Good Bank(er) vs. Bad Bank(ers)

Good Evening: Looking a bit winded after its more than 25% sprint off the March lows, U.S. equities had plenty of excuses to pull back today. That the major averages ended up suffering only minor to moderate losses is a testament to either resilient buyers or a current lack of motivated sellers. At the crux of today’s early sell off and late rally were opposing views on the sins committed by bankers during the last credit cycle. If only more bankers had simply followed D. Andrew Beal in just saying “no”, however, then the fallout from this mess would have been far less severe.

U.S. stock index futures were up in sympathy with higher markets overseas early this morning. EU finance ministers this weekend apparently called on “Miss Mark-to-Market” to pay a visit to their shores in the vain hope to restart world trade by importing this ostrich-like accounting method from the U.S. The brief flicker of upside this me-too call generated was soon extinguished by a report from Calyon Securities bank analyst, Mike Mayo (see attached). His “seven deadly sins of banking” came as a reminder to market participants that while write-downs on residential mortgage paper are now well along, it will now be the rest of the loan book that will weigh down the banks.

Stocks opened 1% lower, tried to recover, and then spent the next few hours moving steadily lower. Down 2% or more by lunchtime in New York, financial shares then mounted a comeback. Now on her own, another star bank analyst known for being negative on the prospects for banks, Meredith Whitney, told CNBC viewers that she was now just a bit less skeptical (see below). Financial shares recovered half their early losses and were a tonic for the main indexes. By day’s end, the best performer was the NASDAQ (-0.25%), while both the Russell 2000 and Dow Transports (-1.85%) lagged behind. Treasurys were down despite another purchase of longer dated maturities by the Fed. Yields at the front end of the curve were well behaved, but those beyond 3 years rose 2 to 4 bps ahead of this week’s auctions. The dollar bounced 0.7%, a move that helped lead to profit taking in commodities. Every sector in the commodity complex was on the defensive today as the CRB index gave back 2%.

Amid the cantankerous debates about banking these days — whether or not the various alphabet soup lending arrangements, the contortions of the Fed’s balance sheet, and the Herculean programs offered up by the Treasury Department are too little, too much, or just the right amount to heal the wounded banks — some simple preventative medicine has unfortunately been overlooked. “Just say no” may have been popularized by Nancy Reagan as the way to respond when one is offered drugs, but it should have been said more often by bankers in response to fees for poorly underwritten loan deals between 2004 and 2007. Mike Mayo and Meredith Whitney became highly respected analysts by first chronicling, and then warning about the inevitable disaster that was to be spawned by the unending use of the word “yes” by so many bankers to so many lending schemes. Alas, precious little time has been spent wondering why they did so.

At least one banker found the fortitude to say “no” during the boom, but let’s first look at how Mr. Mayo compares modern banking to the list of “Seven Deadly Sins” commonly credited to Pope Gregory, the First. According to Mr. Mayo, who rates the banks “underweight” in his debut effort for Calyon, bank earnings during the last cycle were front-end loaded, while the costs/risks embedded in the lending decisions underlying those earnings were back-end loaded. As such, Mr. Mayo kicks off Easter week with the following list of deadly banking sins. This clever compilation is quite self-explanatory:

Greedy loan growth — once in a generation excess

Gluttony of real estate — historic asset concentration

Lust for high yields — loan losses exceed Depression (to come, in his estimate)

Sloth-like risk management — highest ever consumer debt

Pride of low capital — lowest level in 25 years

Envy of exotic fees — exotic turns toxic with $400 billion of charges

Anger of regulators — consequences of past lobbying

At least one banker stood apart from the crowd between 2004 and 2007, however, and his name is D. Andrew Beal (see Forbes article below). In stark contrast to the unseemly behavior on display at our nation’s largest regional and money-center financial institutions, the only sin committed by the Beal Bank during this same, expansionary period was to shrink its loan book and payroll. Assets at his Dallas-based bank footed to $7.7 billion in September of 2004, but Mr. Beal simply stopped lending when he foresaw fewer profit opportunities as credit spreads tightened. He sold some securities and loans at rich prices while letting other loans run off until his bank’s asset base shriveled to $2.9 billion in September of 2007. “Every deal done since 2004 is just stupid”, says Beal in referring to the loan practices among his competitors at the time.

Chuck Prince and the others may have felt the urge to “keep dancing” while they heard the music playing on the last cycle’s boom-box, but Mr. Beal bided his time and kept his powder dry for the tremendous opportunities now on offer for a bank with surplus capital — private capital. Beal bank is TARP-free and proud of it. It no doubt helps streamline the decision-making that Mr. Beal owns 100% of his namesake bank, but there’s still a lesson bankers can learn from him. Bankers should treat every transaction as if the capital at risk was their own and not just “other people’s money”.

Not only did Mr. Beal not contribute to the damage wrought by his short-sighted colleagues, he is helping to clean up the mess by bidding for their less than tidy assets. His contrarian tactics haven’t always pleased regulators, though. Would it surprise you to learn that the Beal bank came in for some federal scrutiny because it decided to swim against the tide? He had the examiners puzzled, befuddled, and even worried about his financial institution because it taking ever less risk while others sought to take on ever more. The stereotypical bank examiner of 50 years ago would likely have shaken his hand and offered to buy Mr. Beal a drink for making his job so easy, but not so with today’s growth-oriented crowd.

As long as humans do the lending and borrowing, banking crises will always be with us. We can only hope to limit the systemic damage of the mistakes that will inevitably be made during each cycle. Sure, some sensible new rules (e.g. less leverage) would help, as would the less comatose enforcement of existing ones. But bankers with solid values and sound judgment are even more important to the health of our banking system. Goodness knows the next generation needs to learn less about financial engineering and complex models and more about role models. Maybe Harvard and the other business schools will soon use Beal bank as one of their famous case studies for future MBAs. “How a bank can achieve an above market ROE with below market leverage” would be a snappy title. Wouldn’t it be wonderful if it attracted students in droves?

— Jack McHugh

U.S. Markets Wrap: Stocks Drop on Bank Concern, Treasuries Fall

Mayo Says Loan Losses Will Exceed Depression Levels

The Banker Who Said No


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