|Bad moves that don't fool anybody (March 2008)|
…irk bank analyst Richard Bove. The Wall Street veteran takes a blunt instrument to some cherished industry beliefs
Richard X. Bove has been in the securities business since Lyndon Johnson was president. He spent about five years in sales beginning in 1965, then became an analyst following building and housing companies. In the late ’70s he became a bank analyst working for Wertheim, Shearson, and then for Raymond James and Hoefer & Arnett. His position now is financial institutions analyst at New York-based Punk, Ziegel & Company. He works from an office near Tampa.
The All-American analyst (9 times) presently covers about 25 banks and five New York City brokerage firms. ABA Banking Journal interviewed Bove (pronounced bo-vay) in late January and posed several questions to him. A summarized version of that interview is in the March print edition of ABA Banking Journal, which you can read in our digital edition by clicking here. The full interview appears below. An audio file of two of Bove’s more detailed answers is also on the website. (http://www.ababj.com//content/view/357/164/)
ABABJ: Let’s talk about a broad trend first—consolidation. It has been a theme for most of the 30 years you’ve been covering banks. What forces are driving it, and has the speed of it surprised you either way—slow or fast—over that time period?
Bove: It was particularly rapid at the beginning of that timeframe, and it was also the policy of the United States Government to stimulate bank mergers. Because in the late ’80s early ’90s period they were finding a great deal of difficulty with the smaller banks in the United States and clearly they had been fighting the whole problem of the thrift industry for a decade by that time. So that Secretary of the Treasury, Nicholas Brady, came out with a report at the request of then President Bush. That report suggested that the United States had too many banks, that the banks were too small, and that competitively the United States was losing ground to Japan and Germany who had the biggest banks in the world at the time. So it became almost a stated policy of the United States Government to facilitate as many mergers within the banking industry as possible. As a result you’ve never seen a Justice Department challenge to any bank merger in this country, even when you put Chemical together with Manufacturers Hanover, with Chase, and with JP Morgan, which in any other industry would have stimulated screams related to anti-trust. There wasn’t a peep from anyone in Washington.
Second, you have the fact that economically consolidation made sense. For decades it was believed that the smaller the bank the more efficient the bank, but as time evolved it became evident that the bigger banks could develop scale products within the industry—mortgages being one, credit cards being another, auto loans being a third—where they could achieve a lower operating ratio [Bove doesn’t like the term “efficiency ratio”] than the smaller banks, and therefore that accelerated the move toward consolidation.
And then, of course, the nature of the way banks consolidated also changed. Initially, it was a marriage and there was a great deal of effort placed in making sure that your future partner was compatible, that the people you [would be] working with were compatible with your organization, that there wouldn’t be a cultural problem because you felt that you had to fit the two organizations together. Today, you’re simply buying customer bases, and what you want to do is get rid of the management teams in the acquired institution and you want to get rid of their infrastructure. You simply want to get that customer base added to your customer base so that you can function at the lowest cost possible.
In terms of what’s going to happen from this point forward, it’s pretty clear that the largest banks in the United States have a very reduced appetite for acquiring anyone in the banking industry. There are maybe one or two—JP Morgan Chase is one perhaps—that have an interest in buying a large bank. Bank of America is not going to do it. Wachovia is, I think, held back at the moment. Citigroup is looking overseas. Wells Fargo prefers fill-in mergers. So it’s pretty hard to find an American bank that wants to do a big merger. HSBC of course is always mentioned but they don’t do them. Deutsche Bank doesn’t do them. Royal Bank of Scotland hasn’t done one [here] for awhile. The large banks believe that they can now take market share without acquiring others. And therefore most of the mergers that you are likely to see are going to be among the banks that are of similar size, relatively small. And I think you’ll see a great deal of those simply because revenue opportunities are contracting and there has to be a bigger emphasis on getting costs lower.
ABABJ: You’ve covered a lot of ground in that answer. Do you believe that there are economies of scale in certain areas, or broadly in mergers, particularly among larger institutions?
Bove: Well, it’s been demonstrated. Bank of America has one of the lowest operating expense ratios of any bank in the United States. Not in 2007, but in 2006 their efficiency ratio dropped below 50%. So the net effect is they’ve proven that there are economies. And the reason is because they sell homogenized products. In other words, Bank of America is not as interested—nor is any large bank—in the labor-intensive delivery of service to the consumer. They are more interested in automated delivery systems that produce products like a credit card loan, or an auto loan, or a mortgage, or a home equity loan, which essentially can be done using credit bureaus and scoring systems and a variety of electronic delivery techniques.
ABABJ: In terms of reducing cost, there have been cases in the past where that kind of approach has gone too far and has caused more damage to the resulting institution than success, would you agree? I’m thinking back to one or two of the First Union acquisitions a number of years ago.
Bove: Yeah, but that’s ancient history. Basically what those banks did, what First Union specifically did, was overpaid for the companies that it acquired and it simply made the assumption that it could cut costs as dramatically as necessary to make the acquisition productive, and it couldn’t. It wound up reducing services and therefore harming the marketing approach of the individual company. But you know to me that’s like talking about when they invented the wheel. First Union—now Wachovia—has the number one rating in consumer service of banks in the United States and they’re increasing their market share in virtually every market they operate.
ABABJ: Right, it’s an old example, but have people pretty much learned that lesson?
Bove: I think that it’s understood that cost reduction is not a function of firing people. Cost reduction is a function of changing delivery systems, of reconfiguring the product, of using larger computerized operations. It’s not buying a bank and now you’ve got six loan officers, and saying I think those loan officers are too expensive. That’s not how you reduce costs.
ABABJ: You described before a process of where you are basically acquiring the customers and eliminating the management of the acquired institution. Are you suggesting that that’s actually a good model to follow?
Bove: I think what you are trying to do is you’re trying to convert the management of a company that you acquire into a sales force. Anyone who isn’t sales oriented or who doesn’t have direct customer contact you really don’t need. So you can wipe out that whole core of middle management, back office, etc. In addition to which usually the acquirer has superior operating systems to the acquiree and therefore you would move or convert all the accounts over to your system, and what you now have is significantly reduced costs in terms of the systems. You have reduced the amount of management not interfacing with clients. Those people who are sales people, or who, again, have direct contact with clients are kept, but everybody else is expendable.
ABABJ: Do you have a particular preference as an analyst for organic growth versus growth through acquisition?
Bove: What we know is that the companies who can grow organically have higher price/earnings multiples than companies that make a lot of acquisitions. So clearly the preference is for companies that can show significant organic growth. Wells Fargo has a much higher multiple than Bank of America for example.
ABABJ: You talked about culture at one point. How much of an issue is that in mergers?
Bove: It’s not an issue any more. In other words, before, meshing cultures was considered to be a critical event in making a merger work. For the big banks it’s not an issue now. You adopt the acquirer’s culture, period. That’s it, end of story.
ABABJ: One of the theories that comes and goes over time is the so-called barbell theory relating to the shape of the industry. It seems to have been coming back lately. It’s the idea that there’s no room, or no future, for the mid-sized regionals. Do you see that occurring?
Bove: The issue is—to use a very old cliché—you’re either going to be high-touch or high-tech. If you’re high-tech you’re using these homogenized products delivered through commoditized systems which you know reduces their cost substantially to the user of the product. And if you’re a high-touch bank you’re dealing with a customer who wants a high level of personal service and is willing to pay for it. Generally speaking, mid-sized banks do not have the volume to be totally high-tech and they can’t afford the cost of being totally high-touch, so they’re in this middle ground which makes it more difficult for them to function. But I don’t see any compelling reason why they have to be pushed out of business or pushed out of the way. As far as I’m concerned they’ll be here for another 100 years.
ABABJ: I know you don’t particularly cover community banks, but do you have any particular thoughts on the future of institutions in that category?
Bove: There’s no reason they can’t be successful. They have to understand they are providing a totally different service than the larger bank does. They have to be willing to provide a very labor-intensive approach in selling all of their products. They have to charge differently. Here in Florida, at least, banks tend to find niche positions in the market so that they can distinguish themselves around a specific product line. So each company has taken on kind of a unique set of characteristics in order to succeed in their specific markets and stay away from the big banks that can undercut them in pricing right across the board.
ABABJ: You’ve talked about or written about stock buybacks a number of times. Can you explain why you feel that buybacks don’t make sense?
Bove: I don’t think it’s ever made sense anywhere, ever, at anytime. It’s one of the worst things that management can do and it’s an example of the fact that management can’t figure out what’s good for the company and prefer to [follow] what they read about in the newspapers or what stock analysts tell them. Because if they understood anything about banking, they would never under any condition get involved in stock buybacks. And the reason that I say that is because first, it reduces net income. In other words, you’ve got to go out and borrow money to buy back common stock, so you’re now paying interest on the money that you borrowed and therefore your net income will be lower than if you had not bought back any stock.
Second, when you buy back stock you are reducing the capital in the company, which means your ability to leverage your capital base has been impeded and the net effect is you have less funding capability to take advantage of whatever opportunities there are in the market. Now of course most bankers buy back stock because they are poor bankers and they don’t know how to run their companies and therefore they don’t see any opportunities in the market. But the fact of the matter is that if they did have opportunities they wouldn’t reduce their capital and they wouldn’t reduce the amount of funds that they have to put to work in the communities that they serve.
Number three, they think that people are fools. They think that if they financially engineer their return on equity higher by reducing the amount of capital in the company, that they will get a higher p/e multiple on the stock. That has never happened, ever. In other words, those companies that buy back the greatest amount of stock tend to have the lowest p/e multiples even though they have returns on equity which might equal 20-21%. Because investors simply do not believe that if you’re running your business in the normal fashion you can get more than a 13-15% return on equity. And if you use financial engineering—which is all banks are doing with these stock buybacks—to move your return on equity higher, investors believe that you’re attempting to manipulate the data and they reduce the multiple on the stock.
Next, there is no regression that you can do that will show anyone that companies who buy back more stock have better price performance on their issues than companies that don’t buy back stock. I challenge anyone to prove to me that companies that have high ROEs in this business tend to sell at higher multiples than companies that have average ROEs, or to prove that companies that have high stock buy-back programs have better stock price performance than companies that don’t. You can’t do it. It doesn’t work.
Look at what Citigroup is doing. And what Bank of America is doing. They buy back stock at extremely high prices and then they come back and they sell stock at extremely low prices. Where is the logic to that? I mean, haven’t these people thought that this is a cyclical business and in a cyclical business you need the capital growth at certain points? So you don’t eliminate capital at the top of the cycle when you are doing well and buy stock back at the highest price possible, and then go and sell stock at the bottom of the cycle at the lowest price possible. This is an absolute abortion in terms of handling of stockholders funds.
ABABJ: Would that be true in any business or is it particular to banking?
Bove: There are stock buybacks that are done in all industries, and I would argue that the same is true everywhere, but I haven’t studied all industries. I’ve just studied banking, and therefore I can speak with a great deal of conviction about the industry that I study.
The other thing that you have to consider is that the raw material of a bank is money—capital—right? Because the degree that you reduce your ability to get at the raw material you reduce your ability to grow your earnings. Can you imagine an oil company that makes a decision that they would rather have stock than new oil fields? Or a steel company that doesn’t want iron ore deposits? Or a copper company that wants to get rid of it’s copper because it can buy back stock? If you can’t imagine those things, why would you imagine with a bank, where money is the raw material, that they would try to get rid of the raw material in order to buy back stock?
ABABJ: In terms of financial and performance measurements, you’ve mentioned a few that you look to. Which ones do you consider the most important indicators?
Bove: Loan quality is what people look at first. If you take a look at what moves bank’s stock prices more than any other factor it’s the quality of their assets. So whenever investors feel very comfortable about asset quality in the banking industry—notably they think the loans are good, the securities are good—bank stocks will go up even if you have weak earnings and you don’t have interest rates going in a direction that you want. If investors feel that loan quality is poor, it doesn’t matter what banks are earning and it doesn’t matter where interest rates are. You saw that clearly in 2007. They don’t want to own the stock. So loan quality is by far the most important of all factors, and the best indicator of loan quality is the direction of nonperforming assets.
The second most important factor is interest rate direction because 95% of the assets of a banking company are financial in nature, right? Then basically a change in interest rates has the same impact as the change in loan quality.
Third most important factor obviously is earnings. So I’d say those are three in the pantheon that I look at. And I think that all of these other numbers, whether it’s return on equity, intangibles relative to book, loan-to-deposit ratio are all eyewash—they don’t mean anything. Because, again, I’m only interested in, is the stock going to go up or isn’t it? And none of those factors have any impact on the stock going up or down.
ABABJ: I’d be interested to hear you’re views on what sets apart successful banks? As an example, in a conversation with Dick Kovacevich a number of years ago, he harped a great deal on the concept of execution and how you don’t need a great strategy necessarily to do well, you just have to have a good strategy and execute it better than other people, which is very hard to do, he said. Do you have any points of a similar nature or do you happen to agree with that one?
Bove: He’s exactly correct. If you think of what a bank does, it takes in deposits and it pays, if you will, lenders to the bank—you know, the depositors—a rate which is below what the United States government pays to raise money. So that gives the bank a staggering advantage. And deposits go up every year, virtually. Since 1934 when the statistics were first gathered, there were only three years in which deposits did not go up, and the last time that happened was 1948. So you are getting this constant flow of free cash and what you have to do is maintain some type of spread in terms of how you redeploy those deposits and keep your expenses low. If you do that—and it sounds very simplistic—but if you do that, you will have an extraordinarily successful banking company.
Unfortunately, most banks don’t think it’s that simple and most investors don’t like that strategy. What they don’t like about the strategy is that it’s a slow growth strategy and therefore they get involved with wacko programs like buying back stock. But the point is that in order to execute that strategy the first thing you have to do is concentrate heavily on your internal workforce. Because your internal workforce has got to be motivated and has got to feel a commitment to the company and has got to believe that their future is tied in totally to the performance of the company.
And where Wells Fargo has really excelled relative to other companies is that it has conveyed that message. And people who work for Wells Fargo, or [the people] who used to work for Fifth Third, or the people who used to work for SunTrust, they were part and parcel of a long-term strategy which employs people who are committed to the company. Bank of America fires people left and right. Citigroup is firing people all the time. Neither one of those companies are perceived to be as well managed as the ones that I mentioned. SunTrust, you know, when it started firing it’s people it lost it’s face to the world. It became a different entity and all of a sudden what was one of the best banks in the United States is no longer one of the best.
Washington Mutual, when it was opening up all these branches and it had all these clear career paths for its people, had a level of enthusiasm within its workforce that was superior, and the net result was the institution did very well. When it got into trouble and it started firing people, then all of a sudden all hell broke loose all through the institution.
So I think that you’ve got to start with commitment to employees and a real strong program to show that those employees are part of the fabric of the institution.
The second part of execution is you have to spend a great deal of money on customer service. You’re selling a commodity, right? Money is money, a mortgage is a mortgage, or what have you. The price differential might be relatively large or relatively small, but the fact of the matter is you are not selling a unique product and you cannot argue in any way, shape, or form that what you’re providing to the market is unique. I mean, every bank sells home equity products, that’s their biggest consumer product, right? Every bank has some sort of lifestyle account. So it’s the way you deliver the product which is critical. Again, customer relationships, customer service.
So I think for most banks those are the critical factors. It gets back to what Kovacevich said: It starts with the employee and ends with the way the customer feels that he or she has been treated. That’s what makes a good bank.
And what tends to screw up that very simple model—collecting deposits, getting a spread, making a decent loan—is going into other businesses which are unpredictable, and developing financial engineering techniques which do nothing to improve the model.
ABABJ: Well let’s talk about that a little bit because as you well know over the years there has been tremendous talk and pressure and presentations about generating new sources of revenue because you had to go beyond the traditional model that you’ve just been describing.
Bove: Maybe you can tell me why.
ABABJ: I don’t know if I can, but there do seem to be banks that have done a good job with sales of insurance, for example.
Bove: But a handful, right? You’re not going to tell me that of the 7,800 banks in the United States that there are as many as 50 that are doing a fabulous job as insurance brokers, or that you can find more than half a dozen that are doing really well as capital market entities. The core bank of the United States is still doing it the way I suggested to you. The need to grow faster than 6-8% is what harms banks. The need to prove that they can defeat the [business] cycle harms banks. I still think the core model is the best model.
ABABJ: One way that some banks have attempted to grow as we discussed before is through acquisition. Or even through a very aggressive branching strategy into new geographic areas. That can accomplish a similar kind of growth, would you agree?
Bove: Well, we started off the conversation by saying that the acquisitions were being made to lower the cost base on incremental business, right? So you know I’m not sure that the revenue potential from acquisitions is well defined, or is as well defined as the cost side of the transaction. Unfortunately, you simply have to sell more products to the same customer. I mean the Wells Fargo approach is clearly the best approach in banking and every bank in the United States in one fashion or another is emulating it. Although they may call it by some other business model or technique, the fact of the matter is that Wells Fargo’s cross-selling approach makes more sense than anything that any other bank in the country is doing.
ABABJ: But even they tripped up recently when they began to pursue some of the more exotic mortgages..
Bove: But they didn’t trip up. I mean you’re going to compare what happened to Wells Fargo to what happened to Citigroup? Or Bank of America? Or the write-offs that are being taken by Wachovia, or JP Morgan? What Wells Fargo took was not even spit relative to what these other companies took. It’s a big bank, it’s in all of the core products that the banking industry sells. When the cycle goes down there’s no way that it can avoid getting hurt by the decline in the cycle. What is evident, however, is that the impact on Wells Fargo is dramatically less than the impact on any of the other banks that I just mentioned. That would suggest that something with Wells Fargo’s strategy has worked.
ABABJ: In regard to financial engineering, and the related area of exotic structures and products that mainly the big banks have come up with, I remember Alan Greenspan a few years ago touting some of these more exotic financial products as beneficial because they help diversify risk. I’m wondering in hindsight do you think that he was correct as to whether some of these structures have actually been useful or not?
Bove: It appears that the companies that have used them most aggressively have not made money out of them. They make a lot of money in the short run, and then they give it back. But I do think that it’s correct that over time the financial industry’s structure is evolving so that there are new products that are going to be developed and sold, and they are going to be developed and sold into new markets.
ABABJ: That they have been beneficial, is that what you’re saying?
Bove: Yeah, in other words, if you’re Keycorp, sitting in Cleveland, Ohio, you’re ability to reach out with these new products to your market is fairly limited and therefore they don’t have a whole lot of relevance to what you are doing. But if you’re JP Morgan in New York or Citigroup which is trying to reach customers in China and in Japan and India and Chile and Argentina the new products are critical.
ABABJ: You described in a couple of your newsletters how the whole sub-prime mortgage mess essentially was just a problem of loans being made to people that shouldn’t have gotten the loans, and then from that you have this elaborate structure that goes up and expands using some of these exotic financial instruments. And so are you saying, Dick, that essentially that it’s not necessarily the exotic instruments that were the problem, but that the foundation that they were based on was wrong or weak?
Bove: That’s what I’m saying. The problem with the system was that it stepped aside doing underwriting. At every level of that structure whether it was the initial origination of the mortgage, the RMDS, the CLO, the CDO, the CDO2 all the way up to the SIV or the guy who’s buying commercial paper, nobody had any incentive to underwrite the product. The theory always was that they could pass on the risk to the guy at the next level and therefore why waste time and the money to underwrite properly. I think what has now been discovered is maybe you should be underwriting. And if you [had been] underwriting, basically the whole superstructure of the inverted pyramid above those loans would not be troubled.
In other words, if State Street were to buy a hundred million dollars worth of mortgages 20 years ago, they would look at every mortgage, they would throw out the ones they didn’t want, and they would value the remaining mortgages based upon the present value of the stream of cash expected off those mortgages. If State Street buys $100 million worth of mortgages today they are buying a CDO, they are looking at the ABX index or they are looking at the rating on the CDOs. No one has taken the time to underwrite and they pay whatever the amount is. Then of course if there is some trouble with the mortgages underlying the CDO, well no one’s ever looked at them. So they have no idea as to what the product that they bought is worth.
ABABJ: With that as a backdrop, how has the role of bank boards has changed or, perhaps, should change?
Bove: I think boards of directors in banking companies are generally ineffective. They tend not to exert their presences. They tend to do pretty much what management or what the CEO tells them to do. To a company I cannot recall a board of directors that has protected shareholders’ interests in the banking industry. In my view, the role has always been to see how much money they can make available to the CEO. That role has never changed. They are totally ineffective and in most cases it’s a failed institution as far as banking companies are concerned.
ABABJ: When I heard, for example, that Vernon Hill was let go at Commerce Bank, I wondered, what about the board? What was their responsibility there?
Bove: Boards have a great deal of responsibility, it’s just that I am not aware of boards that exert that responsibility. I just don’t know one that does. In my view if anybody is pushed out of a banking institution, it’s because the regulators have initiated the event. Obviously Chuck Prince was pushed out. That wasn’t the board that made that decision either. Boards do not step up and do things to restrain management that I’m aware of in this industry.
ABABJ: You’ve been critical of the Fed generally, but particularly in regard to the subprime mortgage situation. In your opinion, what should the Fed do to assist in this crisis?
Bove: I think the Fed should do nothing. I don’t think it’s the job of the Fed to step in and effect change in the financial system or the economy. I believe the Fed should do as little as possible and if we slip into some major crisis, and I don’t believe we are in one, if we slip into some major crisis then I think the Fed will be forced to act.
I think the Fed is panicked. I think it is being driven by Wall Street rather than by intellectual, if you will, probity. I think that this Fed has lost its way and has not come up with a clear philosophy as to what it wants the financial markets to understand.
It seems to be totally reactive, not at all proactive. I just think this whole Fed stuff is garbage. If you think that we are an essentially planned economy and that the only entity that can affect whether the economy is strong or weak is the Federal Reserve, then you should be living in Eastern Europe or the Soviet Union. I mean, this is a democracy and a republic and a capitalist economy, and so, therefore, I don’t believe that the Fed determines whether the economy is strong or weak. I don’t think the Fed invented the internet. I don’t think the Fed runs the health care system of the United States. I don’t think the Fed operates retail stores, and I don’t think the Fed does anything to inspire greater population growth or greater immigration or changes in income in a broad sense. And the fact that there are so many people who believe that this is essentially a planned economy run by the Federal Reserve I find to be somewhat chastening. Is there anybody left that believes in capitalism?
ABABJ: They’ve turned on the spigot now pretty freely and probably will again…
Bove: They’re chasing the T-bill rate. In other words if you go back over the past 20 years and you take a look at interest rate changes in the United States you will see that the T-bill moves first and the Fed moves second. Which means that the Fed is not stimulating the change, it is the T-bill that is. And the T-bill is a free market. And I’m a big believer that the more you leave the free markets alone the much better off you are. The more you get the Fed involved the worse off you are. And I think that Mr. Greenspan—who I still think was an excellent Fed chairman and I don’t believe created the mortgage bubble—has articulated clearly in his book the rule of unintended consequences. And that the Fed by moving proactively can set off many of these unintended consequences. And he also is a big believer that the Fed really doesn’t know the full impact of what it does. And therefore he thinks the Fed should move in measured paces and I think the guy is right on. That’s why I get so upset when every time I turn on the television or pick up a newspaper and the Fed did this, the Fed is moving this direction, the Fed is moving in that direction, the Fed should be doing this. These statements implicitly make the person stating them a believer that this economy has no ability to function on it’s own. And I reject that. I reject that totally.
ABABJ: [This next question was based on a proposal Bove has put forward to resolve the huge overhang of problem mortgages that is hurting the economy. It involves reactivation of a program known as Section 8 established by the Emergency Home Finance Act of 1970. It would permit low income homeowners to refinance their existing mortgage into a Federal Housing Administration 30-year, 1% mortgage. FHA would insure the mortgage and package and sell it to Ginnie Mae at a slight premium to par. Ginnie Mae then would sell the loan to Fannie or Freddie at market yield, which would mean a big loss for Ginnie Mae, i.e. the taxpayers.] At what point, Dick, did you conclude that the mortgage problem was too big for the private sector to handle?
Bove: I don’t think it’s too big for the mortgage sector to handle. My point is if the Fed and the government are going to get involved, then this is a way that they could get involved. But personally I think that the system will cleanse itself. It’s just that it will be painful. So the issue is, do you want the government to step in and reduce the pain—which our politicians want, and all people in the investment business want—[in which case] you’ll get a half solution which will be extraordinarily costly, or do you want the system to cleanse itself? I think if the system cleansed itself you’re much better off, but no one’s going to allow that to happen. So the question is what is the least costly way to do it, given the fact that you can’t keep the government and the Fed out? The one that I suggested is going to cost in my view $200 billion dollars. BJ
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