Capital and More of It!

The regulatory definition of "well capitalized" has not changed post financial crisis.

Tier 1 leverage ratio: 5%

Tier 1 risk-based ratio: 6%

Total risk-based ratio: 10%

So where is all of this belly aching about capital requirements coming from? It has come from three places, in my opinion.

1. IMCRs

When the financial crisis struck, and FIs began to falter, regulators were issuing regulatory orders (supervisory agreements, written agreements, cease & desist orders, and memorandum of understandings, collectively "ROs") faster than my daughters point out that I'm wrong. If you are not familiar with my family, it happens a lot.

A typical article in an RO requires an FI to increase its capital based on perceived risk. The only relevant perceiver, in this case, is the regulator. The FDIC IMCR commonly required a Tier 1 leverage ratio of 8%, and total risk-based ratio of 12%. The OCC, not to be trumped by their arch nemesis, opted for 9% and 13% respectively.

But this technique to raise the capital bar only applied to FIs under ROs. So the next shoe to drop was...

2. Capital Plans

Regulators began requiring formal capital plans during routine exam cycles. I knew this trend was going to stay when a bank with a 16% leverage ratio called me for help developing their capital plan. My response: you need a plan to say what you are going to do with it all? But I digress.

In 2009 as a result of the crisis, the Fed performed a Supervisory Capital Assessment Program (SCAP) on our 19 largest bank holding companies to see if they required more capital under adverse conditions. What adverse conditions do you say? Look at the table below that shows loss rate assumptions applied to specific loan portfolios.

In other words, the banks had to assume they would lose 25% of their home equity loans in a stress scenario. The Fed never intended to apply these loss rates to traditional community FIs. But regulators are increasingly tightening the noose on FIs for applying more aggressive loss rates to their stress scenarios in developing capital plans. In addition, they are requiring Boards, based on the results of the stress scenarios, to set their own minimum capital ratios.

This was step 2 of the increasing capital requirements without actually increasing the capital requirements. And the next step...

3. Basel III

And now the trifecta of capital pressures, Basel III. Deferring to international regulators, US regulators get their way. Adopt Basel III, and suddenly that Tier 1 leverage ratio goes from 5% to 7%, and qualifying Tier 1 capital is re-defined. Total risk-based capital goes from 10% to 10.5%. Not bad you might think. But the risk weightings of certain asset classes change, and will be more difficult to track.

Basel III puts pressure on the numerator (what qualifies as Tier 1 capital) and the denominator (risk weights of certain asset classes).  If Basel is adopted according to its timetable, FIs will have to be in full compliance by the end of 2018. Better get your popcorn.

The solutions: Greater earnings, lower dividends, greater amounts of common equity... and lower returns on equity.

Is your FI making changes to increase capital?

~ Jeff

Mortgage Banking: How profitable should it be?

I recently spoke to an old friend that is a bank equity research analyst and asked him how his coverage universe was doing with second quarter earnings. He said his "mortgage banks did great". Meaning that those that specialized in originating and selling or putting residential mortgages on their books had a great quarter due to the strength of originations.

Occasionally I get asked how much a mortgage banking unit should make. This is a tough question because there are various models. One where all loans are brokered and closed in the funding bank's name (mortgage brokers). Another model is where the bank funds the loans at closing and holds them for a brief period until they are packaged and sold (mortgage banking). The opposite extreme is where the financial institution books and holds the loan until maturity or pre-payment. This model is typically followed by some thrifts and credit unions.

What has proven the least profitable model of late is the mortgage brokering or holding mortgages briefly until sold. These models tend to rely on mortgage originators for volume, versus using traditional bankers such as branch managers or consumer lenders. Mortgage originators are notorious for demanding a significant slice of the revenue pie of the mortgage banking unit. This puts pressure on profitability.

I took a look at banks within my firm's profitability universe to look for models that relied heavily on originations then quick sales. My criteria was to ensure that over 50% of the unit's revenues were from fees on sold loans. It was true that just under half of the revenues of those that I reviewed were from the spread. But I wanted to get a granular look at how much a mortgage unit "should" make. The results are in the accompanying table.

There you have it. If your financial institution has a mortgage banking unit, it seems reasonable to me that your leadership should require profits of 25% of revenue. In efficiency ratio parlance, that is a 75% efficiency ratio. Not exactly knocking the cover off of the ball.

But I have found that many mortgage origination shops subscribe to what one banker described to me as the "five cookies" approach. If there are five cookies on the plate, is it fair that one party should take four and a half and leave the crumbs for the other party? Especially since the crumb-keeper must bear most of the risk.

Why be in a business that isn't improving your bottom line? It's a fair question.

~ Jeff

Guest Post: Second Quarter Economic Update by Dorothy Jaworski

Second Quarter Surprises

We received two big surprises at the end of the second quarter — one from Washington and one from an ocean away. On June 28th, the Supreme Court upheld the Affordable Care Act as constitutional, calling penalties on individuals for failing to purchase health insurance a “tax.” This decision sets in motion a series of steps to implement the law over the next few years along with the estimated $813 billion in taxes and levies over the next ten years.

On June 29th, we received word that the seventeen Eurozone members had agreed on a program to save governments and banks from financial stress. Raise your hand if you think the Euro crisis is over. Okay, then, raise your hand if you think the Euro crisis is only averted or postponed for now. Yeah, I agree. We’ve seen this show before; we are bound to see it in reruns in the next year or two.

The markets did not care for the Supreme Court decision, with stocks ending slightly down for the day on the prospect of increased taxes. But the markets loved the Eurozone agreement, especially Angela Merkel’s capitulation, and stocks rose about 2.5% to 3% on the last day of the quarter. Can you say “short covering” rally?

Although the major indices fell by 2.5% to 5.1% during the second quarter, they are still up 5.4% to 12.66% for year-to-date 2012. This is good news and right in line with the historical tendency of stock markets to rise 11% on average during election years since 1928.

Tempest in a Teapot

J.P. Morgan CEO, Jamie Dimon, uttered the words “tempest in a teapot” to describe the issues raised in articles by the Wall Street Journal in April regarding the risks of huge complex credit derivatives trades by J.P. Morgan’s London office. One trader in particular was cited as the source of the high risk trades and is nicknamed the “London Whale” for his normally large market positions. By the time May rolled around, we received a surprise that saw Jamie Dimon announcing losses of $2 billion that were “misguided” and “egregious” mistakes. The losses could reach $5 to $6 billion before they are unwound, according to sources. (The NY Times even speculated that the losses could top $9 billion.) We will not know until J. P. Morgan announces them as part of their second quarter earnings release in July.

Dimon and his bank have long been viewed as one of the best run banks in the world and leaders in risk management. They are even credited with developing one of the premier risk measurement systems called Value-at-Risk to measure daily losses that can occur at designated standard deviation intervals. They were certainly knocked down a few pegs when they tried to change to a new model and had to revert to the old one because the risk of the large credit derivatives trades were not reflective of reality.

Stock markets took out their frustrations on JPM stock, knocking it down close to $30 billion in market capitalization, before it began to recover; year-to-date, JPM stock is up 7.5%. Congress hauled Dimon to Washington to testify about the losses; as ever, he handled himself with authority and remained feisty. The end result will likely be more overzealous financial regulation. But, hey, at least J.P. Morgan, Dimon, and the London Whale took some of the attention away from the surprising Facebook IPO fiasco.

More Yield Curve Manipulation

The Federal Reserve is at it again. As I wrote last quarter, the Fed continues on their campaign to artificially push long term rates lower. They continue on with their “promise” to keep short term rates at exceptionally low levels until the end of 2014. And in June, they announced that they are increasing their “Operation Twist” $400 billion program, where they are selling shorter term securities and buying longer term securities, by an additional $267 billion through December, 2012. This will continue to keep downward pressure on longer rates, such as five through thirty year maturities.

Inflation continues to run at about 2%, with long term expectations at about 2.1%. Treasury yields continue to decline, with the 5 year currently at 0.70% and the 10 year at 1.60%. Granted, the Federal Reserve is not the only presence pushing long term rates lower; weakening economic data throughout the second quarter and the flight to quality with investors buying safe haven Treasuries to park funds safely during the European crisis both contributed to lower interest rates.

Mortgage rates are falling to all time lows along with Treasuries. My biggest fear is that the Fed is sowing the seeds of the next crisis with their flatter yield curve tricks, leaving many investors holding these low yielding long bonds when rates rise in future years, unable to get out without substantial capital losses.

Déjà vu

For the third year in a row, we are seeing economic growth slow into the second quarter. Job growth has noticeably slowed and the unemployment rate inched up to 8.2%. Oil prices spiked above $100 per barrel and gas prices spiked to about $4 per gallon early in the year two of the past three years, including this year. Nothing puts a damper on consumer spending quite like high energy prices. Consumers reach a so-called “tipping point,” and cut their spending.

The only situation worse, of course, is unemployment and we have seen a dramatic slowdown in payroll growth to under 100,000 per month for April and May, down from the stronger pace of over 200,000 per month in the first quarter. So it’s déjà vu again.

Economic releases have been mixed during the second quarter, with the aforementioned slowing of job growth causing economists to lower their GDP growth forecasts for 2012 and 2013. In June, the Federal Reserve, with their thousands of economic analysts, lowered their projection for 2012 by 0.5% to a range of 1.9% to 2.4% and for 2013 by 0.4% on average to a range of 2.2% to 2.8%. It’s hardly encouraging. Isn’t this déjà vu, too?

When the final GDP first quarter 2012 figures were released during the last week of June, corporate profits were revised to a decline of 0.3% in the first quarter, which was the first drop since the fourth quarter of 2008. This explains some of the stock market decline as earnings were being released during April and early May and were coming in weaker versus the prior quarter.

Déjà vu can signal positive things too; in the last three years, we saw economic slowdown, not recession, in the spring and summer, and then slight recovery into fall and winter. That pattern should hold again, given how much stimulus is in the economy from the Federal Reserve. So much this quarter has been surprising that I can hardly wait for the third quarter to begin, although I would prefer not to be in the midst of another heat wave on the east coast.

Stay tuned!

Thanks for reading! DJ 07/01/12

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

Random Stuff About Me

A tweep of mine, Ken Mueller (@kmueller62), posted an interesting bio-post titled "Random Stuff You Should Know About Me" on his Inkling Media blog. I saw his reference to it on Twitter, I read it, I enjoyed it, so I decided to copy it... with Ken's blessing of course.

A key benefit of blog writing versus newspaper journalism is the ability to let readers know more about you than is reflected in a typical journalist's bio page. Actually, journalists like to hide many things about themselves for fear of exposing their bias, as if we can't discern their bias by reading their articles. In blogging, we have no need for the facade.

So here are some random things about me you might (or might not) find interesting and give you some greater insights into the person behind the words.

I grew up in Scranton, Pennsylvania. Veep Joe Biden once quipped that it was a "hard scrabble life" growing up in Scranton. It must have been hard for him since he moved out when he was a child. I went the distance. Scranton is lampooned in the popular sitcom The Office. Although I would characterize Scrantonians as quirky, we are not quirky like those in the series. I think we would be funnier. Scranton is an amalgamation of European immigrants that came over the pond between the Irish potato famine and the southern European immigration wave that ended in the 1920's. We are Irish, German, Polish, Italian, Czech, and various other nationalities that came through Ellis Island to the land of plenty to mine coal. I am of Italian and Irish descent. I have a lot of internal conflict. My wife is Sicilian. I sleep with one eye open.

I am wired to engage my tongue before my brain. This is an offshoot to being a Scrantonian, as many of us suffer from the same affliction. It is not an endearing quality for a consultant. I have made considerable progress with this shortcoming. But be careful asking for my opinion. Because you may very well get it without the benefit of a filter.

My sports allegiances are... You can read these on my Twitter bio (@JeffMarsico). But you may be curious as to the why. Here goes. Yankees: When you grow up in Scranton, you like the Phillies or Yankees, although there were smatterings of Mets and Pirates fans, but why torture yourself? My older brother liked the Phillies. Ipso facto, I'm a Yankees fan. This logic did not apply to me liking the Sixers, as all of my brothers do. Dr. J, Moses Malone, Mo Cheeks, Bobby Jones, Chocolate Thunder! C'mon, like anybody else and I'm not sure you followed basketball back then. St. Louis Rams: This one is out in left field, I will admit. But in 1974 the Rams drafted the only Heisman Trophy winner from Penn State, one John Cappelletti. Perhaps you saw the movie Something for Joey, where Cappy gave his Heisman to his little brother that was bravely suffering from Leukemia. I cried... and I never liked another professional football team. Notre Dame: You either liked Penn State or Notre Dame if you were from Scranton because 90% of us were Catholic and we had a fair amount of Irishmen. My older brother liked Penn State. Enough said. Washington Capitals: I never watched hockey growing up, so this is a later in life decision. The Caps farm team is the Hershey Bears, eight miles from my house. I saw many Caps play when they were young'uns. Philadelphia Union: I never saw a game of soccer until I was an adult. I had the same attitude as baseball and football fans. But my 13yo is pretty good at the sport, and I must admit it has grown on me. Soccer fans, by the way, are awesome. And check out the pic of PPL Park. What a great place to watch a soccer match.

I coach youth girls lacrosse. Note above that there are no favorite lacrosse teams. Because, like soccer, I never saw a game or even knew the sport existed. Even if I did, I would not have played girls lacrosse, which is a different sport than the boys variety. But I have noticed mixed results when parents coach (disclaimer: my 13yo also plays lacrosse and on my team). And when they asked for volunteers, I begrudgingly raised my hand, knowing I would work my tail off to learn the sport, how to coach, and how to develop young ladies into productive players and members of society. Lofty goals. It's still a work in progress. But coaching middle school girls nets a treasure trove of quotes, such as: "Coach, I'm on my period and will probably be a b**** tonight." Or, "Coach if you send me out there I'll probably pee on the field." It also helps with my personal goal of developing more patience.

I am uncomfortable with opulence and putting on airs. I grew up on the lower rungs of the socio-economic ladder. The first family car I remember was the Dodge Dart Swinger. My dad passed away when I was six. I had the same glove, bat, and cleats all through high school and I rode the shared family bike to games when the local tuff kids didn't steal it. So I am not used to a life of driving luxury vehicles, staying in swanky hotels, and sipping single malt scotch. Some of these things are the trappings of my profession, and I don't rebel by going to the local Econo Lodge when my colleagues stay at a top tier hotel. But I drink beer. I drive a Chevy. I'm sorry if that makes you think I am not successful.

There you have it. I could go on and on, but I get bored myself when blog posts get too long. However, if you have any questions, fire away. I would also like to know some factoid(s) about you, so feel free to share.

~ Jeff

How stable are your deposits?

I am attending the Financial Managers' Society (FMS) Forum in Las Vegas this week. The Forum is chock full of education opportunities for banking finance professionals. One session caught my attention. The tandem speakers taught the audience about going "long", or at least longer, in their investment portfolio and minimizing risk.

One of the underlying assumptions in advising to "go long" was that core deposits were as stable today as they were four years ago. I challenge that thinking. Average balances per account among most core deposit categories have been growing and I think customers are parking their money waiting for greener pastures. When they arrive, what will they do with that money? I put this question to Dallas Wells, an asset-liability specialist from Asset Management Group in Kansas City. I have followed Dallas' writings on his informative blog for a while now and caught up with him at the Forum. Here is what he had to say.

What do you think will happen to core deposits once rates rise?

~ Jeff

Data Driven Strategy

You recently read an excellent book on strategy. Your financial institution faces challenges... economy is crawling at road-kill pace, customers struggling to remain current on loans, regulators breathing hot and heavy down your neck. You need to assemble the team, assess your situation, chart your course.

So you schedule a strategic planning retreat. Your strategy team wonders how they should prepare. Or will this be a brainstorming session?  Although so many decisions are made "from the gut", I put to you that your strategic direction should not be one of them. But so often I see strategic decision makers enter the fray with little more than their past experience and a truckload of anecdotes as their guide. This, to me, is like bringing a knife to a gunfight.

Here is the data I think every strategy team member should have when making strategic decisions:

1. Industry trends and statistics

2. Competitive trends, statistics, relevant data

3. Market trends and statistics

4. Customer analysis

5. Emerging customer preference analysis

6. Your FI performance data, trends, and analysis

7. Brand position analysis

So often strategic leaders assume their bank occupies a superior position based on nothing more than a customer comment heard during the past year. But does the FI truly have a superior position and if so, should the strength be exploited as a competitive advantage within the strategy? This requires discipline because there is a lot of data out there. I once proposed a banker education session titled "Big Data: Big Advantage or Big BS" (Note: I did not use the acronym BS). Cheeky subject line. It didn't get selected. But the point here is to use data that is reliable, relevant, and not BS.

Regarding how data influences strategic decisions, I once had a CEO tell me that when rates rise, his closest competitor will have to lead the market in deposit rates because of that bank's interest rate risk and liquidity positions. That is an important piece of strategic information he knew about the competition because he researched the competition. Positioning yourself for such an eventuality helps increase the liklihood you will successfully execute strategy.

As Sun Tzu said over 2,000 years ago in The Art of War, "he who knows the enemy and himself will never in a hundred battles be at risk".  How well do you know the competition, your customers, your markets, and yourself?

What other information should strategic decision makers bring to the strategic planning retreat?

~ Jeff

Grow or Die. Really?

Grow or die. Acquire or be acquired. Build it or kill it. And so go the banking platitudes. Now, perhaps those that invoke these phrases have strategies that compel them to grow. Shareholder value, so the logic goes, is created if I grow my balance sheet 10% per year and my earnings, because I'm realizing economies of scale, grow faster.

But what if you adopt the strategy of the tortoise? Go slow. Be methodical. Right size your cost structure as you go. Prune the tree frequently. Or what if the markets where you exist can't support 10%+ growth? You are pushing the proverbial rock up hill expecting your employees to beat a plodding market, year in, year out.

Calamity say the consultants, the investment bankers, the rock star banks. You must grow or die! In this environment, how could you possibly face the industry headwinds without doubling your size?

But wait a minute. If we are a public financial institution, what do our shareholders expect? Would a 10% total return be sufficient? It certainly is greater than our industry has been delivering, regardless of the size. In fact, as a disgruntled Citi shareholder, I put to you that their size worked against them. The risk on their balance sheet was (is) incomprehensible, even to them. I bought in at $50, which is now the equivalent of $500 due to a reverse stock split so they can increase their embarrassingly low share price. Today they trade at $25. Their clarion call should have been grow AND die.

What if, in the board room of a community financial institution, your strategy team decided to go slowly? What would your shareholders say to 5% earnings growth that translated to 5% stock price appreciation? Not too sexy. But what if your strong profitability allowed you to pay a 5% dividend yield. Now we have a 10% total return to shareholders delivered by a steady hand. Such was the strategy of City Holding Company, a $2.8 billion West Virginia bank. Its 10-year growth rates, represented in the accompanying table, doesn't exactly wow analysts.

But look at their 10-year total return to shareholders compared to the industry. Slow growth, combined with a 50%+ dividend payout ratio resulting in a 4.5% dividend yield delivered impressive returns. Compared to the rest of our industry, off the chart returns.

How do those that sound the growth siren square City Holding Company, and the many slow growth, highly profitable financial institutions like them?

I would like to hear from you.

~ Jeff


Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works out. You read that I invested in Citi, right?