Friday, October 05, 2007

Bank Writedowns

The Globe and Mail, Eric Reguly, 5 October 2007

UBS is a sober Swiss banking giant that has had remarkably few blunders since it was formed 10 years ago from the merger of Union Bank of Switzerland and Credit Suisse. But even it got engulfed in the U.S. subprime mortgage mudslide. On Monday, the bank announced it would write down the value of its fixed-income assets by $3.4-billion (U.S.), creating the company's first quarterly loss in nine years, and eliminate 1,500 investment banking jobs. Among the casualties was investment banking chief Huw Jenkins.

UBS had company. On Wednesday, another conservatively managed biggie, Deutsche Bank, said it would take a $3.1-billion charge, half of it related to structured credit products and mortgage-backed securities. The charge will push its investment banking business into a third-quarter loss.

Seasoned bank investors shouldn't be shocked by the writedowns. In spite of their size, generally capable management, attentive regulatory oversight and sophisticated risk management, big banks are remarkably fragile beasts. This is especially true of big domestic banks with big international ambitions, like UBS.

UBS is a retail banking and wealth management powerhouse, with growing and relatively stable profits from those businesses. That's the good news. The bad news is that it's hard for UBS (or any other bank, like Royal Bank of Canada) to expand in those areas beyond their home market. HSBC is one of the few banks to have pulled it off.

But size is everything for banks. They have to find growth somewhere. Management egos demand it; so do shareholders who like some daring mixed with their dividends. So they expand their investment banking and trading businesses outside of the domestic market.

When it works, it works beautifully. UBS has made fortunes from its global investment banking business and now has twice as many employees outside of Switzerland as within. Then - kaboom! - along comes a financial catastrophe like the subprime mortgage meltdown or a credit crunch. Or a wrong bet on a commodity trade - Bank of Montreal took a recent beating on natural gas. Or cowboyish behaviour mixed with arrogance. CIBC comes to mind. A few years ago, it retreated from the United States after taking huge writeoffs in its investment banking business and testing the patience of the U.S. Department of Justice and the Securities and Exchange Commission.

In banking, the retail business is a high-multiple business. Investment banking is a lower-multiple business because of unsteady earnings and occasional blowups. When you lump high- and low-multiples businesses together, you get a blend best described as mediocre. That's why big retail banks with big investment banking operations can be frustrating investments.

The solution? There isn't one, really. UBS has been under some pressure to spin off its investment bank. There is no doubt it has run the numbers. So, probably, has every other retail bank with a good-sized investment banking arm. The idea looks fine on paper, because it would shield the retail bank from investment banking volatility, allowing it to trade at higher valuation multiples. Then nothing happens. Shorn of the investment bank, the retail bank wouldn't have a growth strategy. Shorn of the retail bank, the investment bank would lose the protection of the cautious and highly profitable retail bank.

The Canadian banks, notably RBC and Toronto-Dominion, seem to have found the near-perfect balance between retail banking, on one side, and investment banking and trading, on the other. The Canadian banks dominate the domestic retail market, to the point foreign competitors - with the exception of HSBC - can hardly be bothered opening a branch. The profits they make from the retail network are lavish. At the same time, they have strong domestic wholesale operations and haven't blown their brains out trying to compete in this market beyond Canada.

Canadian banks have been rewarded for the compelling mix of highly profitable retail banking, dividend growth and middling exposure to investment banking and trading. In the banking universe, their high price-to-earnings multiples stand out. The made-in-Canada formula allowed TD to buy New Jersey's Commerce Bancorp for $8.5-billion without breaking a sweat. TD's fat multiple came in handy; three quarters of the price is being paid in shares.

UBS and Deutsche Bank will survive the subprime market problems. In fact, UBS's share price bounced up after the writedown and the announcement of firings were made (raising suspicions the bank used the credit crunch as an excuse to launch a delayed house-cleaning exercise). They might thrive. Then get whacked again. For investors, that's the price to pay for growth stories.