Wednesday, February 25, 2009

The Trouble With Harry, or CCC

You are a large global bank. What is your business model, right now? I discussed this with a friend at a bank today and we came up with this: cross my fingers and hope to survive.

In other words, current banking strategy is based on the fervent hope that things are not as bad as they seem, that the global economy will improve faster than feared, that credit and equity markets have overshot on the downside because they are panic stricken instead of discounting a terrible future.

That, above all else, The Trouble With Harry is not that he is stone-cold dead from repeated overdoses of deleterious debt, but that he is suffering from a temporary confidence coma.

A Banker Hard At Work Implementing
His Current Business Model

Well, good luck with that.

Hope may be a fine personal trait but it does not make for good banking business models. When bankers have to rely on sentiment instead of hard-nosed greed you know they are in deep trouble. And what is the nature of their problem? It's in the title of today's post: the Capital Conservation Conundrum, or CCC for short.

Let me explain.

Banks are very simple businesses: borrow - lend - repeat. The crucial word being repeat, because if the cycle stops banks almost immediately start losing money. When principal is repaid (or defaulted) and is not re-lent net interest margins (NIM) decline and high fixed costs hit the bottom line hard. Therefore, as banks go into capital conservation mode and shut lending down they create a negative boomerang effect for their own earnings. In more ways than one, banks are like sharks: they have to keep swimming in order not to sink.

Banks striving to preserve capital (i.e. to maintain capital adequacy ratios) are in effect winding down their core business. This is another reason - beyond loan defaults and trading losses- that banking stocks have been pummelled into the dust. The KBW banking index is down a whopping 80% in two years (see chart below).

KBW Banking Index (US)

As a confirmed contrarian investor/speculator I look at the above chart with interest. But when I try to attach a fundamental story - where is the next seminal earnings upswing going to come from - I cannot find one.

Perhaps it is my own lack of imagination, but I cannot see the next big thing for banking revenue and earnings. (For example, after 2001 it was clear that mortgage and consumer lending was going to boom as the Fed slashed rates). So, in my own mind at least, the banking sector is not worthy of a long-term investment commitment - even as a dead-cat rebound may be imminent. (I would be very interested if readers could supply alternative perspectives).

In my opinion "Green" is the sector - many sectors, actually - providing future multi-year opportunities. More on that in the next post, based on my recent trip.


  1. I think you pick on the banks too much. How is what you describe any different then the widget maker who's fixed costs become toxic when the market for widgets dries up? What business model has no fixed costs so that margins do not decline when business dries up?

    As for the catalysts for these stocks going higher, wouldn't the other side of the business cycle plus 1/2 the competition be enough to make 'um go higher? Surely there will be a cycle.

    If your point is that debt in general is just the buggy-whip of the twenty first century then sure the banks are done - but thats not realistic.

    I know at the big bank I work at (full disclosure...) our unit has remained solidly profitable (part of an investment bank) and we are now doing the work we were doing before with 1/2 the people. Considering how much of that "fixed cost" in banking is actually people (tell the guys they were fired they are a "fixed" cost..) I think we will say outrageous margins when business comes back.

    But I'm talking my book here.

  2. Dear Anon,

    Yes, you are right - I DO pick on the banks too much. I guess it's because I'm in the finance business and I expected more from them - like possessing a modicum of common sense.

    I believe that debt GROWTH is the buggy whip of the 21st century, not debt itself. My point is that it takes precisely that, DEBT GROWTH, for banks to earn money consistently.

    Thank you vm for your input.


  3. loss of access to cheap funding is what kills banks. As long as banks can have access to cheap funding, they can generate positive cash flow.

    I do not foresee a systemic run on deposits in the US nor at Bank of America (BAC) in particular. Thus, I believe that the problem that Minyan Peter is referring to will not come to pass.

    Even if there were some sort of run on deposits at some point, as long as the Fed continues to act as the “depositor of last resort” providing unlimited cheap funding to banks (as they have promised that they will) then there should be no problem. When people realize that for ever dollar that panicky savers withdraw, the Fed is willing to replace one dollar or even more at an even cheaper rate, then people will not bother withdrawing.

    Interestingly, I did not address the issue in the article, but the issue that Peter brings up, is in my mind, one of the greatest potential sources of upside for the banks: funding costs are dirt cheap, almost zero percent and are likely to remain so for a long time. Banks are making a killing on spreads. That means high net interest margins and high profitability on their performing assets. At these funding rates, banks are a cash-generating machine and this will accelerate balance sheet repair. Indeed, the Fed might even commit to keeping some special sort of funding windows open long-term to help the banks out. This is what happened in several countries that had banking crises.

    Thus, as long as the Fed stays behind the banks as a sort of guarantor of cheap funding – and there is every indication that they will – then the profitability assumptions in my model may be too modest. Banks might have rip-roaring profitability in the next few years and repair their balance sheets faster than anybody thinks.

  4. That BKX chart looks to me to be a recognition by the finance community that crude oil production has peaked. Certainly some major players were well aware of that quite some time ago. Without continuous supplies of cheap transportation fuel, the debt model blows up. For those pointing to the crude oil price as a definitive sign that peak oil is a scam, I would say that the planet's capacity utilization has just undergone an historic plunge, and conventional oil production levels have remained essentially flat.

    So, it is quite different this time and logic would indeed point to a green future. Unfortunately, logic and the existing power structure are not necessarily congruent concepts, especially when ethics are removed from the equation. I'm thinking we've squandered our brief window of opportunity pursuing a last man standing approach. President Obama's address last evening provided little in the way of hope for a different path.

  5. I don't see funding as a problem for banks, at least not for much longer. I think it is on the loan demand (and loan approval) side that the problem resides.

    Simply put, people don't want to borrow. And those that do are not being approved because they are already in or near default.

  6. Do people trust the Broker of last resort. No the taxpayer cannot but at least they see 3 plus million lost jobs. They did not care while it was happening since why and will they ever. They never create value but spend capital poorly. Banks should remember they need us and we do not need them given alternate sources of funding. This is in regards to the 70 percent who are the economy. To date people are defaulting and every week goods are offered at slashed prices. Maybe a "the" silent green grass roots revolution will sweep these poor models away for good.
    Double the integration of green from black technology's for 5 years is all we can assume to maintain the margin of any grouwth
    IMO or more social acrimony will ensue since when and why support models of a soon to be corpse leviathon.
    Oh yes we have cut back also, and half of them still are not needed anyway. Pointless to state the affairs of common sense unless its attached to a foot to kick them in the butt called positive cash and proper investment's to produce
    cash flow to net long term value.
    The customer is not always correct but understand group think got us here anyway so think for yourself what is important.

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  8. Hell, didn't you say you work for a large bank??? As an outsider, I do not understand, how people like you who knew what was coming could not change the course for the banks. How were you treated before and after the crisis? Did they ignore your opinion before? Do they still ignore you?

    Thanks for this excellent post.

  9. I do not work for a large bank - or any bank. However, I did work for two large investment banks ages and ages ago.

  10. Here is a more positive scenario: let's say that after all of the losses are taken, you own a bank stock at 50% of tangible book value. Net interest margins are improving for banks, especially without the disintermediation of securitization. Even in a tough economy, a bank can earn 8-10% returns on equity so long as net interest margins are strong. (Since you're in at 50% of book, the bank is earning 16-20% on your equity.)

    In a tough but not tanking economy, a bank is likely to trade for 10x EPS. Voila, you've doubled your money. Furthermore, if the bank is bought, it will likely trade for some amount in excess of tangible book value.

    The key to this admittedly rosy scenario is the initial analysis of buying at 50% of real tangible book, rather than stated tangible book.

  11. "where is the next seminal earnings upswing going to come from"

    From the tax payers. Here's how it works: tax payers buy equity, infuse capital, tax revenues fall short (deficit), banks buy gov bonds at 3%--pure profit. And if you are smart (Goldman Sachs) you short gov bonds because you know the new bubble circle-jerk scheme will soon fail.

    On a serious note Hell, I do think you are right about your green energy concept. I hope we have leadership at the top that sees it your way.