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David Rolfe Comments on M&T Bank

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Oct 22, 2013
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M&T Bank (MTB)

Warren Buffett has oft remarked of Berkshire's ownership of the jewelers Borsheim's Fine Jewelry, Helzberg Diamonds and Ben Bridge Jewelers, "...if you don't know jewelry, know the jeweler." The same could be applied to Buffett's views on banking and bankers. The list of Warren Buffett's favorite bankers - and it's a short list to be sure – include the likes Jamie Diamond (J.P. Morgan Chase), Dick Kovacevich (Wells Fargo/Norwest) and Brian Moynihan (Bank of America). Of these three, Berkshire owns multi-billion stakes in both Wells Fargo ($20 billion) and Bank of America ($5 billion 6% preferred and 700 million warrants – warrant strike price $7.14, current share price $14.) Berkshire also owns a $3 billion stake in U.S. Bancorp.

(We sold our holdings of U.S. Bancorp in the fall of 2011 – please don't look at a recent stock chart.) Wells Fargo/Norwest is a former holding of ours as well. Buffett also owns shares of J.P. Morgan in his personal account. As notable as each of these heavyweight CEOs may be, their banking accomplishments pale in comparison to Buffett's and Berkshire's earliest bank investments.

In the pantheon of this country's greatest bankers, the names Wilmers and Abegg are little known outside of banking circles – particularly Abegg. For those that endeavor to study the careers of either we can promise you a rich education in banking. The first is Eugene Abegg. The second is Robert Wilmers, the Chairman and CEO of M&T Bank. We purchased shares in M&T Bank this past July. We will save him for last.

Eugene (Gene) Abegg is arguably the greatest banker nobody has ever heard of. In fact, Abegg could have been cast as a crusty version of George Bailey of the Bailey Building and Loan Association in Frank Capra's It's a Wonderful Life.

Indeed, if it weren't for Buffett's acquisition of 97.7% of the shares of the Illinois National Bank and Trust of Rockford Illinois in 1969, fewer still would have reason to know of Abegg. Gene Abegg built the Illinois National Bank (colloquially known as Rockford Bank) in 1931 with $250,000 in capital and $400,000 in deposits. In its first full year of operation, the bank earned $8,782. Abegg defined old-school, conservative banking. He paid his employees in cash and cashed checks on weekends. Fascinatingly, the bank was chartered in the days before the U.S. Treasury had the monopoly on issuing legal tender. As proof, Buffett still has Rockford $10 bills sporting Abegg's picture.

Sixty-eight years later when Buffett bought the bank - and with no new capital contributed to the bank – Abegg had grown the bank's capital 68-fold to $17,000,000 and deposits 250-fold to $100,000,000. Never forgetting that the bank was the trusted fiduciary of his neighbor's money, during the National Bank Holiday in March of 1933 (the Emergency Banking Relief Act) Abegg had enough cash in the bank's vaults to cover all depositors.

(An aside: To put into perspective the shear economic chaos at the time that Gene Abegg founded the Illinois National Bank and Trust Company we have reprinted an excerpt from our Client Letter The Great Bull Market of 2009 written in October of 2008.)

... It was during the fateful years in late-1929 through early 1930 that government policy prescriptions would eventually kill the economic patient. The recession had gathered strength by the spring of 1930. Industry after industry not only pleaded, but demanded action out of Washington. Most wanted price protection from cheaper imports. Average ad valorem rates on dutiable imports averaged 26% from 1921 to 1925. The infamous Smoot-Hawley Tariff Act raised the duties on over 20,000 imported goods – averaging 50% from 1931 to 1935. Although President Hoover had called for lower duties, he nonetheless signed the bill (against the wishes of a signed petition of 1,038 economists; J.P. Morgan's CEO Thomas W. Lamont said he "almost went down on my knees to beg Herbert Hoover to veto the asinine Hawley-Smoot tariff." ) on June 17, 1930.

International reaction was swift and brutal. Retaliation began long before the bill was enacted. When the bill passed the House of Representatives in May 1929, boycotts broke out. Foreign governments raised rates against American exports. Thirty-four formal protests were lodged with the Department of State from foreign countries.

In May 1930, Canada preemptively imposed new tariffs on 16 products that accounted for around 30% of U.S. exports to Canada. France, Germany and Great Britain protested and unilaterally developed new trade avenues. U.S. imports collapsed 66% from $4.4 billion (1929) to $1.5 billion (1933), and it's exports fell 61% from $5.4 billion to $2.1 billion, while both drops far exceeding the 50% fall in GDP. Unemployment rose from 3.2% in 1929 to nearly 14% by December 1930. By June 1931, the former recession spiraled into the Great Depression.

Simply, and tragically put, the collapse of the global economy and the concomitant collapse of the global banking system put the "Great" in the Great Depression. As seen in the chart below, the U.S. banking system was certainly under stress by late 1929, yet the deposit-currency ratio was at a new high, indicating faith in the banking system. But by late 1930, bank suspensions and failures began to alarmingly increase, only to skyrocket after the failure of the New York Bank of United States in Bronx, New York on December 11th. This bank was the fourth largest in New York and wiped-out 450,000 depositors. In the resultant panic, 300 banks would fail that month alone across the country. The Federal Reserve of the 1930's did not possess the plethora of monetary tools that the Federal Reserve of the 21st century has at their disposal. Yet the few tools they did possess were woefully deployed. Interest rates were cut early on in the crisis. But when the banking panic hit, the Federal Reserve simply did not attempt to increase credit to member banks. Fed credit fell to $1 billion by the summer of 1931. It had stagnated at that level as early as 1924 - and at $3.1 billion in 1919.

Milton Friedman, the American Nobel Laureate economist, best known among scholars for his theoretical and empirical research on monetary history, never minced words in his criticism of Hoover's Treasury Secretary; the brilliant, yet taciturn Andrew Mellon who was quoted during this period as saying: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate ... It will purge the rottenness out of the system...values will be adjusted, and enterprising people will pick up the wrecks from less competent people..."

The Hoover administration finally acted in October 1931 with the launching of the National Credit Corporation to extend loans to banks. In February 1932, the Hoover administration created the Reconstruction Finance Corporation to extend loans to both banks and railroads. The Glass-Steagall Act was passed that February and also permitted government bonds to serve as collateral against Federal Reserve notes. But alas, those attempts to increase liquidity in the banking system were simply too little, too late.

As the economic depression deepened in the early '30s, and as farmers had less and less money to spend in town, banks began to fail at alarming rates. During the 1920's, there was a national average of 70 banks failed each year annually. After the Crash, and during the first ten months of 1930, 744 banks failed – 10 times as many. In 1931, 2,294 banks in the U.S. failed. The stock market bottomed in July 1932, but the Great Depression lingered on until the United States began to supply and aid Great Britain's war effort in 1939. The final economic and financial toll from 1929 to 1933 was simply staggering – if not beyond comprehension. Durable goods dropped -67%. Non-durable goods dropped -70%. Industrial production fell -50%. Wholesale prices fell -40%. Nominal GNP fell to 1917 levels. Real GNP fell to 1922 levels. S&P Composite earnings dropped -68%. Nominal corporate earnings fell to 1880 levels. Real corporate earnings dropped to 1873 levels. U.S. exports fell from $5.2 billion to $1.7 billion. The Dow crashed -89%. 9,765 banks failed. By 1933, with out modern-day FDIC-type depositor insurance, depositors saw $140 billion disappear through bank failures. Henry Ford cut wages from $7 per day to $4. Unemployment rose from 3% to 28% (ex agriculture: 38%). The Dust Bowl ended in 1939. Devastatingly, 100,000,000 acres of topsoil was lost – much of it ended up in the Atlantic Ocean.

Postscript: President Roosevelt's National Bank Holiday (and the Emergency Banking Relief Act) was passed in a special joint session of Congress on March 4, 1933. The EBA's most significant measure was the creation of de facto deposit insurance. The days of panicked bank runs was over. The first day of trading (March 15), the Dow Jones Industrial Average recorded its largest percentage gain in its history rocketing +15%.

That short banking panic history notwithstanding, Berkshire's ownership of the Illinois National would prove to be far too short-lived. In late 1970, new bank holding company laws would require Berkshire to dispose of the bank's stock ten years hence. The decade that Berkshire owned the Illinois National, Abegg (71 years young in 1969) would lead the bank to sterling growth and profitability. Over the course of Berkshire's decade long ownership consumer time deposits quadrupled, net income tripled and trust department income had more than doubled. A couple of Abegg's most remarkable years standout during this period are worthy of note. Despite very conservative lending standards and maintaining out-sized balance sheet liquidity, in 1975 and 1977 the bank earnings on assets were 4-times and 3-times the rate of the nations largest banks. Abegg's last act as CEO and year before Rockford Bank's shares were distributed to Berkshire's shareholders, the bank set an all-time record by generating return on assets of 2.3% - again, 3-times the industry rate. Gene Abegg would pass away at the age of 82 the next July.

History would not be kind to Rockford Bank in the ensuing years. In 1985 the Rockford Bank merged with the American National Bank of Rockford Illinois. The new bank changed its name to AMCORE Financial. The new entity prospered during the 1990's, but the real estate boom-bubble-bust took the worst kind of toll on the bank. The bank's construction and real estate loan portfolio grew from $280 million in 2004 to over $900 million by just 2007. By early 2010 the bank was doomed to failure. In April 2010 the Comptroller of the Currency closed the bank. All deposits were transferred to BMO Harris Bank.

Gene Abegg's banking philosophy was more than "...all banking is local." Abegg was a community banker cut from a Norman Rockwell painting. Abegg made it his and the bank's business (literally) to be involved in countless aspects of the Rockford community. What was good for the community was good for the bank – and vice versa. Robert Wilmers is cut from the same community banker cloth.

Robert Wilmers is the 78 year-old CEO and Chairman of M&T Bank headquartered in Buffalo New York. Much like Abegg, Wilmers' is banker. Period. He is not a speculator or trader, much less a Master of the Universe. We have long admired M&T Bank's business model and are pleased to report that we began buying these shares this past July.

There is often a strong bond among the religious institutions, the local businesses, the schools, the libraries, the universities, the hospitals, and the social organizations, as well as the people who work in local government. It has always been important that bankers play a leading role in such communities as they tend to be part of the glue that bonds them together with a focus on improving the quality of life.

Central to the long tenure, loyalty and employee commitment is ownership. Avoiding banking fads and the lure of short-term spikes in earnings requires long-term commitment. At M&T, that commitment is sustained, in part, by its ownership structure. Today some 18.5% of the company's stock is owned or controlled by M&T's management, directors and employees. Fully 2,638 or 93% of the employees with corporate titles at the level of vice-president and above own M&T stock. If they act like owners, it's because they are. - Robert G. Wilmers

In our +20-year investing history we have steadfastly avoided the banking business. Commodity businesses – which most banks are - are rarely winners. In most commodity-related businesses only the lowest cost providers survive. If however you add sticky customers with a sustainable low-cost advantage, now you have a chance to thrive. Lastly, if such a thriving commodity business can regularly add new customers to its roster, well, you may just have a gold mine on your hands. Credit goes to Wilmers for creating the gold in Buffalo. Lastly, these very few exceptions can be spectacular businesses. Witness GEICO. One of the all-time great growth businesses, GEICO sells a commodity product, but what makes their delivery of a commodity product so lucrative? They are consistently the lowest cost provider and they deliver a differentiated customer experience that renders very sticky customers. (In fact, GEICO's incentive bonus plan is measured largely on customer persistency.) Hence, GEICO is consistently the auto insurance industry's most profitable company. Comparisons between M&T Bank and GEICO are not perfect, but they are illustrative. In sum, low-cost products and superior service = sticky customers = competitively advantaged profitability.

M&T Bank traces its roots back to 1856 as the Manufacturers and Traders Bank. During the Great Depression, nine Buffalo-area banks went bust. M&T Bank survived. After cutting his banking teeth at Bankers Trust in the early 1960's and later Morgan Guaranty Trust, Wilmers started an investment firm with the sole mission to buy an underperforming bank he could call his own. Buffalo was as unlikely a place than any to launch a banking empire. Like many other Rust Belt cities, Buffalo has seen its population decline by half since the 1950's. In 1983 Wilmers' investment firm had winnowed their list of acquisition targets to First Empire Corporation. The bank had 60 branches (even one in Paris!?), just $2 billion in assets and just fourth by deposit share. The stock was selling at just one-third of its book value and its principal banking subsidiary was M&T Bank. Wilmers and his partners purchased about one-quarter of the shares. Wilmers became CEO and Chairman of the Board and soon began pushing for a new direction. Charlie Munger: Because he talked about morality and business, Bob Wilmer sounds like an Old Testament prophet. He doesn't like that banks make so much money in trading. He thinks these banks are just trying to outsmart their own clients. It is one of the best annual reports ever. Warren Buffett : Wilmers also discussed the fact that he doesn't like that - money flows to people who work with money. Sadly, this attracts people with a lot of ability to banking when they should be doing something else. Over the next half-dozen years or so, Wilmers set out to change the culture of the entire organization into a focused, no-frills, bread-and-butter, low-cost/high margin community bank that championed banking conservatism on all matters, and to the extinction of anything even remotely smacking of a banking gun slinging attitude. For example, M&T Bank typically only lends 55-65% of the cost of a project. Net charge-offs were just .30% in 2012. By way of perspective, over the past 30-years the bank's charge off ratio on loans has averaged an industry leading .37%. Similar too to Abegg, Wilmers instituted a culture by his own example in Buffalo to insist that the bank's branch senior executives become intimately involved in the local economy and in local charities. In 2012 and 2013, M&T Bank has been named in the Top 10 of BusinessWeek's lists of Most Generous Companies. The bank has earned the highest possible rating under the Community Reinvestment Act for 25 straight years.

As the bank grew in branches and territory, and in the seniority of his local branch presidents, Wilmers decentralized the majority of the lending decisions at the local board level. Included on these local boards were the leading businessmen in the community. This deep relationship approach at the local level was key in the bank's march to grow local market share and keep it, i.e., sticky customers. The bank's early focus on middle-market small business (SBA) lending continues to this day. M&T Bank is the #1 SBA lender in the Districts of Baltimore, Buffalo, Philadelphia, Rochester, Syracuse, Washington, D.C. and Delaware.

We often find that businesses with low-cost advantages, especially in commodity industries, lack scalability, particularly on the organic growth front. Particularly in regional banking, we have seen that organic growth is largely a composite of three factors - more products per customer, market share take and better net lending spreads. However, M&T Bank has other levers of potential growth beyond their low-cost advantage. Like any bank, M&T Bank can grow organically and by acquisition. These two factors are not mutually exclusive and, if executed well, they serve to compliment each other as accretive acquisitions can provide significant scaling opportunities to the organic business.

By 1987 Wilmers had been waiting patiently to unleash his other potent growth weapon by aggressively acquiring troubled, but fixable banks and savings and loans. He didn't have to wait long for his first catch. After the stock market crash in 1987 he announced his arrival in New York City by buying the $2 billion-asset East New York Savings Bank. In 1990, Stan Lipsey the publisher of the Buffalo News (a subsidiary of Berkshire Hathaway) introduced his Buffalo friend Wilmers to his Omaha boss Buffett. Buffett, always quick to recognize talent and opportunity, bought $40 million in new M&T Bank preferred shares and encouraged Wilmers to proceed apace with this new cache of capital. Wilmers did, making ten acquisitions from 1990 through 2001. A needle-mover during this spree was the purchase of Keystone Financial Services with $7.4 billion in assets. The bank's markets now included Northern Maryland, Central Pennsylvania and West Virginia. By 2001 assets were up more than ten-fold to $31 billion. In April 2003, Wilmers struck big again acquiring Baltimore-based Allfirst Financial from the troubled Allied Irish Banks. The $3.1 billion asset purchase increased M&T Bank's assets by almost $16.5 billion, and expanding the bank's mid-Atlantic footprint – notably gaining the leading deposit market share in Baltimore, the second largest share in Maryland and the fifth largest position in Pennsylvania.

Growth by acquisition would continue apace with the acquisition of twenty-one Upstate New York branches from Citibank in 2006, thus securing the #1 deposit market share in both Buffalo and Rochester. In 2007, just as the ill winds of the gathering financial storm were blowing, M&T Bank acquired the thirty-three branches of Partners Trust Financial Group. This acquisition solidified the bank's market share in the Central New York communities of Binghamton, Syracuse and Utica. Over the course of his career, Wilmers would be an acquirer in every economic or market downturn.

The canary in the coalmine of the imminent collapse of the housing cheap-and-easy credit bubble was the swift collapse of two Bear Stearns hedge funds in June and July that year. The ensuing financial meltdown would bring the global banking system to its knees. Wilmers was one of the lone voices of reason during the heyday bubble-lending years of 2005 and 2006, vocally criticizing the banking industry's culture of both speculative lending and speculative trading. The bank under Wilmers watch would not bend to the common convention and become a "virtual casino." That said M&T Bank would not escape the carnage unscathed, yet through the trials and tribulations over the next half-dozen years, Wilmers capital allocation philosophy would be put to the test (and opportunity) like no other period during his realm as CEO.

M&T Bank had the fortune that they had to deal with their canary in the coalmine lending misfortune in the early innings of the gathering-banking storm. In February of that fateful year, Wilmers & Co. tried - and failed - to sell a $1.4 billion portfolio of Alt-A (almost sub-prime) mortgages. Sobered by that singular experience, the bank was quick to shut down all related business by August 2007. That error of commission aside, from 2007 through 2010, the bank's charge-off rate on their home equity portfolio was just 1.7%, compared to the crushing rate of 6.5% for its peers. Furthermore, M&T Bank was profitable in every quarter during those dark years – leading to their unmatched record 147 consecutive quarters of profits under Wilmers regime. Lastly, M&T Bank is one of only two banks in the S&P 500 Index that did not cut their dividend during the crisis. (The other bank is Northern Trust.) As in many aspects in life, crisis breeds opportunity in commerce too. M&T Bank would take advantage of the multi-year banking crisis like no other bank. From 2009 through 2013 M&T Bank would acquire three troubled banks of size and scale that doubled the banks size and geographic radius by just 27 miles – as well as generating an earnings accretive internal rate of return ranging from 16% to 20%, conservatively calculated and well in excess of the bank's cost of capital.

The first was the acquisition of 128-year old, $6.4 billion in assets, Provident Bancshares in Baltimore in December 2008. The combination of M&T Bank's 143 branches with Provident's 177 branches elevates the combined entity into the largest branch network in the Baltimore/Washington area – plus the #2 deposit share.

The second acquisition in November 2010 was the acquisition of the significantly impaired Wilmington Trust. At the time of this acquisition, the staid Wilmington (founded in 1903) was reeling from six consecutive quarters of losses stemming from their busted Delaware real estate portfolio. Owing to the depressed price of the acquisition price – 50% of tangible book value – the accretive IRR on this acquisition was north of 20%. Wilmington held the largest deposit share in Delaware, and it's +$50 billion suite of trust and investment services are national in scope. Post-acquisition, M&T's trust revenues as a percentage of total fee revenues more than doubled to 35%. In addition, mortgage banking as a percentage of fee revenues declined form 17% to 13% and deposit service charges declined from 42% of fee revenues to 33%.

The third and latest acquisition in August 2012 was the acquisition of Hudson City Bancorp – a traditional savings and loan based in Paramus, New Jersey. Hudson City is unique in that nearly all of their $28 billion assets are residential loans. The bank is also capital rich and we view M&T Bank's asset-sensitive balance sheet will serve nicely to mitigate Hudson City's interest rate sensitive asset base.

Hudson City's branches are quite vibrant with deposits per branch of $175 million – more than double the amount ($85 million) of existing M&T's branches. Furthermore, Hudson City's 97 New Jersey branches, 29 branches in downstate New York and 9 branches in Fairfield Count, Connecticut significantly expands M&T Bank's relatively small footprint in these three lucrative regions.

Since Wilmers & Co. took over M&T Bank in 1983 the bank has acquired 23 banks and Savings and Loans (S&Ls) – expanding from a single state to seven – and assets have grown from $2 billion to $110 billion. M&T's branch count has grown from 60 to over 870. The bank currently boasts a customer base of over 2 million retail household customers and nearly 220,000 commercial customers.

In terms of future acquisitions, considering the group of Northeastern regional banks and a handful of S&Ls, we approximate that there is about $30 billion in market cap trading at or near 1X book value, relative to M&T's roughly $15 billion market cap on 1.5X book value. If management continues the same M&A cadence (every 18 to 24 months), then we expect further accretive acquisitions in M&T's future to drive double-digit growth.

The powerful trifecta of low-cost banking products, sticky customers and accretive acquisitions, coupled with the conservative culture of strong credit metrics has enabled M&T Bank to consistently generate high returns on tangible common equity, which then in turn has driven capital generation. Since 1983 through the first half of 2013, the bank's net operating earnings per share has compounded at a rate of 17%. Dividend growth has compounded at a rate of 15% over the same period. It is no surprise the bank's stock price has compounded at a rate of 15.8% over the same time period.

Key too to M&T Bank's long-term success has been Wilmers & Co. near textbook application of exemplar stewards of shareholders capital. Over the past ten years the banking industry has had to navigate two extreme (and mutually exclusive) environments in the management of shareholders capital. Few banks navigated this period successfully on behalf of shareholders – many failed. For example, during the cheap-and-easy credit bubble years (2003-2007) when spreads were too tight, prudence dictated a deceleration of lending out money. Prudence also dictated in such a lean banking environment that excess capital should be deployed more effectively in share repurchases and increased dividends. On that score, during 2003-2007, for every $1 of capital, Wilmers & Co. split share repurchase, dividends and capital retained, 52%, 28% and 20%, respectively. Earnings in 2012 finally topped earnings in 2006, yet tangible book value per share is up 56% over the same period. At the other end of the spectrum, during the near collapse of the U.S. banking system from 2008-2012 the bank retained 51% of earnings - providing the capital to double the size of their franchise via accretive acquisition. Over the past 30 years, capital allocation, surprisingly has been quite balanced between capital retained (37%), dividends (32%) and share repurchases (31%.)

Post-2013, the "growth spring" is set to recoil over the next few years (both organic and accretion). This harvest will be measured in years, not quarters.

We do need to caution and temper expectation that the 25% to 30% returns on tangible equity during the pre-banking crisis years will not be repeated in the future. Regulatory capital levels for community banks, regulatory compliance expenses and higher FDIC assessments today (which don't adjust for loan quality) will be quite higher than years before. Main Street will bear the brunt of the sins of Wall Street. Specifically, the bank's Tier 1 common capital ratio as of the just reported third quarter stood at 9.07% - 50% higher than the approximate 6% from 2003 through 2009. That caution duly noted, along with a higher capital base and the low hanging M&A fruit largely picked over, we still expect M&T Bank to generate solid double-digit earnings growth over the next few years. The stock is currently valued at just 1.5X trailing book value. A valuation we believe to be quite attractive for this high quality bank.

From David Rolfe's Wedgewood Partners third quarter 2013 commentary.

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