Six thoughts on the lay of the land for those of you considering investments in Wells Fargo, Citigroup, JP Morgan, U.S. Bancorp, Goldman Sachs, Morgan Stanley, or Bank of America:
#1. Recent History Of Regulatory Environment, Wave 1: The Wall Street Journal has provided readers with excellent journalism recently regarding the changes for America’s megabanks, starting with the general piece “What is a bank?” and continuing through yesterday’s column “Stressing Over The Bigger Costs of Being a Big Bank.”
Every now and then, government actors scratch the itch to do something that sounds like it has a salutary objective in mind but ends up imposing very costly agency costs that takes away much of the intended wealth maximization. In the 1985 Smith v. Van Gorkom Delaware case, the court held that business executives need to “reasonably inform themselves of all material facts” before making a “substantial” decision.
Well, that’s a heck of a hurdle. “All” material facts–if you are an executive, how on earth are you supposed to discharge your duty to know everything important about making a decision in real time? Well, the Delaware Supreme Court answered this obvious follow-up by saying that evaluative or fairness opinions from investment bankers will serve as proof that an executive reasonably informed himself if he got the opinion and read it.
Soon after, this opinion was joked about as the “Investment Banker Full Employment Act of 1985.” Executives don’t want to take on the risk of being held liable for a fiduciary violation of reasonable care, so they would automatically hire investment bankers to issue opinions to insulate themselves from shareholder derivative litigation.
This trend, born of a well-meaning desire to make executives perform due diligence before making substantial decisions, imposes high agency costs. If a southeast bank wants to buy up 100 branches from a competitor, and has expertise in the area, it might have to pay Morgan Stanley $2 million to approve a decision it was going to perform anyway. That’s $2 million coming out of the shareholder’s pockets. If the amount of money spent confirming executive decisions is greater than the amount of money saved by getting investment banker opinions, then the “reasonably inform yourself of all material facts” standard has ended up squandering the wealth of shareholders.
It is also infringes upon the autonomy of a business to run itself. Instead of only bringing in consultants and investment bankers for extraordinary transactions, ordinary transactions caused executives to forfeit their autonomy to bring in someone else to share in the decision-making.
This is also a symptom of the trend where no one wants to be responsible for decision-making until the outcome is certain. In recent years, you’ve seen college sports programs bring in committees to provide recommendations for the athletic director on which coach to hire. It’s an outsourcing of authority–hiring coaches is a primary responsibility of being an AD, and yet, athletic directors are now shying away from making the decision themselves because they’d rather point to the committee and dodge accountability when the decision doesn’t work out.
Even before the financial crisis, American shareholders were indirectly ponying up for these ongoing, frictional expenses that go towards advisors aiding in decisions that are just slightly above what we would have traditionally considered everyday decisionmaking. The Smith v. Van Gorkom aftermath, coupled with the social trend favoring the outsourcing of decisionmaking, hastened this rise in agency costs.
#2. Dodd-Frank, Wave 2: Any time you try to regulate, you have to ask yourselves two questions: Do you want to implement standards or rules, and do you want to be overinclusive or underinclusive?
The advantage of standards like a general “duty to act prudent” is that you get to follow common sense a bit, and contentious matters tend to get resolved in your favor–the absence of a rule puts the benefit of the doubt in your favor since you’re not knowingly breaking any black letter rule. The downside is that cunning individuals can take advantage of this leeway generosity by crafting a screen of plausible deniability for behavior that they know fails a standard but can make a pretty arguable case that it doesn’t.
To remedy this latter issue, you can of course pass rules. And that’s what Dodd-Frank does–two thousand pages of them. The 2010 Congress decided that the high agency costs of complying with thousands of pages of regulations is superior to the wiggle room and lower transaction costs that come with a standard-based approach.
Once you decide on rules, the next question is: Do you want to be overinclusive or underinclusive? By that, I mean: Do you want to err on the side of maintaining all the wealth-creating things, and in so doing, permit some bad behavior? Or are you more driven by weeding out nearly all the bad behavior, and in so doing, you will also limit responsible wealth-creating actions that fall within the purview of the rule? The Dodd-Frank chose the latter.
As a result, bankers need to hire a lot of other bankers, accountants, and people with financial expertise to avoid unknowingly breaking the law.
Imagine if you’re a Goldman Sachs swap-dealer, and you have discounted federal funds sent to you in advance–what kinds of credit swaps can you do? Well, you can only hedge risk for things that are “substantially related to core business activities” which then has its own list of 23 permissible uses of direct activities. If the swap involves rate shifting, you are given the vague-sounding rule that you can only do credit swaps that are permissible by national banks. You also have to check whether at least 5% of the original loan amount is maintained by the securitizer, and if less, you can’t do the transaction at all. So you look up the national bank regulations, and figure out when they can trade rates on the transaction you’re contemplating. If it is a security based swap, or one based on an index fund containing less than 9 securities, different regulations apply. And if one of those security index components involves a qualified residential mortgage loan, then your ability to engage in the transaction is dependent upon the underwriting standards of the originator according to its own sliding scale (and this limitation doesn’t apply to banks with less than $50 billion in assets). You can see how this gets cumbersome. This is just one hypothetical I drew up from two pages of the act.
This leaves bank investors with two questions: How can banks grow shareholder profits in this regulatory environment, and should the banks contemplate a series of spinoffs that make them substantially smaller and outside the purview of Dodd-Frank’s onerous restrictions?
#3. Loan Portfolio Growth: The core signal of health for a bank is the rate of growth of its loan portfolio coupled with the quality and interest rates on those loans. Many people have been concerned that banks with trillions of dollars in assets would struggle to grow. Well, over the past three years, the collection of JP Morgan, Bank of America, Wells Fargo, and U.S. Bancorp has a loan growth rate of 5% per year. That’s pretty solid.
Absent a 1991 or 2008-2009 type of increase in default, that is the kind of thing that can translate into respectable single digit earnings growth of around 7% or so. If someone in your social circle has been complaining about difficulty securing a loan, he is probably correct–the number of home loans from these institutions is about a third of what it was back in 2007. The megabanks have largely focused on business lending to perk up their portfolios.
The natural follow-up then: How does this shift towards commercial lending affect the interest payments and default risk of the portfolio as a whole?
#4. Loan Portfolio Quality: Usually, when a megabank lends to an individual, the loan amount is attached to some piece of property. You secure a mortgage, and the bank gets the home that runs with the land–if you stop paying up, there’s a nice consolation prize of getting the property.
But when mega-banks lend to businesses, only about a third of the overall lending is attached to machinery, office buildings, and the like. The remaining two thirds constitute unsecured loans to businesses, almost all of which are operating as limited liability entities.
Normally, this issue can be resolved before the loan is given–if a business borrower doesn’t have adequate quality, the bank can refuse the loan altogether. If the earnings power is a bit of a gamble, you remedy this through higher interest rates. You might charge 8%, 9%, 10%, or more to compensate for the risk of uncertain payment. Sure, some businesses will go bankrupt and not pay up, but the ones that prosper and pay 10% interest will offset the defaulters.
Coming out of the recession, the banks have only made one misstep with their lending: they did not charge the proper rates for low-quality E&P energy firms. There’s a lot of oil companies that went bust that were only paying 4% or 5% on their loans, when the risk of default was much higher. There was no one paying 10% to offset this because the bank’s mis-appraised the risk of extended low gas prices.
As a result, about 2.5% of the bank’s loan portfolios have been decimated from oil in the trading in the $30s and $40s. But other than this, the loan quality has been. The non-performing rate of loans outside of the energy portfolios are, in aggregate, less than 1.5%.
If I had to guess, the next risk to the megabank portfolio will be auto-loans. In the past three years, a lot of people have taken out car loans in the $25,000 to $30,000 range while having household earnings power of less than $50,000 per year. That’s about 40% of the auto-loan market. Another recession, and the default rates here could be high. I would imagine the effects would be similar to that brought on by the oil glut–the kind of thing that knocks earnings down from the high single digits to the mid single digits, absent other economic changes as well.
#5. Net Interest Income: When interest rates rise, the net interest income of banks and insurance companies stands to increase. If interest rates rise faster than the market anticipates, then the P/E ratio of nearly all stocks will compress. However, the net interest income from banks and insurance companies will rise, offsetting this. Even if interest rates increase at a slow pace in the coming years, which the market expects, it will still add substantially to the bank’s bottom line.
Imagine if Berkshire Hathaway’s $60 billion cash hoard starts earning 4%. That’s an extra $2.4 billion for shareholders–each share of Berkshire would represent an extra dollar in cash from interest rate changes alone. Insurance companies and banks would see their net interest rise, as capital on hand earns higher rates and the gap between what banks can demand from loans and what it pays out to depositors expands.
Experiencing over thirty years of declining interest rates have altered just about everybody’s perception of what is normal, but it’s always good to remember that those with large amounts of “stagnant” capital on hand will start earning more and the P/E ratio of stocks in general decline as the risk-free alternative becomes more impressive.
#6. Big Bank Breakup Reminder: You know how some people make the superficial error of concluding that stock splits create wealth? Well, there is another, larger segment of people that act as if split-ups lead to a destruction of wealth. People forget that large breakups have led to some of the biggest wealth creations in the history of our civilization.
The most recent one was the old Philip Morris–you get chunks of ownership in Altria, Philip Morris International, Mondelez, and Kraft-Heinz. Before that, the biggie was Standard Oil–if you owned it in the early 20th century, you got stock certificates in what is now BP, Buckeye Partners, Exxon, Chevron, Conoco, Phillips 66, and a couple dozen others.
You maintain ownership throughout the changes. If Bank of America breaks up, you’d get to be the owner of Bank of America California, Bank of America New York, and whatever else gets created from the corporate change. It’s not something that should cause apprehension–often, the more focused entities feel less encumbered and grow a bit faster as the afterthought assets become the core assets of the smaller entity. The reason it doesn’t happen is usually empire-building–if you become the CEO of a trillion-dollar empire, would you want to voluntarily decrease the scope of your dominion to $50 billion? It’s an area where the interest of the controllers can conflict with that of shareholders–I don’t think even Warren Buffett himself is immune from this, as he often understates the benefits of a Berkshire break-up which would probably be the most value-creative corporate change in the history of the American markets.