The Great Recession and Financial Crises have unquestionably changed the modern banking industry. While Wall Street was once shrouded in shadows and obscurity, today it is the lead on the evening news, the first topic at political debates, and a common enemy both at the water cooler and kitchen table. “Credit derivatives”, “subprime loans”, and “systemic” have suddenly become everyday terms. But out of this financial disaster hard lessons have been learned and the game has changed. The paradigm in banks of “bigger is always better” is no longer valid—the glory days of the big banks are over. Today we return to a bygone era in banking: the era of communities investing in each other, of people helping people.
But it’s not all just feel good fluff, the fundamentals paint the picture…-The Flaneur
It’s A Wonderful Life – A Return to the Community Bank
Banking is an industry of managed risk. Institutions accept the deposits of the populous and pay them a small interest rate in return. The institution invests those funds in loans or other investments at a higher interest rate. The bank keeps the difference for overhead and a respectable profit. This basic model has been successful for thousands of years, and it will remain successful for thousands more. It is time tested, and with reasonable risk management can be predictably profitable with healthy returns on investment. Predictability is valued and uncertainty is shunned.
Over the last several years, the banking industry has paid the price for poor risk management. Banks grew concentrations in businesses they did not fully understand, they made loans without understanding fully how those loans would be repaid, and they created highly complex, risky products under the guise of innovation. They even gambled their own capital on speculative trades—no different in essence than sitting at the blackjack table in Las Vegas. This was coupled with an unprecedented consolidation in the industry that placed a small number of institutions with immense influence over the entire economic system (the “systemic” banks). Once again, the banks marketed this as an advantage, a risk management strategy to protect earnings against any economic possibility. The model of the big bank was broken with the financial crisis—institutions become so large and complex that even the most talented managers cannot appropriately manage the risk. This persists even today with the recently announced $800 million trading loss at JP Morgan Chase under CEO Jamie Dimon. However, in the aftermath, it is the community and regional banks, those that understand the fundamentals of banking, the blocking and tackling that are set to grow and prosper over the coming years. By sticking to the basics, these institutions will reduce uncertainty and demand an increasingly high premium in the markets.
Optimism for the Industry
Before any argument can be made to invest in this industry, the economy must first be sufficiently healthy to support the repayment of loans at the macro level. It is our position at The WSF that now is the time to buy low. Several key trends demonstrate that the industry is beginning to bounce from the bottom.
- Delinquency rates, that is, the percentage of loans that are 30 days or more behind on their monthly payments are showing broad-based improvements. The average delinquency rate of all outstanding commercial loans has improved 24.7% from March 2010 through March 2012. This is improvement is primarily driven by Commercial & Industrial (C&I) loan delinquency rate of only 1.16% and the Consumer Loan delinquency rate of 1.37%.
- Bank failures and banks identified as “Problem Institutions” by the FDIC has shown dramatic improvement over the past 2 years. Since the peak of the crisis in 2010, the number of “Problem Institutions” has declined from 884 to 772 as of March 31, 2012. This is a 13% improvement. There were 157 bank failures in 2010, compared with 92 in 2011 and just 16 in the first quarter of 2012. If the trend in 2012 continues, the Flaneur projects a 59% decrease in bank failures from 2010 to 2012. While there are still a large number of “Problem Institutions” and bank failure remain high (there were only 29 bank failures total from 2000 to 2005), the trend is very positive and is a clear indication of a healing industry poised to prosper in the near term future.
- Bank capital, which roughly corresponds to the equity on their balance sheet, has also been increasing steadily since the bottom of the Great Recession. This is significant in that it adds a layer of protection to the bank in the event of future losses. For the biggest banks this is being driven by the regulatory requirements both at home (Dodd-Frank) and internationally (Basel III), but for the community banks and regionals it’s an indication of profitability and sound banking practices.
Avoiding Uncertainty – Profiling the Winners in the Banking Industry
As we see it, there are a number of material uncertainties facing the big banks that put them at a distinct competitive disadvantage with the smaller banks.
- Regulatory Uncertainty – The impact of Dodd-Frank is still widely unknown. Regulators are dragging their feet implementing some of the most controversial provisions, such as the proposed Volker Rule eliminating proprietary trading. The impact will be huge. In 2010 JP Morgan Chase reported net income of $15.8 billion. Of that $5 billion came from trading profits from just one proprietary desk within the bank. If the Volker Rule as in effect at this time, JP Morgan Chase’s 2010 profitability decreases 32% just from taking away propriety trading from that one desk. Additionally, new international regulatory guidance calls for the phasing in of higher capital requirements for the big banks over the next 10 years. This will make it more difficult for these banks to post high Return-on-Equity ratios relative to their smaller competitors because they will be required to maintain a higher equity base. The only certainty is that the most draconian of these regulations will only be applicable to the big banks—Dodd Frank exempts institutions with total assets less than $10 billion from the majority of its requirements and the new international regulations only apply to institutions with total assets greater than $50 billion.
- International Uncertainty – China, the growth engine in the world economy over the last 10 years has suddenly seen its GDP figures decelerate rapidly. As the Chinese consumer adjusts to this reality, their spending (and therefore Chinese imports of foreign made goods) will decrease. Banks with exposure to international trade will indirectly feel this pain. Further, and perhaps even more significantly, the current drama in the Eurozone has the entire region on the verge of a second, severe recession. Any deterioration or potential breakup of that union will cause significant currency fluctuations and volatility.
- Ongoing Foreclosure and Housing related Litigation – The Federal Housing Finance Agency (FHFA) has filed lawsuits against 17 banks for $196 billion dollars claiming that the banks sold Fannie Mae and Freddie Mac billions of dollars of mortgage securities that were misrepresented or falsified prior to being sold. Analysts estimate that Bank of America could face a total loss of over $40 billion alone just from this lawsuit. The “robo-signers” controversy where large banks short-cut appropriate legal procedures to accelerate the foreclosure of homes is also still up in the air. Analysts are predicting that major banks will likely settle with state and local prosecutors for somewhere in the neighborhood of $25 billion.
As the industry heals and then once again prospers, some players will succeed more than others. We believe that a premium will be placed on banks that are both sound and predictable. These institutions will be small and/or regional, they will be domestic, and they will be well capitalized.
- Small and/or Regional – The significance of size in this profile is driven by the uncertainty in regulatory requirements and the simplicity of operations. These banks have historically never had proprietary trading desks. Their historic earnings are representative of their future earnings thereby making them more predictable. And the majority of regulatory rules (and therefore expenses and risks) are targeted at banks with total assets greater than $50 billion with even more relaxed regulations for institutions under $10 billion. Stay small and you get you play by a simpler, established and predictable set of rules.
- Domestic – The global economy is currently wrought with challenges, questions, and uncertainty. The EU is on the verge of collapse, the results of which could be devastating for those economies and could be highly disruptive to currencies worldwide. Further there are growing fears of an asset bubble in China that could soon burst with their rapidly cooling economic growth. Without international exposure, domestic banks are largely shielded from these risks.
- Well Capitalized – John Medlin, the iconic CEO of Wachovia Bank in the 1970-1990s famously said that the key to successful banking was a three legged stool – Soundness, Profitability, and Growth. Without all three a bank couldn’t stand. He was careful though to always put Soundness first. A well-capitalized bank can make more loans, take reasonable risks, and gain market share. They experience reduced regulatory scrutiny. Their depositors can sleep easy at night knowing that the bank will still be there in the morning. Being well-capitalized is a significant competitive advantage.
A small, domestic and well capitalized bank is poised to profit in the next 5-10 years. The giant banks will be straddled with capital requirements and new regulatory expenses that will curtail their ability to lend. The economy will continue to steadily recover and businesses and individuals will gradually increase the demand for loans. When supply decreases and demand increases, prices go up. As the price for a loan goes up, it will be the community and regional banks positioned to take advantage.
Next week, we’ll dive into this profile even further, highlighting specific banks that are positioned to win in this marketplace.