BANKTHINK

Big Banks Lack Convincing Business Model

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To my way of thinking, the big banks share a common problem with their old-line counterparts in the airline industry. Like the legacy air carriers, the top banks in this country have yet to find a sustainable profit-making model in a changed world.

Consider the latest round of quarterly results. Earnings quality was mixed at best. Profit "growth" at Bank of America, for example, was primarily fueled by asset sales and reserve releases – one-time events unlikely to be repeated. Even JPMorgan Chase found it necessary to refer to the banking industry’s "malaise" when discussing the decline in pre-provision profits. A bird’s-eye view of the structural issues looming on the horizon makes me feel like a white-knuckle flier. I don’t want to get on the big-bank plane.

Like the legacy carriers, the big banks have been slow to adapt to the new order. Pan Am exemplified what commercial flying used to mean: glamour, comfort and a free hot meal. Then came the 1973 oil crisis. Fleet overcapacity and embedded cost structures conspired with the new reality of oil price-fixing by OPEC to turn Pan Am into a money pit. Corporate consolidations and capacity reductions ensued, but Pan Am never returned to solid profit growth.

Today the survivors of that Darwinian exercise in adaptation, the legacy carriers, have yet to demonstrate a convincing business model. Likewise, U.S. banking has yet to evolve to meet the cyclical and secular changes sweeping the economy.

Granted, the earnings-season news had some bright spots. Capital ratios for all the big banks improved in the fourth quarter as did asset quality. The optimists, however, are reading far too much into the balance sheet. Stronger capital ratios should come as no surprise given the deleveraging of the banking system as well as fiscal support provided since the Lehman Brothers bankruptcy. Deleveraging, though necessary, is not a business model. The banks face a future of feeble economic growth, a moribund housing market, chronically high unemployment, regulatory uncertainty and a low-rate environment for as far as the eye can see. And no industry is more tightly tethered to the macro business cycle than banking. So how are these banks going to make money?

On the retail front, it’s prudent to plan for a continuing decline in U.S. housing prices due to mortgage delinquencies, elevated inventory and low turnover. Even if the housing market is nearing a bottom, prices likely would remain stagnant for some time to come. That base case is an important data point for unresolved legacy issues as well as future loan volume. Litigation related to mortgage originations, servicing and securitization continues to loom large over certain banks. Although fourth-quarter earnings for the big banks showed a glimmer of hope for a pick-up in loan growth, it’s difficult to see how loan demand will improve in any sustainable way without an increase in employment.

On the commercial front, the banking system is subject to the same sweeping changes in technology that tend to presage major societal change. Symbolism speaks volumes about the major banks. Bank building architecture once favored imposing structures with Doric columns to conjure an implicit reassurance of the safety of your cash. Now you can deposit a check to your account with a wave of your smart phone. What, exactly, happens to all those buildings and people? Perhaps Brian Moynihan should give Ryan Bingham, the job-slasher for hire played by George Clooney in "Up in the Air," a call.

Economic growth fans the tail winds of the banking industry. In the pre-Lehman downturns, banks could glide on the “carry trade” until the next upturn in the business cycle. When the economy weakened, the Federal Reserve would ease monetary policy, lowering real short-term rates, causing the yield curve to steepen. If economic weakness persisted and real short-term rates stayed low, bankers would respond by investing in longer-term securities, in some cases funding them with short-term debt.

Unfortunately, the standard playbook may be failing in our post-Lehman world. Deflationary forces are persisting in the face of what the Fed is pleased to call a "recovery." The yield curve today is flattening. Ben Bernanke’s "gift" of a durably low rate environment will most certainly depress the net interest margins of the larger banks.

Last but not least, the banks can’t pay a dividend without the explicit permission of Uncle Sam. That regulatory burden is about to grow heavier with the well intentioned yet misguided Dodd-Frank legislation.

So as in 2011, I’d advise risk-averse investors to underweight banks. What would change my view?  Several issues need to improve or at least be clarified.

A healthier economy and further capacity reductions would be in order. It would be helpful to have more clarity on how the banks’ mortgage issues will play out. What becomes of the $350 billion of second-lien mortgages on their books? And what about all those state attorneys general who think the road to the governor’s mansion is best paved by squeezing cash and making headlines out of the owners of the country’s biggest mortgage lenders?

And let’s not forget Europe. Concrete action by the Europeans to address their sovereign debt problems and bank exposures would help. Instead, the Europeans have staged a series of summits with little to show for it.

Unfortunately, the CEOs of America’s largest banks are in no position to lecture the Europeans about realism. For example, JPMorgan Chase’s Jamie Dimon recently appeared on CNBC and declared that a default on Greek debt would have zero effect on the U.S. banking system. He’s right – insofar as it goes. That cavalier dismissal of Greece misses the real issue: it’s not Greece that should worry us; it’s Greece, Italy, Spain, France and Portugal. 

To the extent a risk is incalculable, that risk belongs to gamblers, not investors. Someone in Europe holds a jumbo-sized loss. I don’t know who. Maybe an American bank or two will share in the fun. I don’t know who. I would need to know the bottom lines and trump cards of Merkel, Sarkozy and Monti. And I would need the ability to calculate the madness of (European) crowds. (They sound pretty mad these days.) Among other things, investing is about choosing among alternatives. Risk-aware capital has no business landing in a political free-for-all.

As a parting thought, let’s remember that the big banks’ exposure to Europe isn’t limited to holdings of corporate and sovereign debt. Counterparty risk is all too real. Recall the demise of MF Global, only the most recent of example of what happens when confidence in trading relationships crashes and burns.

In the post-Lehman regime of socialized losses, Washington won’t allow another outright default among the top banks. But would Washington bless the bank boards’ voting for real dividend growth? Insured by taxpayers and savers? In a time of scant lending, unprecedented home foreclosures and high joblessness? While demonizing bankers has become a favorite sport of politicians?

Not even Ryan Bingham has the savoir faire to finesse that one.

Bonnie Baha is a portfolio manager at DoubleLine Capital LP, a money manager in Los Angeles. She heads the firm’s corporate bond investments in developed markets. The views expressed are hers alone.

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Comments (4)
It's called, get back into the installment loan business, both personal and for small and mid sized businesses. Sure, you have to have experienced staff, since most of the models have proved to be lacking in the past few years.
Posted by Old School Banker | Tuesday, January 31 2012 at 11:59AM ET
What a fluffy load of tripe.. buried in incomprehensible analogies. What party did you attend this weekend that made you think that this was a clear message or did that concern you?

The fact that this has popped up so many places as the banking headline is what has my ire, and caused my reply. I fear few will actually have time to read it all.
long WFC if you would like bias confirmation.
Posted by phr3d b | Tuesday, January 31 2012 at 12:42PM ET
To Paul A. -- Good point, and some banks are already doing that: http://www.americanbanker.com/issues/177_16/consumer-lending-citifinancial-suntrust-wells-fargo-1046001-1.html

Maria Aspan, Consumer Finance Editor, American Banker
Posted by maspan | Tuesday, January 31 2012 at 12:44PM ET
I stopped reading after "oil price fixing." That was enough for me.
Posted by bill d | Tuesday, January 31 2012 at 1:08PM ET
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