October 2014

“Strange isn’t it?  Each man’s life touches so many other lives.”

- Clarence Odbody in the 1946 movie, It’s a Wonderful Life.

Many of us grew up having seen Jimmy Stewart play George Baily in, It’s a Wonderful Life.  The movie peaks during the climactic “bank run scene” when George calms the panicked crowd by explaining how depression-era banking worked.   Times have changed a lot since then. 

The rise of the global economy and the rapid advancement of communications and technology have necessitated massive changes in the financial sector—and, in particular, banking.  There is likely no other sector so misunderstood, praised, vilified, and polarizing than today’s modern banking sector.  But, the point of this blog is not to pass judgment on modern banking, but rather to see how all the changes since the Lehman crisis are reshaping valuations in the banking sector.

Of course the biggest changes were the result of the 2,319 page Dodd-Frank Bill—and, to a lesser degree, the 900 page Volker Rule.  Add to that, the 19,000 pages of regulatory text that came as a byproduct of the two bills (and parts are still being written) and it is easy to see why the banking sector has been forced into new paradigms.  By way of comparison, the 1933 Glass-Steagall Act (banking reform) was 37 pages. 

The intent of these massive bills was to ensure that another “Lehman moment” could not happen again.  But as you might expect from such omnibus legislation, confusion and delays have stalled complete implementation of either law.  This has not made it easy for an investor to commit equity toward an unstable and changing regulatory environment.  Regulators have become a bigger risk than loans. 

To the credit of the banks, balance sheets for the TBTF (Too Big To Fail) banks have improved markedly over the past few years—and there have been concerted efforts to correct the errors that contributed to the 2008-2009 crisis.  On the other hand, however, it has become almost routine to have a “surprise announcement” issued by the Attorney General (or some other agency) which levels a massive fine against one or the other of these same TBTF banks.

According to data from SNL Financial, the six largest banks have paid more than $123.5 billion in settlements over faulty mortgages alone.  Imagine if that equity outflow had been able to fund infrastructure projects or had been loaned to small businesses.  Do you think it might have done more for jobs than the justice department?  Bank of America’s recent fine of $16.65 billion exceeded all of their profits from the previous year.  And while we are not defending every action B of A took prior to the crisis, it is fair to note they were “strong-armed” to a degree to take over Countrywide Mortgage, which was the source of multiple abuses. 

The point is, while investing in financials like JP Morgan, Goldman Sachs, Wells Fargo, and others has been profitable over the past few years, gains have come with far more anxiety than in firms like AT & T and Microsoft.  And we are not alone in this assessment.  If you look at the chart below, you’ll see a definitive gap between the performance of the S & P 500 (red line) and that of the Dow Jones U.S. Bank Index (blue line).  We call the gap between these two lines the “regulation” gap. 

It has now been 4 ½ years since Dodd-Frank was passed and, despite the delays, understanding the legislative intent and the accompanying rules is getting clearer.   What seems apparent is that not all financial institutions will be treated equally going forward.  The big banks were the focus of much of the legislation--- and the regulatory burdens will fall disproportionately to them.  This is not to say that small banks won’t have increased costs and reporting requirements…they have.  They will not, however, be forced out of business lines and regulated to standards that change their entire business models to the extent big banks are experiencing.

The reality is, the legislation is tiered.  Banks of certain sizes will be subject to rules that banks of other sizes won’t.  The bigger the bank the more rules and regulations will be applied.   But not all banks within a tier are the same either.  For instance, if banks with $10 billion to $50 billion in assets are subject to a certain set of rules, it follows that banks slightly under $50 billion will find a lower cost effect than those marginally over $10 billion.  The same principle may also apply to banks in the $50 billion to $250 billion category.  Tipping over a tier can have a negative effect on cost structure.

This tips the “cost of regulation” playing field in favor of banks in the top half of their tier.  It also could change the calculations regarding whether banks merge, expand, contract, pursue take-overs, etc.

The investing point is this----post-Lehman legislation and regulation have distorted the landscape in the financial sector.  Our purpose is to acknowledge the new reality and make reasoned decisions regarding the potential winners and losers.  We believe the biggest banks will encounter the greatest headwinds (TBTF) on improving Return on Equity (ROE), and the smallest banks (under $5bn in assets) will struggle to comply—even with fewer requirements.  The sweet spot will be anywhere in the middle—mainly regional banks with sufficient capital, solid management teams, strong balance sheets, and reasonable price to book ratios are more likely to out-perform the big and small extremes over the next few years.  They are most likely to grow organically by doing what they do best…make loans.  That focus will play a key role, and the reward we hope investors realize is the reversion to the mean of the market value in this historically important sector.

Therefore, as the markets dictate, we will likely begin to partially rotate our bank stocks holdings from some of the biggest banks to well-performing regional banks with attractive price to tangible book ratios and solid capital bases. And, as we do we will be acknowledging Clarence Odbody’s wisdom that, “each man’s life touches so many other lives”...who knew those men would be named Dodd, Frank, and Volker?

Happy Investing!


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