Teflon Tim: You Can't Mess With Wells Fargo

Could the past two years have been worse for Wells Fargo (WF)?

According to an appropriately snarky Gonzo Banker post by Scott Hodgins, Wells' blunders are epic:

September 2016 - Disclosed that they created two million bogus accounts without customer consent to hit the bank's "eight is great" cross-sell targets. That fiasco cost them over $800 million in fines and legal settlements.

September 2016 - Wrongfully repossessed service members' cars. Some of whom were deployed overseas. Thirty million in fines and restitution.

March 2017 - Failed the OCC's community lending test causing "significant harm to customers."

February 2018 - Regulators limit WF growth due to "widespread consumer abuses and compliance breakdowns." 

April 2018 - Agrees to $1 billion in settlements for auto loan and mortgage abuses.

The spate of bad news led to Wells launching a nationwide ad campaign to repair its image.

And since then:

They admitted altering business customer data to address anti-money laundering compliance. Fined by the SEC for pushing inappropriate investment products. Finally got their financial crisis fine. Admitted to 400 wrongful housing foreclosures. And yesterday the Wall Street Journal reported that the OCC notified Wells that "the bank also has failed or isn't expected to meet deadlines on around two dozen technology-focused OCC regulatory warnings... that have been issued since 2014 or earlier."

How many people are in their public relations department? You would think not nearly enough.

Or is it?

I recently addressed a bank client's all officer meeting to discuss industry trends. As part of my comments, I presented the following table of New Jersey Deposit Market Share. I also included the USA deposit market share.

Wells maintained its market share from June 2017 to June 2018 in both New Jersey and nationwide.

In spite of the cascade of bad news, the bank ceded 72 basis points of deposit market share in New Jersey and only 10 basis points nationwide. And this was while they were imposed with a growth

restriction. No wonder why Teflon Tim is smiling in his investor relations pic. I thought it was the green tie. Luck of the Irish. That sort of thing.

So what is it about the bank that has allowed it to endure such bad news, such regulatory scrutiny, and such a mountain of fines and restitution? Superior technology? Nationwide network? The stagecoach?

Wells' challenges are a blinking light for a larger problem. Notice the bigger banks all held serve and maintained leading market share. As community banks, we have not developed a strategy to break through.

So the operative question is, should we be more focused on slaying dragons in our strategic and operating plans? Or, should we be content swatting at gnats? Because the dragon should be wounded.

What do you think?

~ Jeff 

Bankers: Don't Buy the Hype. Let Fintech Equity Investors Bear the Cost of Experimentation.

When JPMorgan Chase released its 2016 annual report, in which the celluloid CEO Jamie Dimon proudly acknowledged spending nearly $10 billion on technology, the talking heads erupted. Ten billion! Must be good. Jamie does it.

And from that moment the conventional wisdom was and is: community banks can't compete. I just heard it on Friday. A team of investment bankers told a community bank board, "how do you compete with that?" 

I have ideas. Watch/listen to my most recent vlog.

Who should bear the cost of experimentation?

~ Jeff

Guest Post: Financial Markets and Economic Update by Dorothy Jaworski

Economy 

The economy is on a roll!  Economic growth picked up strongly in the second quarter, with a reading of +4.2%, as momentum from the tax cuts and deregulation pushed spending and investment higher.  Third quarter growth is also expected to be around +4.0%.  Business and consumer optimism have been high.  Indeed, equity investors have been optimistic, too, sending stock prices higher this year, although these gains have not come without some extreme volatility earlier in October.  Bond investors, on the other hand, are a miserable bunch.  The Federal Reserve continues their tightening

campaign, raising short-term interest rates another .25% in September, to bring the Fed Funds rate to a range of 2.00% to 2.25%.  The Fed has now given us eight rate increases totaling 2.00% since December, 2015.  By the way, I want to run down the street screaming, “Stop!”  At the same time, longer-term rates have risen about .20% to .25% in the past month, while inflation has been falling.  Go figure.  The ten-year Treasury has topped 3.00% and many economists call for its continued rise.  Only a few call for stable or falling rates.  Just remember this:  Rising rates are always the culprit that derails economic growth, ultimately resulting in a reversal for the Fed and falling rates.

We now have four quarters to go before we set a new record length of economic expansion.  I believe that we will.  GDP has increased an average of 2.2% since the current recovery began in June, 2009.  The longest expansion on record was from March, 1991 to March, 2001, with growth of 3.6%, engineered by Maestro Greenspan.  That time period was not without its challenges, especially when the Fed raised rates unexpectedly in 1994.  They may have raised rates too much but quickly realized their error and eased to keep the recovery intact.  We face challenges, too, but we have a good chance of setting the new record in 2019; even if growth slows, I believe it will be back to the 2% trend line through the middle of next year.   The Fed thinks we will make it, too.

Standing in the Way of Growth

I read Dr. Lacy Hunt’s latest newsletter and was surprised when he wrote that the economy appears to be on a downward trend and that long-term rates will fall.  Of course, he does not say when…The Federal Reserve’s raising of interest rates has been a drag on the economy.  Fiscal stimulus in the form of tax cuts, especially for corporations, led to spikes in investment and spending.  But how long can that be sustained as rates rise?  Interest sensitive sectors like automobiles and housing are already slowing.  The yield curve is much flatter this year than last.  The spread between ten year and two year Treasuries is .24% at September 30, 2018 compared to .84% at September 30, 2017.  The curve is not close to inverted yet, but if it does, it will be a precursor of tough economic times ahead.

Government debt poses a threat to growth, but more on that later.  Trade wars and tariffs dominated the market discussion in the third quarter with talk quieting down for now.  Politics is causing concern both here domestically with our upcoming mid-term elections in November and around the world with places like China and the Middle East.  Finally, the dreaded rising oil prices, now at $70 per barrel, always have the potential to derail growth. 

Too Much Debt

Here I go, sounding like a broken record again.  I harp on debt too much, but I strongly believe that it is the primary reason that GDP has only been able to average +2.2% since 2009, compared to 3% to 4% growth in other recoveries.  Debt creates a drag on GDP, especially if it is not productive in generating income.  US Government debt is at 104% of GDP at the end of the second quarter of 2018 and the ratio is likely higher in the third quarter.  Treasury debt exceeds $21 trillion and the growth is on an unsustainable path.  Studies show that GDP growth is sub-par in scenarios where debt is above 90% of GDP for over five years.  Just look at Japan and Europe and see how sluggish their economies have been.  China has slowed from its potential growth rate as debt mounts.  Even US growth is weaker than average.  As rates move higher here at home, do not forget all of the countries that tie their currency to the US dollar.  It is stronger and rates are higher, making it tougher for them to repay debt.

It is not just government debt that is of concern.  Here are some staggering numbers:  Since the financial crisis of 2008, worldwide debt has increased by $70 trillion to $247 trillion, or 236% of world GDP versus 207% in 2008.  US household debt is at $13.3 trillion, up from $9 trillion.  Student debt has more than doubled from 2008 to $1.5 trillion and auto loans are higher at $1.25 trillion.  Just when you think I don’t have any positives, here is the good news on employment and inflation.

Record Low Unemployment

Wow!  The unemployment rate fell in September to 3.7%, matching a low rate first attained in September, 1966 and one that is only slightly above the rate of 3.4% in September, 1968.  This has been great for the economy and is quite an achievement by the Fed, but it is also a source of their constant worry about a low rate of unemployment that could lead to high inflation.  Those who advocate the Phillips Curve relationship would worry.  Those of us who don’t believe in it aren’t too concerned.   It has been great for the economy to see millions of workers obtain jobs and spending ability to push our economy further.  There are over 7 million job openings nationwide.  We still have a large pool of available workers, at over 11 million people, who could jump in to fill jobs.  This “excess capacity” keeps inflation in check.

Inflation

Speaking of inflation… Admittedly, inflation was trending higher early in 2018.  Wage growth on a year-over-year basis scared everyone with a reading of +2.9% and subsequently settled back in a range of +2.6% to +2.8%.  The consumer and producer price indices were rising vigorously, at +2.8% and +3.1%, respectively, but now the year-over-year changes are falling back to +2.7% and +2.8% for August.  The inflation picture in China was very scary in early 2018, with the “world’s manufacturer” reporting producer prices rising at 7.8% in February; in September, price pressures there have eased to 3.5%.  A leading inflation index published by ECRI was also rising annually earlier in 2018, but is now falling.  Still of concern are oil prices that are up 21% and gasoline prices that are up 11% to 13% year-to-date.  Housing price increases continue, but at a decelerating pace.  Should inflation worry us?  Of course.  But is there a risk of huge inflation?  Not right now.  This will also help us get to the expansion record.

The brightest spot in the economy right now is the movie industry, bringing us films featuring Lady Gaga and Queen, two of my favorites!  I also have two great nephews, ages 2 and 4, who want their Aunt Dorothy to take them to see The Grinch.  

Thanks for reading!  DJ 10/17/18

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 Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.

Financial Institutions: What Drives Value v2

In a follow up to my last post on the subject, that was driven by my friends from Performance Trust, I was asked in the comments section of that post if there was a correlation between non-interest bearing checking accounts and price-to-tangible book multiples.

That nugget was asked by Mike Higgins, a bank consultant from Kansas City, who penned a guest post on these pages in the past. Rather than answer Mike in the comments, I opted for the wider audience distribution of a standalone post.

It's my blog. I can do what I want.

I am somewhat limited to how financial institutions report their deposit mix. Call report categories are easiest, and the closest metric is transaction accounts to total deposits. I thought this would give us what we needed.

So, is their a correlation between a bank's relative level of transaction accounts to their price-to-tangible book trading multiple?

See for yourself.

The data, courtesy of S&P Global Market Intelligence, is all publicly traded US banks with trading volumes greater than 1,000 shares per day, and that have non-performing assets to total assets less than 2%. That filtered out most of the very small, inefficiently traded financial institutions, and those with asset quality issues. I also eliminated banks that had NA in the transaction accounts/total deposits ratio.

The filters resulted in 306 financial institutions, which I divvied up into quartiles based on transaction accounts to total deposits. The top quartile, with 56.78% transaction accounts to total deposits traded at 208% price to tangible book at market close on October 4, 2018. The bottom quartile, with 24.71% transaction accounts to total deposits, traded at 145% price to tangible book. The line is linear. Which reads funny as I proofread.

So I would say: yes, community bank investors reward banks funded with a higher proportion of checking accounts with greater trading multiples. So when I wrote in June 2018, in a post titled Branch Talk, my Point 1 was that banks needed to build a cost of funds advantage by having a relatively higher proportion of checking accounts, the above chart is why.

In reviewing the data that fed the above chart, size was likely not a significant issue. All of the numbers above are medians, not averages. And the median asset size from bottom quartile to top were: $1.6B, $2.2B, $3.2B, $2.1B. Wells Fargo and JPMorgan, the nation's largest FIs, were both in the 3rd quartile.

A bonus table:

So there is a neat line in Return on Average Assets too. Price to earnings is not so neat, but I find it rarely is. Still, the message is clear. More checking, better performance, higher trading multiples.

Do you see it differently?

~ Jeff

For Financial Institutions, What Drives Value?

Not all financial institutions are publicly traded. But there are enough of them to help those that do not trade to measure what metrics drive the value of their franchise. 

So what metrics drive value? Umrai Gill, Managing Director of Performance Trust in Chicago presented his findings to the Financial Managers Society at their East Coast Regional Conference this month. Some results were surprising.

He first cited a survey performed by PT, asking their clients "what are the generally accepted drivers of institutional value?" Without identifying ranking or more details about their survey, the preponderance of responses were as follows, in no particular order: loan-to-deposit ratio, investment portfolio size, net interest margin, efficiency ratio, return on average assets (ROAA), return on average tangible equity (ROATE), capitalization, and asset size. 

Some were not very interesting to me, such as investment portfolio size, which might have been influenced by PT's specialty. Others might have been too investment community-like, such as ROATE, which doesn't count high premiums bank buyers pay for bank sellers that results in goodwill on the buyers' books, which is deducted from their regulatory capital. But others struck my curiosity to see if there were correlations between the metric and market valuations. 

And I thought I would share with my readers.The charts in the slides below was PT's analysis of data from S&P Global Market Intelligence based on June 30, 2018 financial information using market data from 08/17/18.

First, the metrics that showed correlation to price to tangible book values. Not surprising, in my opinion.

Asset Size

Efficiency Ratio

Profitability / ROAA

Next, the ratio that did not show a correlation to price to tangible book multiples, at least not over 3.5%. I was a little surprised at this one.

Net Interest Margin

Lastly, and most interesting from my point of view, were ratios that showed mixed results. In other words, they showed positive correlation to price-to-tangible book ratios, up to a point. After which, they showed a correlation, but not what bankers would hope for.

Tangible Common Equity / Tangible Assets

Loan-to-Deposit Ratio

The highest market multiples were afforded to banks with a 70%-80% loan to deposit ratio. Now that may be related to size of institution, as the very largest, JPMorgan Chase (67% loan/deposit ratio) and Wells Fargo (76%) tend to have lower ratios. But there is likely something to the fact that a bank that still has strong liquidity as represented by a relatively lower loan-to-deposit ratio in a good economy has room to improve earnings by growing loans faster than deposits. While the less liquid must price up their deposits to get funding.

And capital, well, I refer you to a prior post where I clearly stated there was such a thing as too much capital. Investors will not pay a premium for hoarded capital. Performance Trust's research puts that sweet spot in the 9%-10% tangible common equity / tangible assets range. Enough capital to grow and/or absorb recessionary losses without selling off assets at a discount to bolster capital during hard times.

Where are your sweet spots?


~ Jeff

Are Bank Products Simple, Fair, and Transparent?

I was on a road trip discussing banking with a colleague, and I mentioned that bank products are anything but simple, fair, and transparent. He said, “sounds like a blog post.”

I have never heard a bank customer say, “gee, I wish my bank relationship was more complex.” Yet we charge business checking fees based on a complex analysis, offer a 7-month special CD only to roll it into a lower yielding 6-monther if the customer isn’t attentive, and require high-interest checking customers to have 10 debit transactions, e-statements, and a partridge in a pear tree to get that rate. Sound simpler, fairer, and more transparent?

On the other side of the coin, bank customers don’t necessarily understand what it takes to run their accounts profitably. Dear customer, the Federal government requires financial institutions to monitor your account for suspicious activity and report anything untoward. That costs time and resources that drive up the cost for your checking account. That is why every overdraft fee, interchange transaction, and minimum balance fee counts. Your government drives up bank costs.

It costs $423 per year for a bank to run a retail interest-bearing checking account, based on my firm’s product profitability database. To cover that cost solely on the spread that your balances generate would require an average balance of $21,363 in your account. All. The. Time.

I have written on these pages that I thought the past practices of relying on customers to be asleep at the switch and accept rates significantly different than market rates will soon be over. Banks must shift business models to pay depositors something closer to market rates for “accumulation accounts”, which are accounts for long-term savings such as an emergency money market account, or a CD ladder.

Cost of funds advantages should be built on having relatively higher “store of value” accounts such as checking, or special purpose savings where convenience and safety are more important to the customer than accumulation.

So I don’t point out a problem without proposing a solution, I have an idea for a Simpler, Fairer, and more Transparent small business banking deposit product. Call it the Jeff For Banks (JFB) Business Banker Account. As I mentioned in past posts, I’m a narcissist and I’m trying to get something named after me.

JFB Business Banker Account

The product is a combined store of value checking account, and an accumulation money market and/or sweep account. But no sweep here into a repo where we have to pledge investment securities against balances. That wouldn’t meet the simple test.

Banks can pay businesses interest on their checking accounts. So I propose banks segment business checking accounts by their resource utilization, and create minimum balances based on this segmentation. So the college bar that drops off bags of money each morning at the local branch has a higher threshold before it doesn’t get charged a monthly maintenance fee and receives interest.

So the average balance for high utilization quartile account might be $70,000, above which the account receives a competitive interest rate, and below which the account is charged a monthly maintenance fee. Here is what the math might look like for Pete’s Corner Bar.

JFB Business Banker Account Profitability Estimates
1	Average Balance	$92,102
2	Checking Average Balance	70,000
3	Checking FTP Spread*	1,463
4	Money Market Average Balance	22,102
5	Money Market FTP Spread*	197
6	Total Account Spread	$1,660
7	Fees**	$540
8	Annualized Operating Cost per Account*	$784
9	Pre-tax Profit	$1,416
10	Pre-tax ROA	1.54%
11	Equity Allocation*	1.00%
12	Pre-tax ROE	154%
13	Total Account Cost of Funds***	0.30%
*Per TKG product profitability peer data
**Assumes one incoming/outgoing wire/month
***Money market balance * 1.25%

The bank would still charge per use fees for things like wires, ACH’s, overdrafts. And receive interchange income. But the spread should cover items presented plus profit for the bank. Imagine having 10,000 of the JFB’s Business Banker Account. Instead of 1,000 of this account, 2,000 of that account, 4,000 of another account, and 3,000 old grandfathered accounts. Which would be easier for your branch and business bankers to explain to your customers? And marketing people tell me that bankers sell what they know.

Does the JFB Business Banker account pass the Simple, Fair, and Transparent test?

~ Jeff

The Real Reason for Bank Scale: Trading Multiples

"Get big or get out." "You must be twice the size that you are to succeed." These are bromides that some industry talking heads might be telling you. I hear it and read it frequently. And in today's social media, non fact-based opinion society, if you say it enough, people may start to believe it.

I moderated a strategic planning retreat with a bank that achieved top quartile financial performance. Their growth was solid too. Their asset size was less than $500 million. A director challenged me: Does our size matter so long as we continue to perform the way we have performed? My answer: Not really, with one exception.

Trading multiples. I referenced this phenomenon in a 2013 blog post, Too Small to Succeed in Banking. In that post I opined, "As we migrate towards greater institutional ownership, stock liquidity is becoming increasingly important." What I said then likely remains true today. Institutional owners (funds, etc.) now own two-thirds of shares outstanding in publicly traded US banks. 

But why does this matter to my sub $500 million in assets bank client?

So I ran some charts for you (courtesy of S&P Global Market Intelligence).

The bottom table was a bonus so readers can see that at the end of 2017 bank p/e's relative to the S&P 500 p/e surpassed their 10-year median in every asset category. Significantly so for banks $500 million to $5 billion in assets. So, on a relative basis, valuations are higher. 2008 was an anomaly because the S&P 500 companies traded at stratospheric p/e's because they had no "e".

Back to my main point. Over the past 10 years, banks that have less than $500 million in total assets have traded at lower price-to-tangible book multiples. In every year. And the differences in multiples match up nicely by asset size. The price-to-earnings chart is a little murkier based on the choppiness of earnings. However, investors tend to value smaller financial institutions more on book value than earnings. A good earner, like my client, tend to trade at relatively low p/e's because they have great earnings. 

Does that sound right? Earn better, and get rewarded with a lower p/e?

Fair is in the eye of the beholder. If you remove nearly 2/3 of the potential shareholder base because you have little daily trading volume, then you have less buyers seeking your shares. Supply and demand.

And that is where the economies of scale argument has merit. If you intend to remain independent, and continue to perform well and grow sufficiently, then you are likely delivering total returns acceptable to shareholders. Even without trading multiple expansion.

But if you would like to acquire a nearby financial institution, and you are trading at lower trading multiples than other would-be acquirers, you would be at a disadvantage. Your "currency" isn't worth as much as your larger competitors. Which may also make you vulnerable to an aggressive buyer's offer to buy you, if the buyer is large and has much better trading multiples than your bank.  

Fortunately, unsolicited offers are not common in our cordial industry. But we shouldn't rely on it.

~ Jeff