently reward his shareholders with superior returns.

He just wants to continue the old NCNB dream of outliving the money centers and being the biggest commercial bank in the country.

By paying so much for both near-dead entities, Lewis has diluted his own shareholders' value to acquire broken business models in two businesses which are about to undergo, or have undergone, radical change.

It would seem, as the Journal article notes,

"Given the precarious environment, Mr. Lewis has paid too generous a price."

Sure, Merrill passively owns half of BlackRock. Maybe Lewis just keeps that on his balance sheet. Maybe he tries to get Larry Fink to sell the other half. But that's a high-end business.

Most of what Lewis has acquired is a failed mortgage bank, just as mortgage finance is about to change radically, as result of the excesses in which Countrywide itself participated.

Same with Merrill Lynch. Its trading function is nothing special. Its underwriting of mortgage securities is what brought the house down. How much is that worth? Lewis could have bought the new Merrill risk management team, fresh from Goldman Sachs, for much less than the price of the whole firm.

And those retail brokers? Oh, yeah, 'wealth managers.' Right. It's a dying business, or an increasingly less profitable one.

Lewis is hoping they will give him a piece of his 'grab the assets' strategy. By having a business in each consumer asset class, Lewis, like most not-too-bright commercial bankers, believes that, eventually, he'll hoover up all the consumer assets in sight.

But time and again, stretching all the way back to Jim Robinson's American Express 'financial supermarket,' this model has failed. Consumers worth having are too smart to settle for mediocre, big-bank asset management and other services. Those desiring the supermarket model are rarely wealthy or sufficiently sophisticated to be profitable for the vendor.

The conclusion is that Ken Lewis, the latest in a long line of average commercial bank CEOs, is making classic mistakes in the face of investment banking travails. The outcome for BofA shareholders is unlikely to be any better than it was for Lewis' predecessors' shareholders. And that is, inconsistent, or consistently inferior or average total returns, despite the extra risk of holding just one equity to achieve them.