Sunday, November 20, 2011

Does Banking Have Something To Learn From Newspapers?

The November 14, 2011 issue of the New York Times carried separate articles dealing with the current state of the banking and newspaper industries.  With a career in the banking industry that in recent years included financing a newspaper chain, I read each article with interest.  The banking article dealt with how the industry is scrambling to replace the revenue now lost from the limitation on debit card transactions which comes after an earlier regulatory action that eroded income from overdraft fees.  The article actually began on the front page of the paper and continued inside the business section.  It went into detail about the clumsy and much publicized debit card fees that have since been rescinded for the most part.  When you cut through all of the article, it described an industry that was basically saying “OMG (to use today’s texting terminology), we need more revenue to cover our cost”.
The first page of the business section carried the start of an article about John Paton the CEO of Media News Group, a chain of 57 daily newspapers that is rapidly moving its business away from print to digital media.  While this transition may seem inevitable to outsiders, consider what the insiders must deal with in the process.  Digital media product generates about 10% as much income as the comparable print product.  The industry calls it trading in dollars for dimes.  But, instead of fighting the declining trend in print revenue, Paton decided "it was time to start stacking dimes”.   Contrast that attitude to the debit card fee fiasco.  Most estimates I’ve seen put the cost of a debit card transaction in the range of a few pennies.  The new limit reduced the amount charged by banks from $0.44 to $0.22.  While it’s true that profit is being cut by roughly 50%, it still leaves this as one of the most profitable products anywhere…. at least that is still legal!  So instead of discouraging the use of the product by imposing a fee, why not instead react by “stacking dimes”?
The bulk of the content of the two articles was published together on page 6 of the business section.  There, just above the banking headline was a quote from a newspaper insider about John Paton.  Paton, he said “deserves kudos for frankly acknowledging what other publishing CEOs’ won’t, which is that the cost structure will not be supported by the business model for much longer”.  After reading that quote, I went back to the banking article and read it with a fresh perspective.  What the banks were saying basically is that their customers are obligated to provide them with the necessary revenue to cover their cost structure.  No they are not.  No more than consumers of news are obligated to cover the cost of printing a newspaper in every city in America.

Monday, November 14, 2011

Banking Industry's Third Wave

The American banking industry through the 1970’s operated within a patchwork of state and federal regulations that were largely rooted in legislation from the great depression of the 1930’s.  Within that framework banks were limited to operating within a single state and in some states to a single location.  Beginning around 1980 state regulations began to give way to demands to modernize the industry through deregulation. 

The 1980’s became what I would characterize as the first wave of deregulation, or perhaps more correctly, reduced operating restrictions.  During this wave banks found success through consolidation both internally and externally, both for the purpose of gaining operational efficiency.  Merged banks consolidated branches and back office units.  Operations and lending functions were centralized with smaller branch staffs focused on sales.  Although it seemed quite challenging at the time, in retrospect it seems more like we were just “harvesting the low hanging fruit”.

The consolidation of the industry continued into the 1990’s when it combined with a re-energized economy to produce growing bank profits.  After catching its breath with the internet bubble induced recession of 2000, the economy took off again, this time driven by increasing real estate values.  During the 1990’s and well into the next decade, banks large and small continued to grow their profits.   In addition to the benefits from consolidation, profits were driven by growing loan portfolios and fee income.  If you look below the numbers just a bit, you could see that loan growth was largely driven by real estate across all categories.  The real estate bubble that developed in the last decade was made possible by consumers’ willingness to go deeper and deeper into debt.  For many community and regional banks their loan growth was concentrated in construction lending and commercial real estate in general.  In terms of fee income, if you looked below the top number you could not help but note that much of the growth was coming from overdraft charges.  As I summed it up at the time, banks were feasting on commercial real estate and overdraft fees.  One of my favorite expressions is from a fictional economist who said, “Things that can’t go on forever, tend not to”.  Indeed they did not.  The real estate bubble burst and consumers finally reached their breaking point on debt and their tolerance of bank fees.  Today banks are dealing with the aftermath of a collapsed real estate market and a reduction in fee income from overdrafts and debit card transactions.

This brings us to what I would call today’s “third wave” of the post-depression era banking industry.  Most banks today are well into the process of recovering from the elevated loan loss provisions that they somewhat grudgingly began in the fourth quarter of 2008.  Nearly every bank will be able to look to their loan loss provision for a lift in earnings in 2012.  But, the lift will not be enough to restore earnings to prerecession levels.  Even with the benefit of historically low funds cost, tepid loan demand will limit growth in net interest income.  Fee income as we all know is now limited by both regulation and consumer backlash.  This operating environment, in my view, will continue well beyond 2012.  In fact, it could very well get worse.  In a future article I plan to write about what may be the future for bank branches.

In this new “revenue challenged” environment the winners that will emerge will have two distinguishing characteristics.  They will be exceptionally skilled credit grantors and exceptionally skilled at improving operating efficiency.  A banker reading this sentence will likely respond by saying, “hey, we are already good in both areas”.  No you are not!  Not in the manner that will be required going forward.   With the pressure building to find new loans, a bank will need to be able to land the good credits and leave the marginal ones to competitors.  And, having tough credit approvers who are willing to just say no (maybe too willingly as if they enjoy it), will not be enough.  Anyone can find a reason to say no to a credit, it takes skill to understand when and under what conditions to say yes.  In a sense, this will be something of a back to the future process.  The winning banks will be those that put forth skilled bankers that can discern credit and at the same time convince those good borrowers to do business with their bank instead of the competition.  In terms of gaining operating efficiencies, let’s just say the industry is ripe for disruption.  In yet another article I plan to write about a growing amount of money being invested by some very smart people with an eye to being very disruptive. 


Tuesday, November 1, 2011

Blogging Again

I returned to the banking industry in mid-2008. Since then I've been absorbed in my job as a workout specialists and after a long day of analyzing, writing, and talking, found it difficult to muster the strength to do yet more of the same in the evening. While I am still busy on the job, I have decided to find the time to add some thoughts here from time to time.
Actually, what brought this on was an accidental Google search that brought up my June 2008 post below about what I then observed as the de-leveraging of America. At the risk of indulging in a bit of self-congratulations, I must say it was "spot on". Just above that post is one about Hudson City Bancorp. I now see that their stock price has taken a beating this year, not because of poor lending habits, but the scarcity of earnings in our de-leveraging economy.

And WOW!  The CountryWide acquisition turned out to be even worse than I predicted! 
On another evening I plan to write about what I see as the banking industry being in the second phase of the post deregulation era.

Thursday, July 3, 2008

This Operation Is No CountryWide

I recently saw Ronald Hermance, CEO of New Jersey based Hudson City Savings Bank being interviewed on CNBC. He was on the show as the rare exception in the otherwise dismal banking sector. He described his $44bb institution as a simple and careful lender that continues to generate record profits. He said they concentrate on mortgage loans and individually underwrite every loan based by the traditional measures of collateral and income. Every loan, he went on, even those they eventually sell are underwritten as if they would be retained forever.

Being something of a skeptic, I wondered if there might be more to the story. So I pulled their financial data and guess what? The only “more” to the story is that they seem to be even more plain vanilla then what was described. Their earning assets are split about 60-40 between mortgage loans and mortgage backed securities. But, all of their mortgage securities contain only loans carrying government agency guarantees. And, while many regional banks have been ‘juicing’ their earnings with construction loan portfolios totaling 200 to 300% of capital, Hudson has a whooping construction portfolio equal to 1% of capital. No typo there…it is 1%. Home equity loans are almost as inconsequential.

So how are they doing? Very well, thank you! Their stock, while off from recent highs, is still double the level from 5 years ago. It sells at 1.8 times book value compared to most banks that now trade at a discount to book value. I can’t help myself from making a comparison to Bank of America which now sells at a 10 year low. In fact, you have to go back to the old NationsBank to get a higher price. Its price is .7 times its book value. Another comparison – Bank of America is 40 times larger than Hudson but has a market capitalization only 10 times larger. Hummm… think Hermance would have acquired CountryWide?

Monday, June 23, 2008

Is America De-leveraging?

One of my favorite books is The Tipping Point. It is a fascinating look at a range of situations using unconventional economic theory. After re-reading portions of it recently, I have begun to focus on what I think may be two areas where we have “tipped” and things will never be the same. The obvious one is energy and its ramifications are being addressed in the media so I will not repeat them here.

The other less obvious one is what I call the de-leveraging of America. First, the good news is that corporate America, with the huge exception of investment banks, has already completed this process. The vast majority of large corporations have used their cash flows and attractive equity market conditions in recent years in a manner that has left their balance sheets in excellent condition. But, some of those same companies were encouraging their customers to do just the opposite. (What’s in your wallet? Don’t leave home without it. Isn’t it about time for your home to start paying you?) The result is that American consumers are more heavily in debt than at any time in our history. The level of debt has been setting records for years now, drawing continuing comments from economists. Which brings to mind that sage economist’s comment, “Things that cannot go on forever tend not to!” Or, we have finally “tipped” and things will not be the same. Parenthetically, I would add that the ‘baby boomers’ finally reaching retirement age is a big factor in all of this. Which reminds me of one of my favorite books from some years ago, Mega-Trends. But, I digress. The mortgage crisis, I believe, is just a sub-component of this broader trend toward de-leveraging. We are already beginning to hear of home-equity and other consumer loans as the next big problem areas. If we sink deeper into recession as some believe, these portfolios will only come under more and more stress.

I believe every business in America, particularly the banks, needs to assess how this de-leveraging will impact their business. As consumers are able to repay their debts, don’t expect them to return to their profligate ways, even with your most clever advertising. As to real estate, we have also reached the point where home buyers are looking at things very differently. Or, as a person on television today said, ‘until we reach a point where buyers once again view a home purchase as consumption instead of an investment, we will not know the true value of homes’. Sounds like a tipping point within a tipping point. Like any change of this magnitude its effects will not just be negative. Big opportunities will be created for prescient companies to exploit.

Tuesday, June 17, 2008

Bank of America CountryWide Watch - Update

The stock market was not kind to banks today on fears of additional write-offs and possible dividends cuts. BofA in particular was noted in this regard as it set a new 5 year low below $30. One year ago the stock traded at over $50 with the decline amounting to about $100bb in shareholder value. Their common stock now yields 8.75% which means the market is betting on a cut in their dividend. The CountryWide acquisition is largely viewed by analysts as ill-conceived and adding more risk to an already risk-laden business. Yet the bank seems determined to go forward.

I like to contrast BofA to U S Bank. U S has chosen a very different path. It has carefully selected its business lines and manages risk with even greater care. Its acquisitions are also carefully strategic in nature. While BofA's stock this past year dropped over $20 to below $30, US Bank has seen its stock slip a mere $3 to $31. Wonder why Warren Buffet owns US Bank and not BofA?

Thursday, June 5, 2008

Bank of America CountryWide Watch 2

The Fed today approved the merger. Now it seems they only need shareholder approval which I believe is later this month. So, it looks as if they are staying the course despite calls for them to get out of the deal. And get out they could. I'm sure the controlling purchase agreement has sufficient language regarding deterioration and legal issues that they could easily kill the deal with no risk of legal retribution. Business deals are often driven by ego & stubbornness, and I think that is what we are seeing here.

BofA will follow one of two options. One, as I have written earlier is just to write down the value of CountryWide's loans just prior to closing. And, I mean REALLY write down to cover their worst case scenario. This will result in booking a relatively large increase to their goodwill account but not doing the deal would mean a write-off of their Preferred stock investment and the various extensions of credit to CountryWide. I wrote about this in more detail in an earlier article. Essentially this is just a clever way to transfer their loss to the goodwill account. The other option for them is to go the bankruptcy route as I also wrote about in an earlier article. It will be fascinating to see how they proceed.

Wednesday, May 28, 2008

Bank of America CountryWide Watch

Bank of America today announced its management structure for the combined companies. This is certainly a signal that they do not intend to scuttle the deal despite my humble advice to the contrary. This also in despite of what the market seems to be telling them. BofA's stock is down nearly 20% YTD. In fact, BofA is trading at its 5 year low. By comparison, US Bank which I think is one of the best managed banks in the country, is up 10% YTD. I still can't imagine the bank assuming all of the legal and credit risk now peculating up at CountryWide. The managed bankruptcy I wrote about earlier must be the path they are on. But, that could prove costly as well because it will most certainly trigger additional lawsuits attempting to shift the liabilities to BofA. It will be interesting to watch this unfold.

Monday, May 19, 2008

Bank of America - CountryWide Update

I am more convinced than ever that Bank of America's prime motivation in taking over CountryWide was and is to avoid the huge write-offs that would be required if they allowed it to continue into bankruptcy. The cost of this maneuver, however, continues to rise. Last Friday a federal judge ruled that CountryWide, its officers and directors must deal with shareholder lawsuits claiming fraud. Also, the FBI is continuing its criminal investigation of CountryWide (and other lenders). In the face of these rising legal costs added to the mounting credit losses, it is becoming apparent that Bank of America's too clever by a half effort to bail itself out of a lousy investment is becoming intolerably expensive. I am looking for a possible announcement this Friday before the long holiday weekend. That seems to be the popular time to release unpopular information.

By the way.... I ran across an analyst's report of last August touting Bank of America's $2bb investment in CountryWide. He said 'this is no fly-by-night lender, it is THE preeminent mortgage lender in the nation'. Wow... wonder how much money this brain surgeon makes.

Saturday, May 3, 2008

Bank of America Bails Itself Out of a Problem - update

When the purchase of Country Wide Financial (CFC) was announced in January I wrote that I viewed it as a clever way for Bank of America (BAC) to bail itself out of a problem loan. Here is why. BofA had invested $2bb in preferred stock last August that is convertible to common at $18 per share. By year end with CountryWide heading for certain bankruptcy, that investment would need to be written off, likely against '07 earnings. Also, BofA had long been CountryWide's principal commercial bank so would have also had credit facilities likely in the range of multiple billions of $$'s. Add-in other possible exposures on swaps, etc and the total charge-off they were looking at was quite likely in the range of $10bb. So, for a mere $4bb in BofA stock (that's not real money, after all!!) they get to soak up the problem with nary a stain left on the floor. Worst case for them is that if the net value of the assets acquired were to fall below their $4bb purchase price, they would incur good will.

When I wrote in January I noted that one significant risk to BofA was the continued deterioration in the quality of CountryWide's assets and operation. Well, it looks like this is happening in spades. At quarter end, just under 10% of CountryWide's loan portfolio was more than 90 days delinquent. That looks to be an astounding $10bb of loans on the verge of foreclosure. And in this case the "trend is not their friend" as some like to say. There is no reason to believe this deteriorating trend will not continue. Operationally, the company is facing multiple investigations including at least one that is criminal. The potential cost from these cannot be quantified. Thus, in a matter of several months what may have seemed like a clever way of dealing with a problem borrower has become very costly. Several shareholders literally begged Ken Lewis to call off the deal at BofA's recent annual meeting.

With the cost of the "acquisition" ever rising it is little wonder that BofA has now let it be known that they may take steps to avoid direct liability for debts and presumably legal issues. (Or, perhaps this was their plan all along.) In their SEC filing on Thursday BofA indicated they would likely not assume all of CountryWide's liabilities. CountryWide has some $97bb in Notes Payable. How can they, you ask, if this is a stock for stock purchase not assume the liabilities? Fortune Magazine's on-line edition today has an article filling in the blanks a bit. It seems the actual entity doing the acquisition is a new subsidiary called Red Oak Merger Corp. The plan, according to Fortune, is for Red Oak to hold the CountryWide entity and then sell certain assets, such as CountryWide's commercial bank, directly to BofA. Red Oak would then hold whatever amount of cash that equaled the fair value of the assets transferred which could then be used to satisfy CountryWide's debt. BofA could also pay for assets transferred by assuming debt but cautions in their SEC filing that they cannot give any assurance that they will assume all debt. They did indicate that some $11bb in revolving bank debt would be assumed. (A big chunk of which is likely owed to guess who ... BofA, that's who) In the end, Red Oak would itself be put into bankruptcy.

What is fascinating about this is that it starts to look very much like what happens when a bank is closed by the regulators and then sold to an acquiring institution. It is also similar to what happens in a bankruptcy liquidation. All of which raises the question, was BofA given the OK by the regulators to pursue this strategy? It will be interesting to follow the drama.