Thursday, October 25, 2012

Too Big For Our Own Good: Lessons from the Past

Too Big For Our Own Good: Lessons from the Past

I have a copy of the master list of eligible securities that I used to manage money in July 1992.  It is part of a notebook (no pictures) I developed that described all the ins and outs of the investment process I ran.  The list contained 72 financial stocks that were large enough for me to purchase for our clients.  Today only 27 of those companies remain.  In the aftermath of 2008, four of the companies or their successors were taken over by the government and 29 received bailouts.  In assessing the bailout recipients, I did not include JP Morgan or Wells Fargo, as it doesn’t appear that they needed the capital that was injected via the TARP program.

Market Share (1999)

It’s a pretty dismal picture.  In 1992, I had 72 investment grade companies to chose from, and 20 years later 46% of them were taken over by the government or bailed out.  The picture is even worse if you break my list into its component parts: insurance, financial services, thrifts, money center banks, and regional banks.  The insurance companies and regional banks fared relatively well in the past 20 years.  Insurance companies such as Cigna, Aetna, Lincoln Financial, and AFLAC are still around and made it through the credit crisis.  Similarly, a number of regional banks, such as BB&T, Key Corp, US Bank, and Comerica got through the crisis with minor scrapes.

The catastrophe was centered among the largest institutions, the thrifts, aggressive banks, and financial services companies.  Here are the lessons drawn from my master list:

1.     The biggest institutions of 1992 all ended up in a really bad way.  The biggest insurance company, AIG; the biggest financial services company, Fannie Mae; the biggest bank, Bank of America; and, the biggest regional bank, NationsBank all cost you, the taxpayer, dearly.  These organizations shared two common characteristics: aggressive CEOs and forays into businesses and investments that were outside their competence.  Beware of big aggressive institutions that are frothing at the chance to conquer new worlds.

2.     Buying banks is okay.  JP Morgan, Wells Fargo, and Bank of America were voracious acquirers of banks.   For example, JP Morgan’s banking business is the amalgamation of six banks from my master list: Bank One, Chemical Bank, Chase Manhattan, Manufacturer’s Hanover, First National Bank (Chicago), and National Bank of Detroit.  There are hundreds of other bank acquisitions imbedded in JP Morgan, but those banks were too small to be on my list.  The acquiring bank may have overpaid a bit to acquire a particular bank, but overpaying for a conventional bank does not land the acquiror at the doorstep of the federal government.

3.     Slow is a good long-term strategy, even though Wall Street doesn’t like it.  The companies that resisted doing big acquisitions, and didn’t stray outside of banking did all right.  Big deals generate huge fees for Wall Street, but they don’t do great things for the acquiring institution, and they put the taxpayer at risk.

4.     Fishing outside your pond is a bad idea, unless the government permits you to shoot fish in a barrel.  When the likes of Bank of America, Citigroup, and Wachovia (after the merger with First Union) purchased investment banking and thrift institutions, they followed a strategy that justified huge pay packages for their executives but put them into financial areas where they were fairly clueless. 

In the aftermath of the savings and loan debacle of the early 90’s, there were only four large thrifts for me to invest in.  These thrifts morphed into sub-prime lending machines and brought huge pain to their eventual owners, mentioned above.  Similarly, the acquisition of investment banks like Merrill Lynch and Salomon Smith Barney didn’t build value at Bank of America or Citigroup and only put taxpayers in bigger jeopardy.

However, institutions like JP Morgan or Wells Fargo were smart enough to buy a thrift or brokerage assets with the assistance of the federal government and the FDIC (shooting fish in the barrel).   Under those circumstance, the acquisition of Washington Mutual or Bear Stearns might be a reasonable foray.

5.     Don’t conflate greatness with bigness.  Bank of America in its core business didn’t become a great company by building a huge bank.  It hired an army of investment bankers and lawyers to systematically buy other banks and then extracted redundancies, thereby creating a serviceable utility (making loans and taking deposits). 

6.     Don’t let government-backed businesses stray.  If you are the ultimate backstop of a financial services company, be it a government-sponsored enterprise, like Fannie or Freddie, or a bank enjoying the protection of deposit insurance, keep the bank on a short leash.  While Fannie and Freddie are even now wards of the state, the big banks are still roaming freely.  

Looking back at the shambles that is my old master list, I’ve learned that we need to cut the biggest institutions down to a size so they won’t destroy our solvency and the growth of our economy when they get into trouble.  I know this last piece of advice won’t be popular, but we need regulators with teeth.  If the regulator can’t bite hard enough to break the bank’s skin, it’s lapdog instead of guard dog.

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