Warren Buffett Agrees: Tangible Common Equity Ratio Is Way Overhyped

I’ve been so busy listening to earnings calls this week that I haven’t had a chance to blow a gasket about this:

WASHINGTON — President Obama’s top economic advisers have determined that they can shore up the nation’s banking system without having to ask Congress for more money any time soon, according to administration officials.

In a significant shift, White House and Treasury Department officials now say they can stretch what is left of the $700 billion financial bailout fund further than they had expected a few months ago, simply by converting the government’s existing loans to the nation’s 19 biggest banks into common stock.

Converting those loans to common shares would turn the federal aid into available capital for a bank — and give the government a large ownership stake in return. [Emph. added]

So the government is considering taking huge direct stakes in the country’s big banks. What an awful idea. First, the feds’ existing TARP investment is in preferred stock, not debt, so conversion into common will have no effect on banks’ equity accounts. (The tangible equity fetishists will dispute this; I’ll get to them in a minute.) But more to the point, the prospect of the federal government deciding to become a major common shareholder of some of the country’s big banks is a potential disaster for the industry and the economy. Here’s why:

1. As we’ve already seen, the government can’t resist the urge to micromanage banks’ business, and rarely productively. Even as a preferred holder, it has stuck its nose into matters ranging from whether banks should hold offsite business conferences to how they should spend their marketing dollars. Sometimes the meddling is harmless. But in the case of AIG, it has materially hurt the competitive position of a number of the company’s businesses, and figures to cost taxpayers billions. Can you imagine what would happen if the government became a major common shareholder? Let’s just say maximizing value would not be its first priority.
2. The preferred-stock conversion that the government has in mind wouldn’t add a single dollar’s worth of new capital to banks’ balance sheets. All it would do instead is re-label one form of equity (preferred) as another (common). This doesn’t even count as rearranging deck chairs on the Titanic. It’s more like leaving them where they are and repainting them.
3. The bigger the government’s stake in big banks, the harder it will be for banks to attract private capital. Private investors have already seen what it’s like investing in banks alongside Uncle Sam. And once the government does become shareholder, when, exactly would it divest itself? Six months? Ten years? It would be up to the federal government to decide. But the government isn’t always rational, and can’t be counted on to act in the interests of its fellow shareholders.
4. And don’t even get me started on the politicization of credit allocation, which would be inevitable, and could occur on a very large scale.

Meanwhile, the first, last, and only point of this TARP conversion scheme (which, I repeat, would be a disaster), would be to raise banks’ tangible equity to tangible assets ratios. Again, no cash would change hands. The mighty, misguided Cult of TCE, however, would be appeased.

It’s ridiculous. For some reason, bank investors have lately come to view a single, once-obscure number, tangible-common equity to tangible assets, as indispensable in judging a bank’s balance sheet. Why, exactly, I’m not sure. For years, bank regulators have made clear that they only care about three ratios: Tier 1, Total Capital, and Leverage. I suspect that the only reason anyone cares about TCE now is that (as befits the zeitgeist of the banking industry these days) it makes so many institutions look so bad.

But who cares? The TCE ratio has all kinds of problems that make it not a great indicator of a bank’s true financial health. No one can agree what the precise definition of capital is, for starters. And the ratio can exclude some intangibles, such as MSRs, that clearly have value. And it includes unrealized gains and losses, which puts the number at the whim of the markets. And, as noted, regulators shouldn’t care.

The problems with the TCE ratio are endless; people should stop obsessing over it. But if you don’t believe me, ask Warren Buffett. He weighs in on the matter in the upcoming edition of Fortune. When it comes to TCE, the Oracle could care less:

You don't make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that's where people get all mixed up incidentally on things like the TARP. They say, 'Well, where'd the 5 billion go or where'd the 10 billion go that was put in?' That isn't what you make money on. You make money on that deposit base of $800 billion that they've got now.

Coca-Cola (KO), Buffett notes, has no tangible equity at all, and nobody seems upset. Yet for some reason the number has become the most important statistic in banking. As regards Wells Fargo’s (WFC) notoriously low TCE ratio, in particular, Buffett isn’t bothered:

To the extent that [Wells’s] tangible common equity is low, a) nobody was even talking about that a year ago. And b) they should be talking about earning power.

Precisely. And earnings power, in turn, is determined by the cost and stickiness of your deposits and the quality of your assets. What you name the various slices of your capital base is pretty much beside the point.

Or would be beside the point, except that the market’s new emphasis on tangible capital now threatens to lead to a government semi-takeover of some of the country’s biggest banks.

By now, I’ve given up trying to change anyone’s mind on the TCE issue and am instead just waiting for the hysteria to pass. Until it does, TCE-ites will no doubt read the Buffett interview and accuse him of “talking his book.” That’s nonsense. He understands the basics of how banks make money, while they’re hung up on arcane balance sheet items. In the meantime, the sooner the TCE cult fades away, the better.

Comments

[Jasper M:]

Good article.
Sadly, we already have politicized allocation of credit, have for some time. Part of the current problem, in reals estate. (With the best of intentions) They made it illegal to discriminate against those who probably couldn't pay.

Apr 24 02:35 AM

[paulsjj:]

Who got how much TARP money? What did they do with it? There seems to be no public record on any of this.

Apr 24 08:37 AM

[MattZN:]

It's only a bad idea if the government holds onto that stake for a very long time. My expectation is that as bank stock prices recover the government will sell their stake and effectively do the capital offering they wanted the banks to do themselves, instead of the bank doing a separate offering.

-Matt

Apr 24 01:53 PM

[auto44:]

What this does is change the taxpayers asset, which was basicly a loan that paid interest into common shares that pay no interest, that can sink in value. This puts the government in the same position as other stockholders. The lowest on the food chain. It is certainly a position much more dangerous and less liklely to result in taxpayers geting their money back .

Apr 24 03:03 PM

[thrifty86:]

Question: Where does Buffett get his "KO has zero tangible common equity" figure?

Apr 24 03:56 PM

[Arnold Landy:]

I believe that he has made an error (see seekingalpha.com/insta...


On Apr 24 03:56 PM thrifty86 wrote:

> Question: Where does Buffett get his "KO has zero tangible common
> equity" figure?

Apr 24 03:59 PM

[Arnold Landy:]

I believe that he has made an error; see my instablog: seekingalpha.com/insta...

Apr 24 04:04 PM

[thrifty86:]

@Arnold: I follow your analysis and you may be right, but for someone of his stature, there has to be a reason why he said that.

Apr 24 04:10 PM

[Atsui:]

Tom, Great post. Please keep them coming. It's not easy finding insightful posts (like yours) among the mass garbage floating all over the internet. Even if I may not always agree with you 100% of the time, I do appreciate your thinking and insights.

Apr 25 03:33 AM

[Ricard:]

Regarding Buffett's comments on KO, I believe he was specifically talking about what a banker would regard as tangible common equity.

KO actually has a respectable tangible book value, compared to assets on hand. It certainly does not have negative book by any stretch of the imagination. KO simply isn't a bank.

Apr 26 12:40 AM