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Eric Houssels
Eric Houssels

Clash of the Titans - the 2009 Banking Version

September 29, 2009

I must first preface by saying that the recount of the financial industry turmoil of 2007-09 is growing long in the tooth. Much has been said and published and in much greater and more informative detail than I am about to offer. That being said, I do believe that in the early months of 2009 there was an absolutely fascinating tug of war raging amongst our most powerful countrymen and that this tug, to date, has been under-reported. So, here goes my take…

Banking is the strangest of industries. Why is this? The simple and direct answer is that it is because the government is the industry’s silent partner. Now, it can be truthfully said that the government is the silent partner of all taxable industry; nonetheless, this partnership runs deeper in banking. Banks are the distribution partner for government money; and it is noteworthy that a government money system running smoothly produces sound economy and is vital to a nation’s prosperity (at least in this author’s opinion). Being so closely intertwined as this distribution partner, banking is much more heavily scrutinized and regulated than nearly all other industries (my partner and I can attest as we have recently looked into starting a bank and have found ourselves to be bombarded with tomes upon tomes of information aka regulation).

The cornerstone regulation for an operational bank or the key question that regulators must answer is this: does the bank have enough capital to absorb its inevitable mistakes and thereby still function soundly vis a vis its promises to its depositors (liquidity runs are a bit of a different animal and really can be construed as an “unfair” fact of life for the banker and/or regulator). But what does enough capital mean? And here begins the 2009 version of our Clash of the Titans.

Let’s get the basics out of the way: from 2003 to 2007, escalating along the way, growth-hungry banks blew up (some exploded, in fact) their balance sheets with progressively worse lending. The day of reckoning was inevitable, and it came. But just how the reckoning was to play out, no one really knew.

As it turned out, 2008 represented the elimination of the really bad actors – Bear, Lehman, Wamu, Indymac, Countrywide, and the GSEs (not to mention all of the smaller mortgage players). Most would agree that they kinda sorta had it coming. Our story becomes interesting, however, when we enter into 2009.

The first two months of 2009 saw a raid on the supposed worthy bank survivors, and it remains my belief that the raid was, more or less, led by a faction of highly sophisticated New Yorkers (their titan born not of the US). Their aim was to drive the supposed survivors, or as many as possible, into dismantlement. From there, they could be one of the partners in the picking up of the pieces, many/most of which would be enormously valuable.

This faction had the government’s ear. We could even say some, their titan primarily, had been working very hard for over a decade to elect exactly this government (i.e. a Democratic President, with huge Democratic majorities in the Congress). A new regulatory construct was discovered (invented) and then heavily promoted – Tangible Common Equity (TCE). TCE was used to make balance sheets look dire for the purposes of prodding dismantlement through either regulatory shutdown or forcing massively dilutive capital raises. You will find very little mention of TCE pre-2008 as regulators were many times more attuned to their classic Tier one and Tier two capital metrics.

In these first two months of 2009, the concept of “nationalization” became all the rage. It was promoted as the savior of Sweden and the great missed opportunity for Japan. Professors of doom, one in particular, were paraded about to disgorge figures supporting a government confiscation of capital as the only sensible road to atonement and recovery.

After these most severe of first two months, the titan of the opposition, who heretofore was quite content going about his normal daily pleasantries, was finally forced to rouse. His companies, not fully inculpable yet capable and worthy survivors, were under assault for the first time in the crisis, and he could see that the attacks – highly political in nature – were working. In the darkest days of March, this titan, from his home in the heartland of America, went public in support of his institutions and those of similar ilk. He stated that they were fine; the only way they were not was if the government forced them to knock out their current owners through dilutive capital raises. Bad loans need time to be worked off and the good institutions would do so through their franchises’ strong core earnings power. The battle had been joined by the titan of Omaha and none too soon.

To date, Warren has won the Clash. Wells, USB, as well as the MTBs and PNCs and CYNs, have not been squashed by the heavy hand of the government. To be fair, his sophisticated adversaries have won as well, as they have picked up some good assets at low prices (just not as much as they would have liked).

What is surprising to me, and I guess the point of this scribble, is just how fundamental and cornerstone politics has been to the resolution of the 2007-09 banking panic. Banks, which seem to represent the height of stodginess and cool calculation have been and will remain nothing more than helpless dependents when their government parent comes a-knockin’. If the parent, for whatever reason, is fed up with the child, he can find ways (TCE) to severely punish him (dilutive capital raises). On the other hand, if the parent wants to be merciful, he can forebear the harsher statistics and allow the child time to get back in good graces. This is the lesson we bank investors must remember for the inevitable next banking crisis (that, and wait for Wells to hit $7, not $27!)

About the author:

Eric Houssels
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

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