Spread the Wealth: Bigger Is Not Better in Banking

“As the first step in promoting the government’s new voluntary bank capital injection plan, Secretary Paulson summoned the CEOs of the nation’s largest banks to Washington and “made them an offer they couldn’t refuse.” He told them that as part of the government’s “voluntary” capital program, he was going to “invest” $125 billion of the government’s money in preferred stock that they would issue. In return for this capital injection, these institutions would also grant the government warrants, and executives would at least nominally subject themselves to limits on executive compensation. It was also “suggested” that they deploy the capital to make new loans, even though many would improve their financial position measurably by redeeming other higher-cost debt, including preferred stock previously issued. Finally, although the preferred stock was to be nonvoting, as would any common equity that the government might acquire through warrants, the “terms of the injection and suggestions” sure had the smell of exercising a controlling influence.”

Bob Eisenbeis Cumberland Advisers

Last week, the global financial system took a deep breath and began to react positively to the heaping quantities of fresh capital that politicians in the US and EU are shoveling at the latest problem created by the subprime mortgage bust, namely bank solvency. So far, so good, at least for now.

We regret to say that the Q3 2008 earnings reports from US banks will do little to dissuade markets that more crisis remains ahead. In front of us still are several quarters of old fashioned realized losses in the form of possibly record levels of bank loan charge-offs, so don’t hold your breath waiting for US commercial banks to start growing lending exposure anytime soon.

The $125 billion allocated to bank capital infusions by Treasury Secretary Hank Paulson so far is the appetizer and soup course of the meal, in our opinion. Next year comes the main course, when we could see Citigroup (NYSE:C) and JPMorgan (NYSE:JPM) end up under government control if aggregate loan loss rates peak well-above 1990s levels. Click here to see the non-accrual loans of the largest US banks by assets.

Like the heavy surf following a tropical storm, the next several quarters promise to reveal some truly ugly problems and also a considerable number of opportunities for cash investors. Here’s the bullet points we gave to the Squawk Box gang last week:

1. The capital injection into the largest banks by Treasury is a down payment, in our view. Expect to see some banks on the list (C, JPM, Bank of America (NYSE:BAC) – in that order of need) go back to Treasury for additional capital by early in 2009 as realized losses mount. Continue deterioration in housing due to a) no credit and b) shrinking economy will drive losses in all loan sectors/categories.

2. Despite grim macro outlook for US economy, most smaller banks in the US are in good shape. While losses will rise for the banking industry as a whole, smaller banks up through large regional institutions have the capital to absorb losses and continue during business. Top five institutions are where the assets are concentrated and the loss rates will be higher as the credit cycle peaks in Q1-2 of 2009.

3. We expect to see peak level bank loan loss rates reach 2x 1990 levels. In 1990, charge offs or realized losses for all banks loss were 2% of total loans, while subprime lenders like Citi were over 3%. Some institutions are already above 1990s level loss rates. Look at Fifth-Third (NASDAQ:FITB) sporting default rates over 200bp in Q3, almost 2x its asset peers and 3x loss rates seen in the 2000-2001 “mini slump.”

4. If we go 2x 1990 next year, means that the whole banking industry approaches 4% charge offs and the US government ends up in control of C, JPM and maybe BAC. Well Fargo (NYSE:WFC), US Bancorp (NYSE:USB), and BB&T (NYSE:BBT), et al shall inherit the earth. A new renaissance in US banking industry occurs as Uncle Sam liquidates these defacto GSEs into an auction populated by banks, private equity and other cash-financed funds.

Last week, we had a conversation with Josh Rosner about precisely this prospect, namely were the Treasury eventually to take control of JPM, C and BAC, would not the better public policy choice be breaking up these giant banks to help recapitalize, re-liquefy and grow the smaller, healthier survivors? There would still be a large concentration of deposits among the top 100 banks by assets, but the distribution would be more even than today.

Instead of trying to orchestrate mergers of weak regional banks, as Paulson is reported to be pursuing, perhaps instead the Treasury should ponder some creative destruction as and when further equity infusions are required. Such is the magnitude of the peak loss wave approaching the banking industry, in our view, that considering how to resolve fully nationalized money center banks to best recapitalize the industry seems appropriate.

BTW, if you have not seen the excellent Sunday NY Times piece on Henry Cisneros et al, “Building Flawed American Dreams,” click here. The Times has filled in another part of the political back story of the subprime fiasco and the “National Homeownership Strategy” championed by Cisneros and President Bill Clinton. The WSJ has also covered a lot of this turf, but the latest report on the good works of Cisneros, Bob Rubin et al is important for the file.

The precursors of the Great Subprime Bust of 2008 start in Washington, with members of both political parties feeding at the affordable housing trough and “spreading the wealth” to use the well worn phrase. Indeed so much wealth was spread, like jam scraped over too much bread, that the result is a partially nationalized US banking system and trillions of dollars in realized losses to investors. And this all in the name of “affordable housing.”

Thus we wonder if the next evolution of the public debate regarding the banking industry bailout should be to consider not whether more capital must be injected into the largest banks – rising loan loss rates should make this obvious to all by now – but what is to be done with the biggest banks that the Treasury may very well control by the end of 2009. Building bigger, dumber mega banks, we submit, is a bad choice, while redistributing the deposits and assets of the big banks into more numerous, stronger hands makes enormous sense.

Originally published at the Institutional Risk Analyst and reproduced here with the author’s permission.

2 Responses to "Spread the Wealth: Bigger Is Not Better in Banking"

  1. Demand Side   October 23, 2008 at 12:19 pm

    Thank you very much. Stepping back from the megabank model and into a market structure that is more stable is certainly more intuitively correct to me.I believe it was your comment elsewhere that there are no economies of scale in banking. As to the centrality of the national homeownership expansion sponsored by both parties, I think there was also the small problem of unregulated derivatives and opaque securities, both of which are concentrated in these larger banks.

  2. Jim   October 31, 2008 at 10:01 am

    Makes sense to me too. Spreading the risk of possible future bank failures among many small entitites vs. far fewer mega banks should spare the public from a repeat of what we’ve gone through. That is, the bailouts associated with entitites deemd too large to be allowed to fail. Of course, this also assumes that regs will be changed to ensure lenders carry and recognize risks associated with lending and don’t dump those risks on others through securitizations.