The Cost Of Being A High-Quality Bank

I haven’t yet written about the cross-selling scandal at Wells Fargo because I suspect there are more relevant facts that will come out, and I want to analyze them before I publicly share my opinion on the surprising business development. But I do want to use the Wells Fargo news to tackle an ancillary question: “Why would a conservatively managed bank feel pressure to goose earnings?”

The best way to answer that question is through example by looking at the story of M&T Bank (MTB).

If someone asked me to build a portfolio of 50 “buy and hold” forever investments where each of the 50 spots had the lowest possible risk of bankruptcy or permanent capital impairment, M&T Bank would make the list.

It has an absurdly strong balance sheet that could weather 5x as many defaults as it experienced during the recession years of 2008, 2009, and 2010. The loan portfolio only grows at a 3-5% rate, and the earnings have only grown at a 3.5% rate since 2006.

The bank does exactly what you’d expect a traditional financial firm to do. It runs 800 branches in New York, Pennsylvania, Maryland, and West Virginia, and uses the retained profits from those operations to upgrade security of its bank portals, train employees, roll out ATM locations, and add teller cash recyclers.

The bank’s conservatism was most apparent in 2008, 2009, and 2010 when the bank not only remained profitable, but was able to keep its outstanding dividend commitment to shareholders intact, too.

In August 2007, M&T Bank raised its annual dividend to $2.80 per share. At the time, profits were $5.60. During the worst of the recession, profits fell to $2.86. But throughout the financial crisis–2008, 2009, and 2010–the shareholders kept collecting their $0.70 per share every 90 days.

That had tremendous value for retirees and someone whose state of mind shifted from wealth accumulation to a “I want to protect what I got” state of mind. M&T Bank had been an excellent compounder in the years leading up to the recession. Someone who purchased $5,000 worth of M&T Bank stock every year for the twenty years leading up to 2007 would have built up 7,423 shares of the stock with dividend reinvestment.

It was an economic blessing that such a long-term investor would have been able to collect $20,784 in annual dividends that remained steady throughout while broadly-defined peers like Wells Fargo, U.S. Bancorp, General Electric, J.P. Morgan, Bank of America, Citigroup, and American Express slashed their dividend payouts.

But the steady hand has come with a price. It is now 2016, and the M&T Bank dividend remains at $2.80 per share. True, core profits have improved dramatically from that low of $2.86 per share in 2009 to $7.85 per share so that the dividend payout ratio has declined dramatically to 36%, but that lower dividend payout ratio hasn’t translated into much earnings growth (M&T earned $7.54 in 2012, an estimated $7.85 in 2016).

Since June of 2007, M&T Bank has only compounded at a 3.8% annualized rate with dividends reinvested. That is right because the price of the stock has declined from $125 to $114 so those $2.80 in annual dividends that shareholders have been collecting each year have needed to offset the P/E compression and then have contributed a meager amount so that shareholders can claim total returns in line with inflation.

With interest rates so low, it is very difficult to generate high returns for shareholders without keeping capital levels low, under-investing into the business, or taking on riskier lending practices. M&T Bank is an example of a firm that eschews all three, but it comes with a cost that shareholders have earned minimal returns over the past nine years but did enjoy the safety of a dividend during down times.

It is also likely that most executive teams would face pressure from more senior management. The Board of Directors, and/or the shareholders if they only spent a decade delivering 3-4% annual returns. At M&T Bank, officers and directors control about 6% of the stock and the CEO R.G. Wilmers owns 3% of the outstanding stock.

Wilmers owns almost 5 million shares paying out $2.80 per share in dividends so that he earns about $14,000,000 in annual dividends alone from his ownership position in the bank. This explains why it is managed so conservatively–he has a very impressive income stream to protect–but it has come with the tradeoff of lower capital appreciation resulting from low single-digit earnings growth.

M&T Bank has a unique culture primarily resulting from high insider ownership that permits it to prioritize quality lending and bank management over financial engineering and higher-risk lending. This strategy provides enormous benefits during the down times, but it also means that M&T Bank shareholders have not participated that much in the economic recovery of the past five years.

Most other banks have to pay the quarterly earnings game because shareholders and the Board are less willing to tolerate 3-5% annual earnings per share growth. That’s why I would look to see whether the Wells Fargo scandal goes deeper than we currently know, and examine whether other banks have adopted similar practices. I would also monitor declines in loan quality in the coming years. The pressure to generate quarterly growth in an environment that does not naturally lend itself to high growth right now is a strong signal that the vulnerabilities of greed and the other excesses of human nature may continue to rear its head in the banking sector.