I don’t mean to be repetitive, but I just want to say another few words about the debt to capital ratio. Using Morningstar’s charting system (by the way, Morningstar has a nicely redesigned website), I created a chart that compares Stifel Financial (SF) to Citi (C). More specifically, the chart shows the returns of SF and C (as indicated by the lines) along with the debt/total capitalization of each (as indicated by the bars).
Over the past 10 years, Citi’s debt to capitalization ratio has often been more than double or triple Stifel’s. This served Citi fairly well while times were good and credit was easy to obtain. During 2007, Citi increased the dept to capital ratio while Stifel decreased their ratio. Citi’s stock declined while Stifel’s increased.
A high debt to capital ratio is just one sign of Citi’s precarious financial position just as a very low ratio was a sign of Stifel’s strength, but in times of tightening credit and assett deflation it seems to me that the ratio takes on more significance compared to other quantitative factors. I know this is probably a very “apples to oranges” and unfair comparison as the two companies differ greatly in size and scope, but I still think the comparison can serve as a lesson that financial strength is of paramount concern in times of crisis.
Low leverage and an excellent balance sheet translates into financial strength during crises
Low leverage for a financial institution does not necessarily translate into unprofitability relative to its competitors. As long as excellent employees and managers are acquired and retained, business can expand at reasonable rates while strong capital positions will be beneficial in the inevitable periods of financial turmoil.
Take for example Stifel Fianancial (SF), a full-service regional brokerage and investment banking firm that is up about 27% YTD. Looking at their financial ratios, its not hard to imagine why they are doing so well in this environment.
- Stifel Financial, the holding company, has a Tier-one capital ratio of 49%, which is 12 times the required level; For comparison, Citigroup’s Tier-one capital ratio is approximately 9%
- Stifel Nicolaus, the broker-dealer, has a net capital ratio of 37%, 17 times the required level
- Stifel Financial’s total capital ratio is 3 to 1…. The major New York investment banks’ capital ratio, on average, has been 30 to 1…. In other words, the large firms are ten times more leveraged than Stifel
In the 2007 shareholder’s letter, Chairman, President, and CEO, Ron Kruszewski begins with a quote from Warrent Buffett: “It’s easy to put on leverage but not as easy to take it off.” It seems to me that Stifel has done quite well simply by not employing the insane amounts of leverage like other investment banks. I’m willing to bet that Stifel will continue to do quite well as a result of their seemingly prudent nature. I look forward to reading the 2008 shareholder letter.
The following quotes are excerpted from an article entitled “Banking With Tisch” first published on October 6, 1986 in James Grant’s Interest Rate Observer. Just some food for thought. A lot of what was said 20 years ago can still be said today.
Thomas J. Tisch gives some advice to bank-stock investors:
First, never buy a bank at twice book. Number two, don’t trust any bank with a superior earnings record. Number three, you’re buying a pig in a poke because assets are inherently unanalyzable. So buy enough comfort and coverage.
On the “winning features” of the banking business:
First off, you can grow as fast as your ingenuity will allow you to. Number two, you never have capital expenditures that far exceed your depreciation. Number three, I’ve never read about a strike against a bank. And number four, the Bank of New York and the Bank of Boston have paid cash dividends every year since you-can-look-it-up. Sow how bad a business can it be?
On the unattractive features of banks:
Then there are the contra rules, [such as the inability to earn exponential rates of return except through recklessness or fraud]. Also, bankers don’t own stock in their own banks. And banks put their customers on their boards of directors.… Another thing: A really smart person says to himself at a certain point—and this is part of the problem of it being so easy to enter the business—that your pricing is set by the stupidest person in the market.
The WSJ says that the ill effects of deregulation, a subject the Dems use to blame Republicans for the current financial crisis, is nothing but a political fairy tale:
As for the sins of “deregulation” more broadly, this is a political fairy tale. The least regulated of our financial institutions — hedge funds — have posed the least systemic risks in the current panic. The big investment banks that got into the most trouble could have made the same mortgage investments before 1999 as they did afterwards. One of their problems was that Lehman Brothers and Bear Stearns weren’t diversified enough. They prospered for years through direct lending and high leverage via the likes of asset-backed securities without accepting commercial deposits. But when the panic hit, this meant they lacked an adequate capital cushion to absorb losses.
Even Bill Clinton says the repeal of Glass-Steagal has nothing to do with the current crisis. I am happy to continue blaming the Dems for blocking reforms and regulation of Fannie and Freddie, two institutions I think are much more causally related to our problems.
Dealscape has a list of the Top 7 bank deals of the 21st century:
No. 7. Jamie Dimon, Bank One Corp. He deserves a higher ranking, but he’s had enough glowing praise lately. When Dimon sold Bank One in January 2004, he got $58 billion at a valuation of 2.7 times book value. All of it was in stock. But it was J.P. Morgan Chase & Co. stock, and it has risen 13% since then. The deal was good strategically and in terms of long-term shareholder value.
…
No. 3. Stephen H. Gordon, Commercial Capital Bancorp. This Irvine, Calif., bank isn’t listed here because it sold out in April 2006 for $983 million, nor because it achieved a valuation of 3.1 times tangible book value, nor even because it accepted cash. It is named here because Gordon did not accept the stock of the buyer, Washington Mutual Inc. That $983 million would be virtually worthless today if he had.
No. 2. Walter A. Dods Jr., Community First Bankshares Inc. Fargo, N.D.-based Community First Bankshares was an illogical amalgam of tiny banks in 12 western states. Yet somehow in March 2004, the bank pried $1.2 billion from the clutches of BancWest Corp., a unit of BNP Paribas SA of France, for its far-flung network. That’s equal to 3.3 times book value, all of it in cash.
No. 1. Charles John Koch, Charter One. Koch hit a grand slam in 2004 when he sold his Cleveland-based bank to Royal Bank of Scotland Group plc. He sold for $10.5 billion — in cash. The valuation was 3.0 times book value. Fantastic. But here’s the most impressive thing. Sources told The Deal at the time that Koch shopped his bank and had a few offers, but RBS was the only one offering all cash. He declined stock offers from other Ohio banks, like Fifth Third Bancorp of Cincinnati and KeyCorp of Cleveland. Those shares have been massacred in the credit crisis.
These guys who sold their banks for cash before 2008 deserve gold medals and trophies. In general, it seems to me that selling a company for cash is vastly more preferable to a share exchange. And of course this is even easier to say looking back from the current financial crisis.
For the past year, I have been bombarded with a steady stream of dire news and various statistics showing worst declines in decades. Bear Stearns and IndyMac have fallen and several huge financial institutions seem to be teetering, yet Bloomberg reports that neither of the political parties are addressing the current financial crises:
The U.S. is facing the worst financial crisis since the Depression. You would never know that from the Democrats’ platform in Denver or its Republican counterpart, or from listening to Barack Obama or John McCain.
While both candidates have bemoaned the ravages of the subprime crisis, they have yet to spell out steps for tackling it, such as using taxpayer money to shore up banks and housing.
“They fail to come to grips with the biggest danger that is going to hit the next president in his first few months in office: the crisis in the capital markets,” said David Smick, a Washington-based consultant to hedge funds and author of “The World is Curved: Hidden Dangers to the Global Economy.”
The Democrats’ platform, adopted at their Denver convention this week, labels the crisis a “debacle” and promises to jump-start the economy with a $50 billion stimulus package. It says nothing about helping banks or bailing out the mortgage-finance firms Fannie Mae and Freddie Mac.
The draft of the Republicans’ plank, to be adopted next week at their convention in St. Paul, Minnesota, supports “timely and carefully targeted aid to those hurt by the housing crisis” and opposes bailouts of private financial institutions. It doesn’t mention Fannie and Freddie.
The lack of attention to what has happened in the financial world in the past year most likely shows that this is not a winning political issue or that lots of people don’t really know what’s going on in the first place. I think this lack of attention is a serious mistake. Refusing to address and publicize the problems that gave rise to the crises decreases the likelihood that these problems will be solved in the future.
Calculated Risk writes there will be many more bank failures, but probably not as many as there were in the 80s and early 90s. From 1982 to 1992, there was a minimum of 100 banks failing per year, with over 500 failing in 1989.
Furthermore, “Unlike IndyMac that failed mostly because of bad Alt-A mortgage loans, most of the coming bank failures will probably be small regional banks with too much exposure to Construction & Development (C&D) and Commercial Real Estate (CRE) loans.”
I believe this forecast to be in line with reality, as there are many states with banks that have contruction and development loans making up very high percentages of their core capital. More banks will fail, but they will be mostly smaller, regional banks. Those that don’t “fail” will be absorbed by better banks. I am starting to believe that a good indicator of an end to this mess will be after a fair amount of consolidation occurs in the regional banking sector.
George Will correctly states we wouldn’t be where we are today without beer.
Did you know that Adams Express was started in the 1800s, became a closed-end fund in 1929, and has paid a dividend every year since 1936? (via Investingfromtheright)
Oh, and did you know that the FDIC just took over Indy Mac, a bank with $32 billion in assets? (via FDIC, Marketwatch)
A couple of days ago, the Resourceful Bear Blog pointed out an article entitled “Is Iceland the Canary in the Mineshaft of Global Financial Contagion?” The article addresses some serious financial issues that, if true, neither bodes well for the small, island nation, nor for the rest of the banking world.
The aforementioned article says that Iceland a Nordic hedge fund masquerading as a country with carry trades that are now unwinding and causing investment flight. Interest rate hikes and currency devaluations are now raising inflation; a credit freeze is also in effect due to highly leveraged bank portfolios gone bad. To me, it sounds like a grim situation.
There is also further news of the rising cost to protect the bonds of Iceland’s three biggest lenders from default. One alarming statistic is that “The financial sector’s net $35.3 billion of debt represents 211 percent of the country’s gross domestic product.”
Investment Application
The Resourceful Bear has some suggestions for investment application in this situation. Similar to previous advice, he suggests that one invest in the gold ETF GLD and use your margin to short any of Iceland’s three largest banks, which are Kaupthing, Glitnir, and Landsbanki.
I’ve already looked and none of these banks are traded on the major American exchanges. However, my broker Tradeking does allow me to buy Kaupthing (available on the pinksheets), but I can’t sell it short. Ho hum. It would be cool to sell short these Icelandic banks, but opportunities abound with pretty much any major financial institution these days.
Ben Bittrolff of The Financial Ninja provides more excellent analysis and commentary on the current crises in the financial sectors.
First, Bittrolff argues that the Fed has done nearly all that it can do to prevent a total collapse of confidence in the financial systems and markets when he writes, “The Fed has almost run out of ammo. Much like George Soros on Black Wednesday, when he ‘broke the Bank of England,’ global capitalists are damn near close to breaking the Fed. 60% [of the $700 billion in Treasury securities on his balance sheet] has been committed and it doesn’t seem to be working. Another push and things could unravel quickly…”
Second, it seems inevitable that Citigroup will be breaking itself up over the coming years. Bittrolf sees Citirgoup’s separation of its credit card business from its banking business is the first step of the pending dismantling of Citigroup.
But, what struck me the most is this simple statement: “It is truly humorous that the Socialists across the pond are the one’s considering taking the ‘laissez faire’ approach while the CHAMPIONS of Capitalism over here are pounding the table for mass intervention.” I don’t think there could be a more telling signal of the immense troubles of the financial sector.
