shareholdersunite.com

Opportunities in smallcaps

shareholdersunite.com header image 2

The shape of US banks

April 14th, 2009 · No Comments

Sensible stuff for US banks and investors..

U.S. Banks: Why Only the Simplest Will Succeed

By Martin Hutchinson Contributing Editor Money Morning

One of the most accurate forecasters of the global economic crisis, Nouriel Roubini, said last week that last September’s spree of bank takeovers deepened the crisis because it made the already-too-big banks even bigger.

He may well be right; more interesting is what this tells us about the U.S. banking system going forward.

The institutions are insolvent,” Roubini said in a Bloomberg Radio interview. “You have to take them over and you have to split them up into three or four national banks, rather than having a humongous monster that is too big to fail.”

But that may be impractical. Citigroup Inc. (C), for example, can sell and is selling peripheral parts of its empire such as Japanese broker Nikko Securities. However, so much of its business involves an international nexus of connections – including its large U.S. operations – that splitting them may be both impractical and excessively value destroying.

However, Wells Fargo & Co. (WFC) showed Thursday what could be achieved by simplicity. It gave investors a preview of its first quarter results, in which it will make record earnings of about $3 billion, or 55 cents a share, after paying preferred stock dividends of $372 million on its $25 billion of preference shares from the Troubled Assets Relief Program (TARP).

Both the old Wells Fargo and Wachovia Bank, which it acquired last year, are showing good results, with $3.3 billion in loan-loss charge-offs for the combined group – down from $6.1 billion in the fourth quarter of 2008. As a result, bank stocks were up sharply Thursday, continuing their healthy rally over the last six weeks.

Wells Fargo is one of six U.S. banks – Citigroup, Goldman Sachs Group Inc. (GS), and Morgan Stanley (MS), Bank of America Corp. (BAC) and JPMorgan Chase & Co. (JPM) – with assets of more than $1 trillion. They are so large they form a separate “top tier” of banks, since the next largest bank, PNC Financial Services (PNC), has assets of only $295 billion.

However, Wells Fargo’s first-quarter success does not mean that all the top-tier banks will do well. Both Wells Fargo and Wachovia were heavily oriented to conventional retail and commercial banking, with massive branch networks all over the United States. The combined Wells Fargo was thus much less reliant on the slumbering investment banking business than other top-tier banks. It was also far less involved in high-risk capital-markets game playing, which got so many other banks in trouble. For example, while Wachovia got $500 million of dubious payouts from American International Group Inc.’s (AIG) dodgy credit default swaps, Wells got nothing, and therefore presumably had no net exposure.

Wells Fargo, in short, is becoming a model of what a nation should require of its behemoths under the “too big to fail” doctrine. It does mostly conventional retail and corporate banking, and provides economically useful services to its nationwide network of clients. It takes few huge risks, and is emerging from 2008’s disaster in pretty good shape. Without the Wachovia acquisition, Wells Fargo could probably have avoided the need for TARP capital.

In my February report on the top 12 U.S. banks, I showed how many of the top banks were in pretty good shape and offered investors good value, which would be demonstrated by higher first quarter earnings going forward. The Financial Select Sector SPDR fund (XLF) is up about 39% since then, so that was a pretty pleasing call.

Of course, what I didn’t get right was that the dogs are up even more in percentage terms than the solid citizens. Citigroup, the biggest bow-wow of them all, has more than doubled. Going forward, I would expect quality to assert itself. While some of the weaker banks should survive, they will be able to take much less advantage of currently juicy lending opportunities than their stronger brethren.

Sorting Out the Winners and Losers

Over the long term, the road forward is clear. Roubini’s suggestion to break up the largest banks – say those with assets of more than $500 billion – may be impracticable. It is also unnecessary. They should simply be tightly restricted, allowed to undertake only “vanilla” banking businesses, without a presence in investment banking, or in high-risk trading.

The market would then sort matters out. Some banks, like Wells Fargo, would probably prefer to remain gigantic, but simple and low-risk – earning a reasonable return, paying their top executives moderately, and having their stock serve as a fine investment for risk-average investors seeking dividend income. Bank of America and JPMorgan might wish to divest their investment banking businesses and move toward this model. The cultural clash between Merrill Lynch and the old Bank of America has been huge, suggesting that their merger has huge negative synergy and that the two institutions would be worth more separated.

The top six’s two investment banks, Goldman Sachs and Morgan Stanley, would have no interest in commercial banking, in which they have little history, so would have to downsize dramatically. One possibility is splitting them three ways – an advisory business, a medium-sized institution with a magnificent client base, and a more or less unregulated hedge fund that could be allowed to bankrupt itself in the shadows. They would not be permitted to retain their current huge positions in “principal trading,” an activity of little economic purpose beyond exploiting the firm’s insider information.

As for Citigroup, it seems likely that its troubles are too great and its culture too aggressive for any Wells Fargo-type solution to be possible. Over time, it should almost certainly be liquidated.

Below the top tier, the U.S. regional banks should mostly be in good shape, with a few exceptions that were based in particularly troubled regions or who had been excessively aggressive. In any case, they would not be “too big to fail” and would be allowed to engage modestly in investment banking if they thought it profitable.

Since they would be allowed higher leverage than the behemoths, they would be more profitable. And over time, the banking business might fragment further, which could only be good for competition.

As the world has seen over the past year, the arguments for creating financial services behemoths were spurious. They were too large to manage, and they survived only because their host country taxpayers gave them an implicit guarantee.

Tags: Credit Crisis · Public Policy