U.S. Big Banks: Survival of the Simplest

One of the most accurate forecasters of the global economic crisis, Nouriel Roubini, said last week that last September’s spree of bank takeovers deepened the crisis because it made the already-too-big banks even bigger.

He may well be right; more interesting is what this tells us about the U.S. banking system going forward.

“The institutions are insolvent,” Roubini said in a Bloomberg Radio interview. “You have to take them over and you have to split them up into three or four national banks, rather than having a humongous monster that is too big to fail.”

But that may be impractical. Citigroup Inc. (C), for example, can sell and is selling peripheral parts of its empire such as Japanese broker Nikko Securities. However, so much of its business involves an international nexus of connections - including its large U.S. operations - that splitting them may be both impractical and excessively value destroying.

However, Wells Fargo & Co. (WFC) showed Thursday what could be achieved by simplicity. It gave investors a preview of its first quarter results, in which it will make record earnings of about $3 billion, or 55 cents a share, after paying preferred stock dividends of $372 million on its $25 billion of preference shares from the Troubled Assets Relief Program (TARP).

Both the old Wells Fargo and Wachovia Bank, which it acquired last year, are showing good results, with $3.3 billion in loan-loss charge-offs for the combined group - down from $6.1 billion in the fourth quarter of 2008. As a result, bank stocks were up sharply Thursday, continuing their healthy rally over the last six weeks.

Wells Fargo is one of six U.S. banks - Citigroup, Goldman Sachs Group Inc. (GS), and Morgan Stanley (MS), Bank of America Corp. (BAC) and JPMorgan Chase & Co. (JPM) - with assets of more than $1 trillion. They are so large they form a separate “top tier” of banks, since the next largest bank, PNC Financial Services (PNC), has assets of only $295 billion.

However, Wells Fargo’s first-quarter success does not mean that all the top-tier banks will do well. Both Wells Fargo and Wachovia were heavily oriented to conventional retail and commercial banking, with massive branch networks all over the United States. The combined Wells Fargo was thus much less reliant on the slumbering investment banking business than other top-tier banks. It was also far less involved in high-risk capital-markets game-playing, which got so many other banks in trouble. For example, while Wachovia got $500 million of dubious payouts from American International Group Inc.’s (AIG) dodgy credit default swaps, Wells got nothing, and therefore presumably had no net exposure.

Wells Fargo, in short, is becoming a model of what a nation should require of its behemoths under the “too big to fail” doctrine. It does mostly conventional retail and corporate banking, and provides economically useful services to its nationwide network of clients. It takes few huge risks, and is emerging from 2008’s disaster in pretty good shape. Without the Wachovia acquisition, Wells Fargo could probably have avoided the need for TARP capital.

In my February report on the top 12 U.S. banks, I showed how many of the top banks were in pretty good shape and offered investors good value, which would be demonstrated by higher first quarter earnings going forward. The Financial Select Sector SPDR fund (XLF) is up about 39% since then, so that was a pretty pleasing call.

Of course, what I didn’t get right was that the dogs are up even more in percentage terms than the solid citizens. Citigroup, the biggest bow-wow of them all, has more than doubled. Going forward, I would expect quality to assert itself. While some of the weaker banks should survive, they will be able to take much less advantage of currently juicy lending opportunities than their stronger brethren.

Sorting Out the Winners and Losers

Over the long term, the road forward is clear. Roubini’s suggestion to break up the largest banks - say those with assets of more than $500 billion - may be impracticable. It is also unnecessary. They should simply be tightly restricted, allowed to undertake only “vanilla” banking businesses, without a presence in investment banking, or in high-risk trading.

The market would then sort matters out. Some banks, like Wells Fargo, would probably prefer to remain gigantic, but simple and low-risk - earning a reasonable return, paying their top executives moderately, and having their stock serve as a fine investment for risk-average investors seeking dividend income. Bank of America and JPMorgan might wish to divest their investment banking businesses and move toward this model. The cultural clash between Merrill Lynch and the old Bank of America has been huge, suggesting that their merger has huge negative synergy and that the two institutions would be worth more separated.

The top six’s two investment banks, Goldman Sachs and Morgan Stanley, would have no interest in commercial banking, in which they have little history, so would have to downsize dramatically. One possibility is splitting them three ways - an advisory business, a medium-sized institution with a magnificent client base, and a more or less unregulated hedge fund that could be allowed to bankrupt itself in the shadows. They would not be permitted to retain their current huge positions in “principal trading,” an activity of little economic purpose beyond exploiting the firm’s insider information.

As for Citigroup, it seems likely that its troubles are too great and its culture too aggressive for any Wells Fargo-type solution to be possible. Over time, it should almost certainly be liquidated.

Below the top tier, the U.S. regional banks should mostly be in good shape, with a few exceptions that were based in particularly troubled regions or who had been excessively aggressive. In any case, they would not be "too big to fail" and would be allowed to engage modestly in investment banking if they thought it profitable.

Since they would be allowed higher leverage than the behemoths, they would be more profitable. And over time, the banking business might fragment further, which could only be good for competition.

As the world has seen over the past year, the arguments for creating financial services behemoths were spurious. They were too large to manage, and they survived only because their host country taxpayers gave them an implicit guarantee.

Original post

Comments

[Ishortyou:]

yup Darwinian models work for the best, this model has worked for ages, those that are fit for the random changes of the moment will make it, I guess that model should be apply accross the human dimensions but I guess you will have a lot of whiners complaining about it.

Apr 14 10:18 AM

[Wreckdiver:]

Excellent commentary. I agree particularly with killing C.

Apr 14 10:28 AM

[bob zimway:]

Citi soars, Goldman sours, a stark kabuki today. Nothing is what it seems. The Goldman stock buy adds 9% to the float. The Horror. It pledges to repay the TARP. Party pooper. It's their "duty." Uncool. Meanwhile Citi is a kon-tiki raft of band-aids and failed greed sailing ahead of secret winds.

Apr 14 10:29 AM

[Chickenpookie:]

Good article Mr. Hutchinson, it's refreshing to read your alternative suggestions of where the banking sector could be headed as opposed to others who demand their ideas be implemented. Wonderful style, logical, and unconvoluted.

Thank you!

Apr 14 11:29 AM

[drbob66:]

"Citi is a kon-tiki raft of band-aids and failed greed sailing ahead of secret winds"

Ha! Good one...

Still, I wish I had bought some at $1...I was staring at it that day, but just couldn't pull the trigger. Bought some BAC instead (and a mega-million lottery ticket at the grocery store).


On Apr 14 10:29 AM bob zimway wrote:

> Citi soars, Goldman sours, a stark kabuki today. Nothing is what
> it seems. The Goldman stock buy adds 9% to the float. The Horror.
> It pledges to repay the TARP. Party pooper. It's their "duty." Uncool.
> Meanwhile Citi is a kon-tiki raft of band-aids and failed greed sailing
> ahead of secret winds.

Apr 14 11:33 AM

[Larry House:]

Some have said we are heading for zombie banks. That may be true, and I also think we are heading for zombie consumers. Banks are going to be tied to the government line of nourishment for a long time. At some point--it isn't talked about now, after a 25% rally in stocks--but at some point we will be asking what happens if all the government has done and is going to do isn't enough? What if our economic stupor and toxic waste are too much for even the gov to overcome? Then we get back to natural selection, which is what should have been allowed to work in the first place to properly cleanse the system. Our economy is in the ER and is only kept going by artifical means. It is not yet knowable as to whether or when the patient will be self-sustaining again.

Apr 14 12:13 PM

[Maklo:]

Good article with excellent points.

I would only add that Wells Fargo did not require TARP funds nor any government support to consummate the Wachovia transaction (unlike Citigroup, which needed a government guarantee to get the deal done). The deal was funded purely with shares of WFC - so no cash out the door. Given Wachovia's distressed circumstances, WFC got it for a great price, after factoring in very conservative mark-downs on the troubled loan portfolio (which came primarily from Wachovia's acquisition of Golden West).

In fact, contrary to what many out there believe, the Wachovia deal more likely improved Wells Fargo's financial position. It doubled the deposit base and significantly increased the earnings power, extended the retail banking network to be a true coast-to-coast network and increased WFC's competitive positioning in a number of profitable areas of finance such as asset management (A.G. Edwards). Meanwhile, WFC took very conservative markdowns on Wachovia's book, and still paid less than 30 cents on the dollar (in stock). In fact, I think they inherited a significant amount of balance sheet cash as a result of the merger, in effect getting the operations for free.

Prior to the acquisition, Wells Fargo was already in the strongest financial position compared to the major banks and had the lowest need for additional capital. A lot of this has to do with how they fund. WFC (and Wachovia in fact) rely more than any of the other major U.S. banks on deposits from its retail banking network, which, with the help of the FDIC, turns out to be much more stable than other funding sources, like the commercial paper market. In fact, as troubles arose in the banking sector, there was a "flight to quality" to Wells Fargo, which shows up in double-digit increases in their deposit base.

At the end of the day, Wells Fargo's rationale to accept TARP funding was more from a competitive perspective. If the competition had access to this low-cost, (relatively) non-restrictive capital, they would be at a disadvantage if they did not take it. And in fact, we are better off that WFC took TARP funding, as they have written by far the most loans by far. They probably would have written fewer loans if they had not taken the TARP funding. Meanwhile, other banks are still scaling back their overall exposures, despite having taken TARP funding, because that funding was needed just to keep them from going down the drain. I also do not believe they would argue with government intrusion on compensation practices, as their business model and compensation culture is different from that of, say, Goldman Sachs.

Apr 14 01:58 PM

[Kinabalu:]

"Nouriel Roubini, said last week that last September’s spree of bank takeovers deepened the crisis because it made the already-too-big banks even bigger."

Well thanks Roubini, you're only about 20 years too late on this one. The FDIC has been pushing bank mergers for the last two decades, because it saved them money, at the risk of greatly increased systemic exposure. Thank goodness the Citi-Wachovia deal they were pushing didn't go through. What a disaster that would have been.

Apr 14 04:17 PM

[E Nuff Sed:]

Excellent article. Banks like WFC and USB etc. will be making money hand over fist with this steep yield curve. They can borrow money at 0.25% and lend out at 3.25%. Leveraged 10 X 1 that's a 30% return on equity. This for prime customers and not counting fees.

Though I suspect C will not fail as its practically nationalized. I think it should be split up into international (good) bank and a domestic (bad) bank. The international bank would be incredibly profitable while the domestic bank with all toxic assets is insolvent.

Apr 14 10:27 PM