Many of the big banks trade at very low valuations today, including Bank of America (NYSE:BAC), which trades at a P/B of 0.6, and Citigroup (NYSE:C) with a P/B of 0.7. Some argue that this is due to unwarranted negative sentiment regarding the big banks, and that they are set to reward shareholders handsomely in the next few years. I'm not so sure. As I argue elsewhere, these banks are so complicated and opaque that they are very hard to value properly. The market seems to be assigning a significant opacity discount to these companies, which in my opinion, is justified given management's conflicts of interest vis-à-vis shareholders, prior lack of transparency and track record of mismanagement.
All this said, there are real, profitable lines of business hidden in there somewhere. The problem is that all of these businesses are grouped together into a black box. Spin off the good operating units, and they will likely trade at higher multiples. Just like the sprawling conglomerates of the 1970s, the megabanks are simultaneously difficult to analyze and have several unnecessary layers of bureaucracy. Shareholders have been hoodwinked long enough by these capital sinkholes, and should demand transparency and profitability. Breaking the banks into digestible pieces will do both.
To illustrate how this might play out, I'll use Bank of America as an example. The company divides its results into six business segments, Consumer & Business Banking, Consumer Real Estate Services, Global Banking, Global Markets, Global Wealth and Investment Management, and All Other. While there are many possible break-up schemes, this article will consider a Bank of America split across these lines. Here's the financial results of the six segments in the latest 10-K (in billions of dollars):
Return on Allocated Equity
Consumer & Business Banking
Consumer Real Estate Services
Global Wealth & Investment Management
It is clear from the table that many of the businesses appear to be doing just fine, and that Consumer Real Estate Services and All Other are struggling.
For the sake of argumentation, let's assume that the two unprofitable segments continue to bleed money: two-thirds of the $100.8 Billion in equity assigned to Real Estate Services and All Other will slowly evaporate under the weight of lawsuits and write-offs. I don't think that this will happen, but it allows for a conservative floor to the estimated value of a broken up Bank of America. It could also be arranged such that these two losers are combined to create "Spin Co," which can assume all legacy liabilities. This would allow other businesses to focus on the future, freeing them from having to subsidize the bad business decisions of other divisions.
After spinning off Spin Co, now we can value the profitable remaining segments. While there are many ways to come up with a valuation, I'll use a simple assumption: investors will demand a 10% earnings yield (P/E 10) because banking is a risky business. Here's how each segment would be valued in this scenario:
P/B (based on allocated equity)
( Allocated equity * P/B)
Consumer & Business Banking
Global Wealth & Investment Management
This estimated $174.8 Billion in value is a 28.6% premium to the current market capitalization and includes a very pessimistic view of future legacy losses. While the details of a real-world breakup would probably be different than the simple plan presented here, this example illustrates how Bank of America's current corporate structure is hardly value enhancing.
Some may object that keeping these different segments under one roof allows for synergies, economies of scale, opportunities for product cross-selling, and so on. There may be some truth to this, but these supposed efficiencies are usually stated qualitatively as facts rather than quantitatively as hypotheses to be tested. Sure, size can lead to efficiency gains, but size can also cause new problems. Given the last decade's operating results, I would say that the burden of proof rests on the shoulders of the bigger-means-more-efficient school of thought rather than the megabank skeptics.
Absent quantitative evidence regarding synergies or economies of scale, there are two qualitative arguments in favor of a breakup besides a possible increase in valuation multiples: 1.) Portfolio blowup risk is reduced because losses in one segment would be cordoned off from the others 2.) Transactions between the different segments will be subject to economic logic rather than corporate politics. I will elaborate upon each of these arguments in turn.
If I could exchange one share of BAC stock for one share in each of the five profitable divisions alongside one share in Spin Co, my holding immediately becomes less risky. If one of the businesses runs into major problems, the worst thing that could happen is for its stock to go to zero. The other holdings are totally unaffected.
This is not what would happen right now. It is quite possible for one operating segment, such as Consumer & Real Estate Services, to experience large enough losses that it vacuums up profits from other segments for years to come. Such intra-corporate welfare can also encourage division heads to make imprudent business decisions because they will be bailed out by other parts of the business. By separating the business into smaller, insulated parts, current BAC investors are better protected from the risk that a leak in one compartment will sink the whole ship.
De-politicize Capital Allocation
As much as some economists would like to think that capitalist organizations are ruthlessly rational, scholars of organizations in sociology departments and business schools know that this is not the case. People in positions of power make decisions for all sorts of reasons, including habit, industry rules-of-thumb, "satisficing," forging and maintaining intra-organizational coalitions, and trying to maximize their own status or power. All of these things may or may not be connected to optimal capital allocation, and tweaking executive compensation practices to perfectly align them with shareholders still does not guarantee success.
When it comes down to it, people are fallible, political beings. In large organizations, division heads fight each other, often bitterly, for scarce resources. The way these resources are allocated may be as much due to personal relationships or patronage networks as maximizing shareholder value. If the different operating units are separate companies, this unproductive competition disappears because each must be self-sustaining. As separate companies, they could still maintain extensive dealings with each other, but will have to pay the going market rate for services. This is often much more rational than bureaucratically-determined transfer pricing.
I believe that breaking up megabanks like BAC is likely to increase shareholder value. Profitable segments will enjoy expanding multiples, while investor risk will be better contained within operating units rather than spread across the entire organization. Doing so will also reduce the dysfunction that is endemic within multidivisional conglomerates, forcing division heads to focus on building their businesses rather than political maneuvering.
Although much of the debate surrounding financial reform focuses on what legislators should or should not do, megabank shareholders also have an important role to play. Mediocrity punctuated by occasional spectacular failure indicates that the underlying business model needs to change. When megabank investors stop tolerating poor capital allocation and demand that their business makes sense, both their portfolios and the economy as a whole will be better off.