Variant Perceptions

Month: January, 2012

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 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 after tax.
  • 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 office building. 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 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 assets 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.


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.

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 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 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 fizzing 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 flip side 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 this mean that the 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 must be checked, specially with the Big 4 taking more investment banking roles, as we will do in a future Charting Banking.