Charting Banking XXIV: pre-tax pre-provision earnings

If tangible common equity multiples have their issues, what is a good valuation alternative?

If you trust the bank to survive its credit headwinds while at the same time its total revenues are growing, or at least stabilizing, I think it is fair to use some sort of multiple of normalized earnings. And if that is the case, pre-tax pre-provision earnings are a good start.

• Why pre-tax? Two reasons. First, with all the recent losses many banks are not going to be paying taxes for a couple of years. And second, it makes easier the comparisons among banks and across time when taxes paid are fluctuating.
• Why pre-provision? Provisions are the main way credit issues get reflected in the income statement, building up reserves for consequent charge-offs. Therefore, if we want to isolate the earnings power from the credit issues this is the main line to subtract. The other way credit issues impact earnings is loses related to sales of real estate owned REO.

And the idea is that after getting a standardized PTPP, you can use your personal estimate on steady state provisions and taxes to get to an estimate normalized earnings. We will get to that later.

There is one little problem though: that is all the consensus on PTPP there is. Each analyst and company do their own adjustments:

• One-offs like goodwill write-downs and gains or loses on securities sold
• CVAs and other mark to market distortions
• REO gains and loses
• Depreciation and amortization
• Credit related operating expenses like mortgage servicing

And there is no consensus even on how to name pre-tax pre-provision earnings:

• pre-tax pre-credit earnings
• pre-tax pre-provision income
• pre-provision operating income
• core earnings

And of course each one of those come with its own abbreviation.

That makes life hard because you are not sure what each company or analyst is including and how to compare across companies and analysts. My opinion is that there is no way around it: you have to get your own estimates … and I will share one fast, but not very precise, recipe:

1. Get the cash from operations from the cash flow statement, and reverse the following adjustments
2. Subtract back all working capital adjustments that are usually the lines that start with “increase” or “decrease”
3. Subtract back stock compensation
4. Subtract back tax provisions from the cash flow statement
5. Subtract the equipment purchases (capex) from cash from investing
6. Add back taxes (taxes provisions) from the income statement

Or the same, start from net income in the cash flow statement and add depreciation, amortization, provisions, one-time loses/gains, taxes, and subtract equipment purchases. Each company has different line disclosures in the cash flow statement so you still have to season to taste. But at least is much more standardized than using analysts and company estimates.

At the end, you get something very similar to what Buffett refers as owner’s earnings only that it does not include taxes. Among its benefits, it excludes non-cash charges and is somewhat conservative because it does not adjust for high administrative expenses related to foreclosures and REO administration (ie: Bank of America has 30,000 FTEs entirely dedicated to solving mortgage issues).

These are the numbers I am using as estimates for the Big 4 and the big challenger. Use them only as a reference. As I said, there is no way around it: you have to get your own estimates.

Do not try to be overprecise, I usually round up numbers trying to sin on the conservative side. Better to be roughly right than precisely wrong.

One way to double check the estimates is to compare profitability ratios  (do it with tangible figures if you prefer) across companies and across time to have a better idea of the earnings power of the bank. These are some high level numbers across companies,

Now how to get from PTPP to a normalized valuation? Well, the long way is to do a discounted cash flow with normalized provision, taxes and growth. I will recognize that I prefer simplicity, with some common sense, and generally use a 10x multiple of PTPP:

• Very simple to calculate.
• 10x pre-tax is close to 15x earnings.
• 15x historic earnings multiples imply growing at the same rate as rest of the economy and returning just cost of capital.
• Big banks cannot grow a bigger share of the economy forever so a conservative multiple looks good.
• Substantial non-earning assets.
• Some of them still have high cost financing (prefs, trups, tarp), despite high liquidity, that will be reduced over time.
• The banks that I am interested in, the ones under some distressed valuations, will not pay taxes for years.
• Non crisis provisions of around 0.3% of revenues are less than what many banks pay in mortgage mess related expenses.

There is at least one big exception to these oversimplified assumptions, banks heavy in credit cards or similar lines based on a model of high normalized provisions in line with high net interest margins. A clear example of this is Capital One. My recommendation, go to previous 10Ks and double check the normalized provisions.

Having estimated a normalized value, it is good practice to go through the credit/legal issues and estimate how many years would take to solve  them, apply your preferred margin of safety discount based on the company’s specific risks and growth prospects, and voilà.

That was today’s look inside the sausage factory.

Long BAC, C

PS: criticism of these numbers based on real figures is very much welcomed!

PS 2: I adjusted USB PTPP to reflect its 2011 growth after comments at the Corner

Munger on patience

How many different things has Wesco done since Blue Chip Stamps? We’ve only bought two or three companies and made a few big stock purchases. We’ve probably made a significant decision every two years.

But nobody manages money this way. For one thing, clients won’t want to pay you.

But this is not fun, watching and waiting, for people who have an action bias. Too much action bias is dangerous, especially if you’re already rich.

It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.

There are a lot of things we pass on. We have three baskets: in, out and too tough. A lot of stuff goes into the ‘too tough’ basket. We can’t do that if it’s a problem at a Berkshire subsidiary company, but if we don’t own it, we just pass. I don’t know how people cope trying to figure everything out.

We have to have a special insight, or we’ll put it in the ‘too tough’ basket. All of you have to look for a special area of competency and focus on that.

But our theory is that getting a real chance to invest at rates way better than average is not all that easy. I’m not saying it’s not moderately easy to beat the indices by half a percentage point every year, but the moment you seek higher returns, is a very rarified achievement.

The only way we know how to do this is to make relatively few investments of size.

It’s not so bad to have one’s money scattered over three wonderful investments.

Suppose you were a real estate investor with a 1/3 interest in the best apartment complex in town, the best mall, and the best [I missed what he said -- another type of real estate investment]. Would you feel like a poor, undiversified investor? No! But as soon as you get into stocks, people feel this way. Partly, people need to justify their fees.

Over many decades, our usual practice is that if something we like goes down, we buy more and more. Sometimes something happens, you realize you’re wrong, and you get out. But if you develop correct confidence in your judgment, buy more and take advantage of stock prices.

The Carousel

Honoring the fallen … and a reminder of what is a brand. This device is not a spaceship, it’s a time machine.

PS: just click through to get to YouTube and play the video

Bank of America’s big improvement

Brian Moynihan is not  the most charismatic of communicators but his prepared statement was excellent. You do not need the Irish gift of gab when you show results.

Some people have said that the Bank of America’s results were made of paper-mache. As any participant of a Mexican piñata can testify, paper-mache can be very robust. With its current capital situation, the piñata would need some serious beating to go down.

This time I am betting on the piñata. Yes, I am finally buying big banks and, as hinted more than a year ago, I did so by buying TARP warrants . It was about time to end this procrastination.

PD: good discussion of the results at the Corner of Berkshire and Fairfax.

The last 2 years, we’ve been executing on a huge transformation here at Bank of America. After 6 large acquisitions in 6 years during the mid-2000s, then the economic crisis and its aftermath, we set on a course to simplify the company, to streamline the company, to reduce the size of the company, to lower our risk and build a fortress balance sheet. During that, we set goals to have 9% Basel I Tier 1 common and 6% tangible common at year-end 2011.

We set goals to reduce our non-core assets. We set goals to bring our credit risk down and to address the mortgage risk related to the Countrywide acquisition. At the same time, we also set goals to continue to invest in areas where our company can grow and has this competitive advantage. Areas like our Wealth Management area, areas like our Preferred Small Business areas, where we’ve added Preferred Bankers and Small Business Bankers, areas like our Commercial Corporate and Investment Banking areas, especially in large corporate investment banking outside the United States.

Along the way, we had to address issues that came up in mortgage, the slowly recovering economy, which isn’t moving — which is moving forward but not as fast as we all like. The European crisis, a muted interest rate outlook and the revenue loss to the new regulations that have been passed. These then result in our focus on cost, and we announced early last fall our New BAC program and the goals that we had for it.

So as we think about 2011, we saw the following. First, on capital and liquidity. This quarter, our Tier 1 common equity ratio ended at 9.86%. Our tangible common equity ratio ended at 6.64%. In the case of each of these ratios, they are dramatic improvement from the beginning of the year. And we made these improvements while absorbing significant mortgage-related costs during the year. We have ratios that are in line with our peers, and we expect further improvement due to continued work on our balance sheet we’ll make during 2012.  In addition, our liquidity is and remains at record levels even after the downgrades we experienced in the fall.

Moving from capital and liquidity to our core businesses. On Slide 3, you can see, we continue to do what we’re here for. We simply serve our clients and customers and we do it very well. Our core business activity continues to move forward. During 2011, we continue to grow our deposits and our investment assets for our corporate and personal customers. We originated 20% more in small business loans this year, in 2011, than we did in 2010. This met our internal goals we had for that unit, but importantly, also met our $1 billion incremental goal we committed to the White House and the Small Business Administration a few months back. For our commercial clients and our corporate clients, we did what we’re here to do. We provided more loans, more capital and more market access here in the U.S. and around the world. For example, in the fourth quarter, you can see strong growth in our loan balances in our corporate area. And for our investor clients, we achieved the #1 Institutional Investor Overall Research ranking. Evidenced in the quality of ideas to match our capital to help them make their investments.

In our Mortgage business, we continue to reshape our operations to focus solely on origination of mortgages for our customers and to do it well. And importantly, we continue to help those who have difficulty making their payments in mortgages. We’ve now crossed over 1 million modified loans in our servicing portfolios.

The third area we focus on, after capital liquidity and the core businesses, was costs. It’s clear that we’re going to grind forward with the recovery in this country. Our clients continue to push forward and we’re seeing the activity continue to move forward, but a full recovery to what we would call normal, may take some time. So with that in mind, we begin to focus on bringing our cost down across the company.

Our cost structure for Bank of America has 2 broad elements today. First, the cost we incur to deal with the mortgage issues. And second, the remaining cost to run the rest of the company for the benefit of our customers. Overall, cost were down from 2010 to 2011, and we expect substantial cost savings in 2012. This quarter, you can see that starting to take hold. We made significant progress towards our overall FTE reduction goals. Our period-end FTE is down about 7,000 people in the fourth quarter compared to the third quarter. This is over and above the 2,500 people we added in this quarter for our Legacy Asset Services. There’s 2 things about this. One, this shows that our New BAC implementation has begun in earnest. And second, the good news is, that we expect that LAS is at and near its peak staffing.

The fourth area we’ve been concentrating on in 2011 was trading. Trading was strong in the first part of the year, but with the issues in Europe, the depth of U.S. downgrades, the downgrades of our company and changes in client risk appetite, results were weak in the second half, especially in the third quarter. However, during the fourth quarter, we partially recovered as Bruce will talk about later. Yet, we still reduced risk during the quarter to ensure we were well positioned to handle what might have come up. We still have work to do in trading, but the team got active this quarter, as the quarter unfolded, and we saw a stronger results.

From a credit risk perspective, you can see that our charge-offs and cover ratios continued to improve. We ended the year with strong ratios. And we’ll also end the year with $15.9 billion in rep and warranty liability reserves. We built significant litigation and other reserves in this area also.

So the 4 areas of 2011 was all about raising capital and liquidity, driving the core businesses, managing the cost and risk management.

Long BAC warrants

Eastman Kodak, legends of the past

Today is a day of sorrow. Eastman Kodak, the icon of American invention, filed for bankruptcy protection. And not only that, it has been an incredible waste of shareholders’ cash and resource over the last decade.

One of the first posts on this blog, and one that I am proud of, was a review of the dangers of Eastman Kodak as an investment. You will be able to read it in its entirety after the jump but first some additional comments.

To start, I am not going to say that I predicted Kodak’s demise because, as you will read, I did not. Instead it was

• an example of the dangers of investing in companies under revenue stress based only on its assets
• a call to avoid investing in turnarounds before they show signs of revenue stabilization.

What happened to those asset that supposedly provided a Margin of Safety? What those assets did provide was time, time to realize that things were not going well and get out! It was one reason I sold Premier Exhibitions: despite the very real possibility that they are going to sell the Titanic assets for a premium: cash and revenues started to decline.

Finally, there are several interesting situations today that fit the mold, priced well below book value but with revenues under stress, like Research in Motion and Sears Holdings. Both have much better chances than Kodak of surviving. Research in Motion revenues are even growing though at a much slower rate. But still be careful, turnarounds are not asset plays. There is no hurry, wait for revenues to stabilize first.

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After a while Buffett asked everyone to pick their favourite stock. What about Kodak? Asked Bill Ruane. He looked back at Gates to see what he would say.

“Kodak is toast” said Gates. Nobody else in the Buffett Group knew that the Internet and digital technology would make film cameras toast. In 1991, even Kodak didn’t know that it was toast.

“Bill probably thinks all the television networks are going to be killed” said Larry Tisch, whose company, Loews Corp., owned a stake in the CBS network.

“No, it’s not that simple” said Gates. “The way networks create and expose shows is different than camera film, and nothing is going to come in and fundamentally change that. You’ll see some falloff as people move toward variety, but the networks own the content and they can repurpose it. The networks face an interesting challenge as we move the transport of TV onto the internet. But it’s not like photograph, where you get rid of film so knowing how to make film becomes irrelevant” – The Snowball

Maybe I gave some of you the wrong impression in my previous post. Turnarounds are not the Holy Grail so let’s start by reviewing a dog. Well OK, maybe not a dog dog but a company that I decided not to invest in given the few signs that the turnaround was turning. And that company is Eastman Kodak.

Is Kodak worth analyzing? Well it is a company that symbolizes the best of American innovation and mass marketing in the twentieth century. Kodak is even today one of the most recognized brands in the world with a book of patents that used to be the envy of every business. A great blog Distressed Debt Investing has his sight on this situation as a debt opportunity and irony of ironies, Bill Gates has invested aggressively in it.

Is Kodak toast? The short answer is I don’t know. But it is also the wrong question, we should ask on the probability of Kodak going toast. And the best way to estimate that probability is to hear the story: what management is trying to achieve:

Is your case based on Kodak’s entry into the inkjet-printer business? The new printer business is part of the thesis, which is that Kodak has introduced a technology that has the potential to disrupt the entire industry because it will be able to charge a lot less for ink cartridges — about half the current price.

What’s the rest of the thesis? It’s simple. Throughout this entire transition, during which sales from film have dropped by almost two-thirds, Kodak has continued to generate about $1 billion in free cash flow before restructuring charges. That’s because as film sales have dropped, its graphic-communications and digital businesses have improved. Investors today are valuing $1 billion of free cash flow at $14 billion to $15 billion in the marketplace. But Kodak’s market value is just $6 billion. Why is it so low? Because for each of the past four or five years, Kodak had cash restructuring costs — for environmental-cleanup liabilities, for the costs of closing plants, for severance when there were layoffs — that have totalled roughly $600 million to $700 million per year at the peak. There will be $500 million to $600 million in additional restructuring charges this year related to closing film plants and the sale of Kodak’s health-care business. Next year, there will be no restructuring charges. Unless the business gets a lot worse in the next year or so, Kodak will do $1 billion to $1.2 billion of free cash flow in 2008. And if that happens, the stock should be up 50% to 100% in that period of time. – Bill Miller 2007

So this is a story of new divisions (graphic communications and digital) taking the torch from the traditional film division that is being milked down. These are the divisions

• Film Product Group is the remaining traditional film business, that will continue to decline. The decline rate will depend on the speed of the transition to digital in both the consumer and film markets.
• Consumer Digital Imaging Group includes digital still and video cameras, digital devices such as picture frames, snapshot printers and related media, kiosks and related media, consumer inkjet printing, Kodak Gallery, and imaging sensors. CDG also includes the licensing activities related to intellectual property in digital imaging. Expenditure will likely be down until the recession ends and if past performance indicates future performance it is unlikely to carry the whole group
• Graphic Communications Group serves a variety of business customers in the creative, in-plant, data center, commercial printing, packaging, newspaper and digital service bureau segments. Products and related services include workflow software and digital controllers; digital printing including equipment, consumables and service; prepress consumables; prepress equipment; and document scanners.

Here is a hint, the type of turnaround is critical. A turnaround based on closing or selling cash consuming divisions and cost cutting is usually much simpler than one that is based on new products, debt restructuring or business model innovation. Therefore, this is a difficult turnaround that merits a guilty veredict until proven innocent. What surprises me is that Bill Miller said so himself

There aren’t many companies that have been terribly successful making big technological transitions. How many typewriter businesses moved into computers? - Bill Miller about Kodak 2005

Besides having a credible story, the execution needs to measure up to the story because turnarounds usually do not have lucky breaks. You want to see the wheel turn. So what can we say about the Kodak execution

It seems that all divisions are struggling in the recession. A good point though is that the Film Products Group is not carrying the whole weight. Can the non-film divisions carry Kodak out of this difficult situation?

Well, maybe management was a little overoptimistic on these new businesses. Or maybe the new printers need more time to penetrate against strong competitors like HP and Lexmark. Also digital cameras are commodities with low margins and profitability. So it looks like this is a company carried by three motors, only one is working (traditional film) but it is stuttering and about to shutdown.

Also it seems that those restructuring costs are never ending.

So if we review a checklist summarizing the thesis of investing in Kodak the situation is bleak and deteriorating

• New inkjet-printer business? Not ready for rock and roll
• $1 billion in FCF before restructuring charges? Disappeared
• Graphic-communications improving? Doing just OK
• Digital businesses improving? Bleeding
• No more cash restructuring charges? Continuing and no sign of abating

This is a difficult turnaround, innovation does not work very well under stress, but I would not dismiss it with a hand wave. IBM’s turnaround, one of the most remarkable success stories in the 90s, was the result of the surge of the business service division.

Instead I am waiting, and this is a key difference with the traditional value investor mentality. A traditional value investor when faced with an asset play with a sufficient margin of safety he would make a decision right there: Is it cheap enough? I argue instead for the value of

• Waiting for confirmation instead of just buying
• Adjusting the commitment as the probability and value is discovered instead of just holding

Is it possible to find a margin of safety in turnarounds like Eastman Kodak? Just look at the deterioration of Kodak’s assets the last quarters, and take into account that it had more $4 billion in cash less than two years ago.

ASSETS	Q4 2008	Q1 2009	Q2 2009
Consumer Digital Imaging Group	1647	1498	1194
Film Products Group	2563	2408	2301
Graphic Communications Group	2190	2115	1826
All Other	8	1	5
Consolidated Total	6408	6022	5326
Cash and Marketeable Securities	2155	1319	1141
Deferred Income Tax Assets	620	587	639
Other Corporate Assets / Reserves	-4	1
Consolidated Total Assets	9179	7929	7106

It is critically important to avoid investing in turnarounds as if they were asset plays. The key success factors, the dynamics and the character traits needed for both situations are very different. With few chances of liquidation, hope trumping reality and red numbers for years, buying based on asset value is asking for pain. I will argue in future cases that it is possible to have some margin of safety but not in the traditional Graham way.

Dimon on housing

I could not have said it better, with such a command of the facts, while impromptu in a conference call Q&A. Demographics help the United States, it is not turning Japanese.

And he does not fall in the temptation of making a prediction. Impressive.

Yes, so let me answer the first in part. I think what you need to see is employment. That’s what you need to see because employment, in our opinion, will drive household formation.

But if you look at the other factors, okay, we’ve been destroying more homes than we build in the last several years. We’ve added 10 million Americans. We’re going to add 3 million Americans every year for the next 10 years, that’s 30 million Americans who need 13 million in drawings or something like that.

Household formation has been half what it normally is, and most economists tell you that’s going to come back with job creation. And the so-called shadow inventory is coming down, not going up.

So for all the chatter about it, it is very high. Rental in half the markets in America is not cheaper to rent than to buy – it’s cheaper to buy than to rent. Housing is an all-time affordability and my guess is, is that mortgage underwriting will loosen, not tighten.

So if we put all of those things together, you’re going to have a turn at one point. Look, I don’t know if it’s 3 months, 6 months, 9 months. But it’s getting closer.

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PS: Having read it twice, this was a feisty conference call. You just have to feel sorry for the analysts. Let me add a couple of extras, here is a good one after a nonsense question,

As I said, we’re not macroeconomists, okay? If you want to know about that you should seek that out yourself.

On media looking for an angle,

By the way, I just got a note that one of the newspapers out there thinks that we haven’t done a full disclosure on Europe. The reason we didn’t add our European business, it’s pretty much like it was last quarter, not much has changed, so if anyone’s interested.

On Basel confusion,

Let me answer your confusion here a second, okay? We’re running Basel I, Basel II, Basel 2.5 and Basel III. Remember, the European banks early on in effect of Basel 2.5. So they just have to go from 2.5 to 3, where the American banks had to go from 1 to 3.

And so when they say it has to get to 9%, it’s not Tier 1 Common, it’s Tier 1 Core, which is slightly different, by June of 2012, that’s an accelerated, getting there already. And they’ve already got, I’d say most of Basel III in there, maybe a little longer than that. But I think most of Basel III is already incorporated in Basel 2.5.

On headcount growth,

No, we’re not pulling back.

In the overhead number, I think we already mentioned the $50 billion is, I believe, going to be pretty consistent so far for next year. And the headcount, let me split it 3 things.

We are always gaining efficiencies which you don’t see. In tech, ops, overhead, a whole bunch of stuff.

And we’ve added and we break it out, and you’ve got to do it by business, with branches. So we’ve added 3,000 salespeople in branches in Consumer, some of that is in the new branches, some of that is in existing branches. We’re adding private bankers, we’re adding branches overseas. We opened 20 branches overseas, mostly for TS&S. So all those things add people.

And for the biggest add, which we’ll not be adding any more, was to handle default. So there’s — I’ve got the total number, we’ve added 15,000 people the last 2 years, maybe more, just to handle default mortgage, in mortgage. That number has probably peaked and I think you’ll see it coming down in the next couple of years.

And add this recent “issue” of releasing reserves,

we have a $9 billion reserves we don’t need, okay? So until we get through all of this, I’m sure we’ll just add them up. But basically, the numbers have gone too good over time to leave up that amount of reserves under current accounting. There’s going to be a change in accounting. But that’s not — we’ll worry about that when we get there.

Analysts must like to be handed their heads off. They were jumping over themselves to get into that queue. But that was not all, there is some clear thinking in this conference call of a man that wants to do the best for shareholders.

Dividends is a small decision from capital standpoint, so that raise a little bit here, that’s not going to be material. We still — we started the dividend again, we’d like to increase a little bit every year. It’s a board decision.

And the stock is very cheap and particularly below tangible book value, I’d like to buy a lot back which, of course, we can’t do. By the time we’re allowed to buy a lot of stock back, I’m sure it’s going to be much higher priced and then we may change our decision about that.

So you can get a little frustration in my — in about how we’ve had to do our capital buyback. But we are getting more clarity from the Fed. The Fed has asked for these stress tests. The stress test, all the banks have put in their CCAR and we are going to tell you what that is when we get it back. 

So, but I’m not going to change the statement I made at the Goldman conference, which was, we hoped to be able to do a little more than we did in 2011.

Jamie Dimon’s conference calls and letters shoot from the hip and are always fun. I wish he had not also taken the role of spokesman for the industry so I have to be skeptical of his views regarding regulation. What can I say, he let it go and that is what is probably going to appear on the headlines.

Charting Banking XXIII: tangible common equity

More than 3 years after Lehman, I continue to get involved in board discussions over the uses of the tangible common equity (TCE) and its close relative the TCE ratio.

TCE ratio = Tangible Common Equity / Tangible Assets

I am not a fan of using TCE for valuations, very seldom you will encounter a bank going through an orderly liquidation. In good times earnings show and in distressed times, like the ones we live, is precisely when banks can not liquidate orderly. They either,

1. Survive: and go on to live better times
2. Dilute: increase capital to navigate bad loan issues
3. Sell: to a bidder with the balance sheet to navigate the bad loans
4. Collapse: so who cares about valuation after a wipeout

Surprisingly, most capital raised has been negotiated around TCE multiples, usually close to 1x TCE. To have a future it is first essential to survive the present so capital sets the rules. I will argue though that with credit issues declining fast, current and potential earnings multiples should increase in importance. The age of TCE multiples should and will recede.

The second use of TCE, and the one that I personally use, is the TCE ratio. A measure of leverage and its close cousin: excessive risk taking.

Why the TCE ratio and not all all the other capital ratios that regulators use for capital adequacy, like tier 1 leverage, tier 1 capital, total risk? I am old fashioned, and I think it is important to be skeptic of measures that open opportunities to hybrid capital, that is partly debt, or use “risk” weighted measures of assets, when there are no “safe” assets only safe underwriting. When financial booms come, hand in hand with financial deregulation argued for by the banks themselves, exoteric metrics can easily hide or tempt risk taking.

Leverage is not the only way that banks can take risks, bad loans and investments are even worse. But a risk taking bank will pull all levers and high leverage is a good warning signal. For example, let’s see the TCE ratio for American banks at the bottom of the 2009 crisis.

It does not look like all banks were pushing the envelope but what about the Big 4! Some will argue that these are precisely the banks with high pre-provision profitability to cushion the crisis, with Warren Buffett one of them, and it has some truth.

Dick Kovacevich specifically told me to ask you your views on tangible common equity.

What I pay attention to is earning power. Coca-Cola has no tangible common equity. But they’ve got huge earning power. And Wells … you can’t take away Wells’ customer base. It grows quarter by quarter. And what you make money off of is customers. And you make money on customers by having a helluva spread on assets and not doing anything really dumb. And that’s what they do. (…)

You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that’s where people get all mixed up incidentally on things like the TARP. They say, ‘Well, where’d the 5 billion go or where’d the 10 billion go that was put in?’ That isn’t what you make money on. You make money on that deposit base of $800 billion that they’ve got now. And that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they’ll put out the money differently.

Even more, I would argue that this set of banks was not even very responsible for the bubble. Investment banks and other banks that had already collapsed should carry more of the blame.

But add a fizzling real estate bubble to large real estate loan and securities portfolios. Who should you trust with this mounting evidence of too much risk taking? Or as Buffett would say

banking is a very good business unless you do dumb things

So with all the complaining about the new emphasis on the TCE ratio in the dark days of 2009, I wonder … what was new? Banks lobby for deregulation and more leverage only later to complain of regulation “overreach” . The system flatlined only because they asked for the rope to hang themselves.

And let’s not forget that capital for the whole system is important. Capital works as a cushion and help banks to recognize loses faster instead of gambling on a rosier future. To be the lonely good bank, and most were prudent, when the national banking system is collapsing is no consolation. As the Bank of Ireland sadly learned.

The flipside of the TCE ratio is that its improvement also signals banks reducing risk, voluntarily or not, and the progress has been spectacular.

What about Europe? As is public knowledge, European banks have their issues. And it is not just the sovereign debt exposure. Some big banks need capital and the TCE ratio is one if several guidelines that hint on this despite all their complaining.

Does it meas that American banks are threatened? Good banks but sadly part of a collapsing global banking system?

Not so fast. Retail banking crisis are more of a local/national affair connected to local/national deflation. International assets  are usually not big or risky enough in retail banks balance sheets. But that is an assumption that should be checked, specially with the Big 4 taking more investment banking roles, as we will do in a future Charting Banking.

Banking quick review: asset quality

The last part of bankregdata‘s review of the banks’ third quarter results. His emphasis is on asset quality and I do not think there are going to be many surprises for the readers that have been following the Charting Banking series despite the slightly different angle that Bill uses:

1. Asset quality is improving fast
2. Construction and development loans are a pain in the neck

In particular, I like his analysis of the real estate owned (REO) composition and the speed on how banks have been restructuring the most troubled loans ( construction and development, and housing mortgages).

Enjoy.

This week BankRegData.com reviews the Banking Industry 3rd Quarter 2011 performance for Asset Quality, Loans, Restructures and REO.

Using the Texas Ratio as a measure of risk we see that (collectively) banks continue to improve:

A review by Asset Size shows some risk in the largest banks (where GAAP issues mitigate some of the concerns) and mid-size Community Banks between $250 and $999 Million.

Unadjusted Nonperforming Loans continue to drop and are at 4.21% of Total Loans. In terms of dollars, NPLs at $309.67 Billion are now 24.47% below the 2010 Q1 peak:

The Adjusted NPL numbers are dropping slightly quicker – more on that shortly.

Quarter over Quarter Nonperforming Loan Amount by Loan Portfolio:

Of the 13 largest Loan Portfolio types, every one experienced a drop with the exception of Individuals: Auto Loans which rose 1.98%.

A couple of thoughts regarding Construction & Development NPLs:

• Even with a 10.10% drop in NPLs, Construction & Development loans still have a 14.57% NPL rate.
• At $254 Billion C&D lending is back to 2003 Q1 levels and $377 Billion (59.69%) off the 2008 Q1 high.
• In 2003 Q1 C&D made up 4.88% of all loans outstanding - today it is 3.46%.
• Is this due to a lack of demand or the fact that banks won’t go near Constuction loans?
• It’s hard to picture an expanding economy without an increase in Construction & Develoment loans.

One concern is that while there is good news with Charge Offs at $31.66 Billion (lowest quarter since 2008 Q3), Adjusted NPLs to Charge Offs has climbed to $7.09. Basically, there are $7.09 of Adjusted NPLs for every $1 of Charge Offs – banks are delaying Charge Offs relative to the NPLs earlier in the cycle.

If you go here you’ll note that it is the small banks struggling with the ratio. Home Equity and 1-4 Family Junior Liens are particularly a problem.

Restructured Debt inexorably climbs higher (and higher):

Restructured Loans to Total Loans is at 2.63%. All reported loan types experienced increases in the rate:

• 1-4 Family Residential at 4.52%
• Commercial Real Estate at 2.08%
• Commercial & Industrial at 0.76%
• Construction & Development at 5.93%

Once again, Construction & Development loans continue to be a problem area – especially with a 52.96% NPL rate on the restructured portion.

Other Real Estate Owned continues to slowly drop:

OREO is being liquidated and slowly coming down. Collectively, banks took a -$1,135,148,000 hit to Non Interest Income, however, they continue to offset it with Gains from Loan Sales.

OREO levels compared to Peak/Previous High by OREO Type:

And on that cheery note, I’ll end this much-too-long missive and wish you a Merry Christmas. If you have any questions or suggestions feel free to contact me.Ahh, yes, there is that pesky Construction & Development issue once again. Comparatively, the smaller community banks have worked through a higher portion of their Construction NPLs and charged them off to REO. The problem is that they are just sitting on the balance sheet – slightly more difficult to get rid of that partially built apartment building.

Looking at 1-4 Family Residential is a mixed bag. All 1-4 Family Residential has come down 19.38%, however, Foreclosed GNMA is still very high. The bigger problem for Housing is that banks are just not charging it off at the same clip – the inventory is being held out of REO. Once again, we look to the NPL to CO ratio which shows 37.34 for 1-4 Family Residential. That’s $37.34 of NPLs for $1 of Charge Offs – which is an 11 quarter high and the highest since the 46.00 put up in 2008 Q4 when the largest banks delayed charge offs to hit year end numbers.

Regards,
Bill Moreland
469-656-1872

Banking quick review: income statement

As promised, this is BankRegData’s monthly comment follow-up. Some comments at the end.

Pre-Tax Net Operating Income hit $48.82 Billion (1.65%):

The quarter over quarter increase was $6.63 Billion. The $48.82 Billion figure is the highest since 2007 Q2 at $54.97 Billion (2.07%). The peak was $56.88 Billion in 2006 Q2 (2.29%).

Let’s look first at the big part of the pie which is Net Interest Margin:

Net Interest Margin is down $663 Million from last quarter. A couple of points here:

• The $105.23 Billion represents the 6th straight quarterly decline from the Credit Card inflated peak in 2010 Q1.
• Funding Costs continue to drop and are now sitting at 0.70%. Banks are clearing another $33 billion per quarter in lower Interest Expense costs compared to 3 years ago.
• Interest Income (Yield) is dropping faster and sitting at 4.25% which is a historically low number.

So where did the increase in Pre-Tax NOI come from? Trading Gains:

Trading Gains once again made a disproportionate impact with a Q on Q increase of $5.55 Billion. JPM made up $4.55 Billion of the increase.

Other Non Interest Income observations:

• Banks are once again finding ways to increase Service Charges income.
• Investment Banking Income at $2.13 Billion is at least a nine year low.
• Net Servicing Fees got hammered at a number of banks – especially JPM.
• Income from Loan Sales is once again on the rise.

As an aside, Loans Held For Sale jumped $49.43 Billion Q on Q. Part of this ($8.14 Billion) is due to the conversion of OTS reporters (who did not previously report the item) to the OCC Call Reports. That means $41.28 Billion is newly marked for sale.

If you have any questions or suggestions feel free to contact me.

Regards,
Bill Moreland
469-656-1872

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When discussing banks for the Charting Banking series I preferred to focus on the balance sheet (asset quality, capital and reserves). That was the key to assess if banks could manage the stress before regulators pull the plug.

It is about time to address the income statement. And yes, the banks in general are showing profits. Very large profits, even after provisions and write downs. And increasing.

However, Bill rightly notices  some weak spots:

• NIM under pressure: both in absolute and percentage numbers. Lack of loan generation, pointed out in part 1, and all time low interest rates are starting to make a dent.
• Large trading gains: that are not sustainable

Even without the jump in trading gains, the net operating income would have shown an increase over last Q ($43.2B adjusted for the increase) so I do not worry about the trading profits sustainability too much.

However, the net interest margin under pressure is very important and is a direct consequence of consumers delevering (fair to say they do not need more debt) and businesses not investing because of lack of demand.

The question is, when is loan demand going to jump start? I have an hypothesis, but for the moment I prefer to keep it to myself. At the same time this is not a life threatening issue with banks trading below tangible book value. Tangible book is a  good estimate of liquidation value so if the worse happens, and banks profits start to decline, the sector would still seem very cheap.

Bronte Capital was very early in noticing this possibility (while thinking it was not going to happen).  A very good example of hoping for the best but planning for the worst.

In fact he was so early that it was one of his first posts. At the time it was radical because everyone was fixed on the bad loans. He says he had only 20 readers. If that is the case I am honored!

• A tale of  two banking crisis
• Japanese regional banks
• Turning Japanese

Banking quick review: assets and liabilities

First of all, thanks to Bill Moreland from BankRegData that granted us permission to post his latest commentary. Every month, he chooses some graphs from his service to address some critical issue. If you are not subscribed I suggest you doing so.

His latest installment tackles the latest results of the banking system. We will start sharing his view on the balance sheet, leaving the income statement for a follow-up.

I have added a few comments at the end.

This week BankRegData.com reviews the Banking Industry 3rd Quarter 2011 performance for Assets, Liabilities and Income/Expense. The next mailing in a couple weeks will cover Asset Quality, Loans, Restructures and REO.

Total Assets industry wide climbed $208.28 Billion over Q2 and are now at $13.84 Trillion. This is the second highest number ever and just shy of the peak of $13.89 Trillion set in 2008 Q4.

Please note the $252 Billion bump in 2010 Q1 up to $13.36 Trillion. The number would have shrunk were it not for the $291 Billion lift from the international Credit Card balances being brought on to the Call Reports. Note the impacts of this on Pre-Tax NOI & NIM in tables coming up shortly

Goodwill and Other Intangibles make up the majority of the drop in the Other Assets category.

The growth in Net Loans & Leases, while considerably lower than Securities, Trading and Fed Funds, does mark the second consecutive quarterly increase. This is the first time that has happened since 2008 Q2.

That said, banks are becoming less and less focused on lending.

The chart above details Net Loans as a percentage of Total Assets. I did a spot check on the FDIC data going back to 1992 and could not find a number lower than this quarter’s 51.70%.

Deposits grew $233 billion Q on Q (2.38%) and surpassed $10 Trillion for the first time. In 3 years, deposits have grown $955.84 Billion, since 2003 Q1 they have grown $4.34 Trillion.

Other notable items from the Liabilities & Equity side of the Balance Sheet:

• $38.18 Billion increase (12.92% Q on Q) in Trading Liabilities
• $26.25 Billion increase (7.34% Q on Q) in Other Liabilities
• $106.85 Billion decrease (-10.87% Q on Q) in Other Borrowed Monies ($17.91 Billion drop (-5.25%) in FHLB Advances)

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What do we make of this?

• What Liquidity Concerns?: the banks are flooded with deposits and what they are lacking is loan demand.
• Loan Growth Anemic: banks are still hoarding but there are some initial signs that it could be restarting.
• Goodwill Written Down: improving the asset quality. There has been a lot of focus in tangible assets and equity, but the issue is becoming less important by the day.
• Franchise Value Increasing: assets are growing, deposits are growing. If the assets are good, the franchise value is also growing

The bad news is that the same large liquidity and lack of loan generation is starting to affect the banks’ net interest margin, but that is an issue we will tackle in the follow-up.