Good Banks, Bad Banks; WFC and WB?

Today’s heresy – which I find particularly annoying because it is so lazy intellectually – is claiming that volatility equals risk. What rubbish! Risk is when a company goes belly-up, a currency goes against you, or a country turns sour, such as Cuba; that is, the possibility of permanent loss of capital – which has nothing to do with inevitable fluctuations of the market.

“The heresies and swamis that can hurt your portfolio”

John Train

Financial Times

June 28, 2008

Can banks add value? Should investors ever care?

News reports about Lehman Brothers (NYSE:LEH) possibly being sold to Barclays (NYSE:BCS) actually pushed the firm’s valuation down by the close yesterday. To us, the implosion of houses such as Bear, Stearns, LEH and, yes, eventually even Goldman Sachs (NYSE:GS) suggests that this pure “agent” institutional dealer business model may be doomed. Are the other heavy users of leverage residing in hedge fund land next?

We know that the larger universal banks are looking for ways to add value, looking at what business lines make sense and those that don’t in the post subprime world. Many of those answers are negative, sad to say, judging by the rising tide of redundancies flowing down the Street. Indeed, many of the systemic, market structure issues upon which we harp endlessly call into question entire business models in the financial sector.

Watching how the bank population evolves and changes is part of our mission statement. Of course, remarking on the discovery of yet another stick of dynamite while sitting in a room filled with dynamite has limited utility. But to those readers who complain that we are become prophets of doom, we cannot take credit. The troubles in the US banking system, the data alone suggests, are of a magnitude that demands a grim tone.

If we taught the computers to write stories — and we can do that — the machines would take the same line. The data is telling us that the adjustment of bank credit loss experience is still mostly ahead and that loss rates, like recent flooding in the midwest, could exceed 50-year highs.

But in a positive spirit, let’s focus on the good news in the financial community for a change, the stories that people never hear. For one thing, how about them boys at BB&T (NYSE:BBT). In the face of the doom and gloom chorus surrounding the banking complex, the $130 billion asset NC-based banking concern reported above peer financial performance in Q1 2008. Last week, the bank voted to increase its dividend, albeit by just a penny, as if to say “Foxtrot Oscar” to the pessimists and the short-sellers.

BBT, readers of The IRA will recall, was one of the few banks in the past few years that was unwilling to pay 3 or 4 times book value for a significant acquisition. This tough minded approach to value when it comes to M&A also seems apparent in the bank’s credit performance, where it remains well below peer in terms of charge-off experience.

If you are logged in to The IRA Bank Monitor, click this link to see the QuickMatrix for BBT. Note that while current loan and lease defaults are below peer, BBT’s loss rate is 2x year ago levels, reflecting the secular shift in bank loss experience.

Note too that BBT’s unused lines or Exposure at Default (EAD) were less than 50% at Q1 2008. The bank’s risk profile drives to a ratio of Economic Capital to Tier One Risk Based of 0.385:1 as calculated in The IRA Bank Monitor.

Then there’s Citigroup (NYSE:C). Citi’s loss rate was over a full standard deviation above peer in Q1 2008, about where this consumer risk heavy portfolio should be this early in the credit cycle. But there are subtle changes underway at C that may suggest that a turn is in progress.

While C’s Economic Capital computed by The IRA Bank Monitor continues to increase, a sign that the overall riskiness of the bank’s trading and credit books is growing, indicators such as Loss Given Default have shown sharp improvement vs. the large bank peers.

C could still be engulfed by a larger than expected increase in defaults — say 2x 1990 levels, our “doomsday scenario” — but give the Citibankers credit for trying. Our 12-month MPL for the C organization’s loan and lease book is 4%, BTW. We could yet see that loss rate actually achieved this year. Sorry, is that not sufficiently optimistic?

The other thing we like at C is the aggregate yield on all of the loans and leases reported by its bank unit’s, a full SD above peer and rising as the peer group faded lower in Q1 2008. Of interest, total unused lines or EAD, as we define it, also increased at C while the peers trended lower.

Subscribers click this link to see the most recent Bank Holding Company Profile for C.

Then we have US Bancorp (NYSE:USB) reporting 2% ROA and 22% ROE in Q1 2008, two SDs above peer. Almost too good to be true? Yes, almost. Take a look at the blazing 41% efficiency ratio for the subsidiary banks of USB.

USB reported defaults at or around peer in Q1 with an LGD also near peer. The difference is cost control and good asset selection, at least looking at the data reported to the FDIC. Of interest, the ratio of Economic Capital to Tier One Risk Based Capital calculated for USB by The IRA Bank Monitor is well-below 1:1.

Subscribers click this link to see the most recent Bank Holding Company Profile for USB.

But in case you think we are leaning toward a bullish view on bank credit, think again. Our continuing machinations back at the shop as we develop our Credit Conditions Index, to reiterate, suggest that the US banking industry is very early in the credit adjustment process. Thus we look for those names that display not only righteousness in terms of historical financial performance but also consistency, and red flag those that do not.

Take the sad case of Wachovia Bank (NYSE:WB). Once among the exemplars of the large bank peers with an LGD hovering around 50%, the bank has now fallen to a full standard deviation below peer. A year ago, WB led the peer group in most respects, but now is an outlier to the opposite degree. Kind of makes the intrepid modeler wonder: Was WB too good to be true in recent years? Or is WB now flushing the bad in a big event, setting everybody up for a “surprise” later in 2008?

Subscribers click this link to see the most recent Bank Holding Company Profile for WB. Note in particularly the heavy focus on trading and securities risk in WB’s Economic Capital profile.

Beside the volatility in the WB reporting, we cannot let the remarkable performance of the WB board of directors go without comment. WB may have rising loss rates on assets and it may need to raise capital, but it does not need its board making the whole organization a laughing stock. Firing your CEO when you don’t have a replacement in hand is a bad idea and reflects very poorly on WB’s governance structures. Then publicy hiring GS to assist with serving up strategic alternatives and/or finding a new CEO is too pathetic for comment.

One idea on WB: Shoot the WB BOD, merge WB with Wells Fargo (NYSE:WFC) and let the latter run the business. Creates a very solid national franchise than does not have a very big trading book in relative terms. BTW, in Q1 2008, WFC performance was right up there with USB. Both banks will feel some pain as the year unfolds, but USB and WFC remain, for our money, among some of the best managed banking institutions in the world. How’s that for being upbeat, eh?

Originally published at IRA and reproduced here with the author’s permission.