Buffett on Banking: 'A Very Good Business'

A while back, I looked at the non-financial components of the Dow Industrials to ascertain whether or not basic business models were solid. The strong ROAs earned by most firms, coupled with moderate leverage, show why many are regarded as best-of-breed.

Today, we’re taking a look at the other side of that – is the business model of banks as used in the past broken, or merely undergoing a correction?

To start with, banking profitability runs under the opposite model – a lower spread over assets, but with more leverage to compensate. It’s simply a fact of life, so it’s more important to focus on banks having reliable earning assets that compensate for the risk being taken.

For a period of years, this wasn’t true – there was too much liquidity, which drove down spreads to extremely tight levels, even as the impatience behind capital meant too much flowed to questionable uses. Those assets have impaired the balance sheets of banks, large and small, and working through them will take time. Losses will need to be recognized, and the equity they eat into will need to be replaced through capital raises (likely on unfavorable terms to banks) or internally generated and retained profitability.

The prevailing view as to banks is very much oriented to the losses on their books, while ignoring future earnings that come from the changing competitive situation in banking. As I’ve said elsewhere, my evaluation process for investments in hostile markets is two-fold: first, whether or not the company in question can survive stressful conditions (i.e. balance sheet strength), and second, whether or not the earnings outlook for the survivors is positive.

Taking either of those categories – or worse, both – and simply extrapolating the increasingly challenging conditions of the last few years into the future will result in a repeat of the exact same mistakes being made at the market top, only in the opposite direction.

Of course, nobody following that process will acknowledge as much outright. Instead, they’ll talk about how things were and how dismal the profit outlook currently is, while overlooking how the situation will evolve. The reality is, business conditions move in cycles, and competitive dynamics change throughout the cycle. How does this apply to banks?

One major change is that major depository banks can actually implement strong underwriting standards without worrying about losing all their business to originate-and-securitize shops. Not only have the options for customers seeking a mortgage been diminished, but with the yield curve showing a strong positive slope, spreads on lending have widened as well; this is the “silent bailout” of the financials, because cheaper deposits will save financial institutions tens of billions in interest expense annually.

Although the current focus on financials’ balance sheets is “tangible common equity,” there is an excellent article from Fortune sharing Warren Buffett’s thoughts on the matter as it pertains to Wells Fargo (WFC), one of his holdings. Specifically, Buffett says:

And what you make money off of is customers. And you make money on customers by having a helluva spread on assets and not doing anything really dumb.

…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.

…To the extent that his tangible common equity is low, a) nobody was even talking about that a year ago. And b) they should be talking about earning power.

If you’re dealing in a commodity business, you need to focus on tangible common equity, because there is no pricing power lever available to increase earnings. Earnings in that scenario are a function of capital invested, although there is no value created above cost of capital. But this is not true for banking; their most important “asset” that drives earnings is actually a liability on the books – that being cheap and sticky deposits.

In the case of Wells Fargo, run-rate interest expense on deposits has decreased from 1.78% in Q1 2008, to 0.50% in Q1 2009. On their current deposit base, that works out to a savings of nearly $10.2 billion – and this is just one bank, albeit one that does extremely well taking in low-cost deposits.

What is the end result? Run-rate pre-tax, pre-provision profitability at Wells Fargo (WFC) in the last quarter was $36.8 billion. When combined with the existing $22.8 billion in credit reserves, that gives $60 billion in capacity to absorb lending losses over the next year.

How does Wells Fargo figure to perform going forward? Even though mortgage originations are down sharply, the company expanded its share to 16%, up from a prior peak of 13.3% in both 2002 and 2006, according to Inside Mortgage Finance. Market share in mortgage servicing also reached 16% in 2008, up from 13.2% in the previous two years.

In other words, as others are pulling back or leaving the game entirely because of prior poor practices, Wells can take a larger share of the remaining business at more favorable terms.

Of course, since the March lows, shares of Wells Fargo – and many other banks – have surged a multiple of their price. At 3.1x pre-tax, pre-provision profit, shares still aren’t that expensive, and the trust preferreds have tightened to around 80 cents on the dollar to offer a high single-digit yield. I’m not crazy about adding risk at current prices, and have finally grown wary enough of that I raised cash yesterday.

Further, I have been too busy, and want to reassess where and how I’m invested in light of earnings releases and other data points.

Disclosure: No position in stocks mentioned.

Comments

[Albert Meyer:]

>>> A while back, I looked at the non-financial components of the Dow Industrials to ascertain whether or not basic business models were solid. <<<

Can you provide a direct link? Thanks.

May 20 10:01 AM

[Albert Meyer:]

OK don't bother, thanks, I found it.

May 20 10:53 AM

[everyotherc...:]

'What is the end result? Run-rate pre-tax, pre-provision profitability at Wells Fargo (WFC) in the last quarter was $36.8 billion. When combined with the existing $22.8 billion in credit reserves, that gives $60 billion in capacity to absorb lending losses over the next year"

I agree completely with this Mr. Cullen's thesis that NIM(Net Interest Margin) is the issue in determining the medium term potential profitabilty of banks such as Wells which have demonstrated a robust ability to gather cheap deposits. His further contention that the weak competititive environment will permit careful lending at strong prices is very astute.

The other issue, of course, is the potential future losses from the current loan books. Given that, I do not recommend investors focus on on future pre-tax AND pre-provision earnings.

The author sums up: "What is the end result? Run-rate pre-tax, pre-provision profitability at Wells Fargo (WFC) in the last quarter was $36.8 billion. When combined with the existing $22.8 billion in credit reserves, that gives $60 billion in capacity to absorb lending losses over the next year."

Question. So? At the conclusion of that hypothetical period loan loss reserves are..........zero. And they obviously have to be replaced out of future earnings.

Investors should take a more conservative view and calculate price/kearnings metric using your projection of pre-tax earnings alone. Then move to an analysis of the adequacy of present reserves taking into consideration your analysis of the historical and current loss and delinquency/default trends.

May 20 11:09 AM

[Ryan Vanzo:]

Yet another insightful article. Thanks again James.

May 22 04:21 PM