Is it wrong to admit to a moment’s amusement in having Tom Brown label me “way too harsh”?
Here we are, in the sixth standard deviation from the mean, the “fat tail”, asymptotically approaching zero, with National City Corp. (NCC) on the cusp of an announcement that it will be dismembered, never to be heard from again, at great loss to shareholders, but probable benefit to the acquirer. But let’s be--indeed--we must be fair and daren’t expect “clairvoyance” of management. That would be unfair, and this market--with its marked peculiarities--no one predicted all its particulars.
But have I “misremembered”, as alleged? Do I suffer willful amnesia, as Tom construes it? Was this the highly profitable, overcapitalized financial holding company that Tom remembers, or something less? Let the reader decide, and let’s be as harsh and uncompromising as the truth.
I start with the observation that not every bank is at risk to lose its independence and existence. The survivors of this mess will be those that doubted their wisdom, as contrasted with those whose confidence exceeded their capacities, intuition, reach, and good judgment. I count National City in the latter number.
What was my sell-side view of National City? In January 2007, after reviewing National City's dreadful fourth quarter 2006 earnings report, I reiterated my “Underperform” recommendation in a January 24, 2007, brief. My five published objections were:
Its two late-2006, early-2007 thrift acquisitions (in Florida) were expensive and dilutive.
The company was inclined to acquire (it subsequently announced the acquisition of Chicago-based MAFB, in May.)
The interest rate environment was adverse, and National City was increasingly spread-dependent.
In 2006, operating revenues declined 3.8%, and earnings 14.5%. According to CEO Daberko, the expected “modest EPS improvement” in 2007 would be "driven mainly by changes in share count."
Credit administration weaknesses were apparent; for example, documentary deficiencies resulted in the put-back of a $1.7 billion subprime mortgage loan portfolio.
Regarding the last objection, management stated boldly that it would cure the documentary deficiencies and sell the loans into the secondary market. We estimated that the portfolio held about 17,000 loans. Based on my regulatory experience, I observed that the process would be complex and time-consuming. Assuming that it could be done, I concluded that it would be expensive to accomplish.
How profitable was National City? Tom says the company earned 18% on its equity in 2006; strictly speaking, that was indeed the number, according to GAAP. Including the sale of First Franklin, its subprime mortgage originator, National City's fourth-quarter ROE was an impressive 25.0%. But excluding one-timers, the operating return on equity was just 6.8% in the quarter, by my estimate, and a middling 13.1% for the year.
Was it universally agreed that National City was over-capitalized? Was there “no controversy” as to the buybacks, as Tom remembers? My recollection differs, on both counts.
First, National City’s $1.6 billion “over-capitalization” was its own whole-cloth assertion, based on a 6.5% tangible equity ratio. The company also asserted that there was another $1.4 billion in excess capital if its target were reduced to 5.5%. There was no particular analysis to support either assertion; rather, it was a mechanical, mathematical determination.
When asked about its planned use of its excess capital, management offered the following options:
Increase the dividend.
Infuse capital into core banking businesses to support organic growth.
Branch expansion through de novo growth and/or acquisitions in Chicago, Cincinnati, St. Louis, and its new Southeast Florida markets.
Share repurchases through any combination of open-market purchases, accelerated share-repurchase programs, and tender offers.
The company ultimately did some of all of these. In sum, it did too much, quite evidently. As I have observed, the cost of share repurchases alone was $3.2 billion in 2007, exceeding management’s estimates of its “over-capitalization” at its lower target. Was this prudent? What motivated this thinking? How were these decisions reached? I only ask these questions rhetorically, but it would be interesting to know.
With regard to the buybacks, I recall innumerable critical discussions with buy-side clients. The company acquired its two Florida-based thrifts in all-stock deals. The company then repurchased an equivalent number of shares. Most investors with whom I spoke would have preferred the repurchases without the acquisitions.
My Upgrade. Now, Tom is absolutely accurate that in February 2007, I upped my opinion of National City to Market Perform. While the change was not exactly a ringing recommendation, management's announcement of large Dutch auction tender convinced me that the stock was not apt to fall as I had expected, that the tender would support the shares. In this, I was correct, though I regard the call as one of the worst of my sell side career. My mistake was that I didn’t slap my Underperform recommendation back on the stock after the Dutch Auction was completed, or with the May announcement of the MAFB acquisition.
On balance, I believe that it’s fair to say that I didn’t like the stock for the right reasons. I did not predict and could not have foreseen the degree to which economic conditions have stressed National City. In most circumstances, National City would have survived its aggressive behaviors, but not in today’s “fat tail”.