The Economist, 24 January 2006
Perhaps banks really believe that bolstering earnings through temporary fixes is a good strategy, a kind of show of effort, even if it is not particularly effective in convincing the market that they run promising businesses. Over the past week, America’s three biggest banks—Citigroup, J.P. Morgan Chase and Bank of America (BofA)—reported earnings that looked good at first glance, only to sag under scrutiny.
BofA was the most brazen of the three, trumpeting its “record” results for 2005 in the headlines of a press release packed with a long list of achievements. Investors skipped the headline and the hype, focusing instead on the sequential decline in quarterly results and the bank’s cost of financing—hitherto low, but set to rise now that its merger with MBNA, a credit card issuer, has been completed. Sober comments by Al de Molina, BofA’s chief financial officer, on January 23rd were well received, in a sober sort of way: growth, he acknowledged, is slowing. To their credit, Morgan and Citi did not bother to hype results that on the surface were quite good but substantially bolstered by clearly disclosed special items. That spared them from the sniggers directed at BofA but nonetheless led to some selling of their shares.
More than one-quarter of Citi’s and Morgan’s fourth-quarter earnings stemmed from the sale of an asset: in Citi’s case, a gain recorded on the swap of its asset-management business for the brokerage offices of Legg Mason; in Morgan’s case, the disposal of BrownCo, a quirky discount broker (it doesn’t even provide quotes) beloved of experienced traders. Morgan and Citi also benefited from the recovery of money previously put aside for litigation and the release of some loan reserves.
Optimists might see these tweaks as demonstrating the virtues of large banks: they seem to have all sorts of hidden wealth to extract when they need it; and a reduction in money set aside for bad loans and litigation suggests that conditions are getting better, not worse. Furthermore, in the interest of efficiency, Morgan is shedding all sorts of duplicative property inherited from one of the many banks subsumed during its acquisitive history. Citi’s recent disposals have ranged from the obvious (its headquarters) to the obscure (an Indian software company). No one outside its executive suite has a clear picture of how many assets it might still have stashed away.
In a manner of speaking, BofA disposed of assets too, by shedding excess potential customers over the past year. This was part of its effort to stay below the 10% ceiling on any one bank’s share of American deposits, until after its merger with MBNA was approved by regulators. It achieved this, according to Charles Peabody, an analyst at Portales Partners, by paying an unusually low rate on deposits, thus minimising growth.
Sceptics shudder, believing that at best, these techniques are deceptive; and that at worst, they amount to the sale of seed corn, reducing future returns. Once they are stripped out, earnings have been sluggish. “Where’s the forward momentum?” asks David Hendler, an analyst at CreditSights, an independent research firm. Reversing strategy is costly. BofA, for example, will soon be paying more for money (to attract customers ensconced elsewhere) and doing so at a time when it would really like a flood of new funds to feed the credit-card business of MBNA.
Morgan has done a particularly good job of controlling expenses, but at some cost. A tough line on bonuses recently prompted many valuable employees to prepare their resumes. It is only belatedly spending money to rejuvenate a retail branch network that for years suffered from underinvestment. And, like BofA, it had poor results from trading. Perhaps it should be spending more. Tellingly, shares of all of these banks sell at a discount to the rest of the stockmarket, notwithstanding their demonstrated resilience recently in surviving a recession and a deluge of litigation, as well as benign economic conditions that should augur well for future returns.
Conveniently, the banks provided two external villains for their troubles which have the virtue of being plausible and temporary. The first, a recent change in bankruptcy law, encouraged people heavily in debt to file last year, thus pushing up defaults; the second is a closing of the gap between long- and short-term interest rates that undermined banks’ classic formula—take short-term money cheaply from depositors and lend it for the long-term, pocketing the spread.
Theoretically, neither of these problems is much to worry about. A one-time surge in bankruptcy should mean that the weakest debtors have now been dispensed with, so that defaults will be even lower in the future. Rates for lending in the distant future should return to being higher than those for the short term. And all of these banks are more balanced in their operations than they were not long ago. BofA has a nationwide franchise. Morgan was probably thrilled to see revenues surge from equity underwriting and merger advisory work, both fields it has long tried to break into. Citi has an oddly stunted retail franchise in America, but its vast international operations did well. None of these banks is suffering.
And yet, something is missing. Mr Peabody speculates it may be that the real cost of the financial industry’s various scandals was not in the initial fines or the distraction of litigation, but rather in blunting the banks’ aggression. Big banks may be nicer than ever—cutting the absurd range of fees for overdrafts or bounced checks or other routine matters, and holding themselves back from controversial trades—but as a result seeing smaller returns. This is plausible but of course impossible to know. Every bank has taken pains to change how it is run. Last year one of the big fears was “headline risk”, meaning being on the front page for doing something wrong. They have now got themselves off the front page, but perhaps in doing so have lost some of their bite.
Perhaps banks really believe that bolstering earnings through temporary fixes is a good strategy, a kind of show of effort, even if it is not particularly effective in convincing the market that they run promising businesses. Over the past week, America’s three biggest banks—Citigroup, J.P. Morgan Chase and Bank of America (BofA)—reported earnings that looked good at first glance, only to sag under scrutiny.
BofA was the most brazen of the three, trumpeting its “record” results for 2005 in the headlines of a press release packed with a long list of achievements. Investors skipped the headline and the hype, focusing instead on the sequential decline in quarterly results and the bank’s cost of financing—hitherto low, but set to rise now that its merger with MBNA, a credit card issuer, has been completed. Sober comments by Al de Molina, BofA’s chief financial officer, on January 23rd were well received, in a sober sort of way: growth, he acknowledged, is slowing. To their credit, Morgan and Citi did not bother to hype results that on the surface were quite good but substantially bolstered by clearly disclosed special items. That spared them from the sniggers directed at BofA but nonetheless led to some selling of their shares.
More than one-quarter of Citi’s and Morgan’s fourth-quarter earnings stemmed from the sale of an asset: in Citi’s case, a gain recorded on the swap of its asset-management business for the brokerage offices of Legg Mason; in Morgan’s case, the disposal of BrownCo, a quirky discount broker (it doesn’t even provide quotes) beloved of experienced traders. Morgan and Citi also benefited from the recovery of money previously put aside for litigation and the release of some loan reserves.
Optimists might see these tweaks as demonstrating the virtues of large banks: they seem to have all sorts of hidden wealth to extract when they need it; and a reduction in money set aside for bad loans and litigation suggests that conditions are getting better, not worse. Furthermore, in the interest of efficiency, Morgan is shedding all sorts of duplicative property inherited from one of the many banks subsumed during its acquisitive history. Citi’s recent disposals have ranged from the obvious (its headquarters) to the obscure (an Indian software company). No one outside its executive suite has a clear picture of how many assets it might still have stashed away.
In a manner of speaking, BofA disposed of assets too, by shedding excess potential customers over the past year. This was part of its effort to stay below the 10% ceiling on any one bank’s share of American deposits, until after its merger with MBNA was approved by regulators. It achieved this, according to Charles Peabody, an analyst at Portales Partners, by paying an unusually low rate on deposits, thus minimising growth.
Sceptics shudder, believing that at best, these techniques are deceptive; and that at worst, they amount to the sale of seed corn, reducing future returns. Once they are stripped out, earnings have been sluggish. “Where’s the forward momentum?” asks David Hendler, an analyst at CreditSights, an independent research firm. Reversing strategy is costly. BofA, for example, will soon be paying more for money (to attract customers ensconced elsewhere) and doing so at a time when it would really like a flood of new funds to feed the credit-card business of MBNA.
Morgan has done a particularly good job of controlling expenses, but at some cost. A tough line on bonuses recently prompted many valuable employees to prepare their resumes. It is only belatedly spending money to rejuvenate a retail branch network that for years suffered from underinvestment. And, like BofA, it had poor results from trading. Perhaps it should be spending more. Tellingly, shares of all of these banks sell at a discount to the rest of the stockmarket, notwithstanding their demonstrated resilience recently in surviving a recession and a deluge of litigation, as well as benign economic conditions that should augur well for future returns.
Conveniently, the banks provided two external villains for their troubles which have the virtue of being plausible and temporary. The first, a recent change in bankruptcy law, encouraged people heavily in debt to file last year, thus pushing up defaults; the second is a closing of the gap between long- and short-term interest rates that undermined banks’ classic formula—take short-term money cheaply from depositors and lend it for the long-term, pocketing the spread.
Theoretically, neither of these problems is much to worry about. A one-time surge in bankruptcy should mean that the weakest debtors have now been dispensed with, so that defaults will be even lower in the future. Rates for lending in the distant future should return to being higher than those for the short term. And all of these banks are more balanced in their operations than they were not long ago. BofA has a nationwide franchise. Morgan was probably thrilled to see revenues surge from equity underwriting and merger advisory work, both fields it has long tried to break into. Citi has an oddly stunted retail franchise in America, but its vast international operations did well. None of these banks is suffering.
And yet, something is missing. Mr Peabody speculates it may be that the real cost of the financial industry’s various scandals was not in the initial fines or the distraction of litigation, but rather in blunting the banks’ aggression. Big banks may be nicer than ever—cutting the absurd range of fees for overdrafts or bounced checks or other routine matters, and holding themselves back from controversial trades—but as a result seeing smaller returns. This is plausible but of course impossible to know. Every bank has taken pains to change how it is run. Last year one of the big fears was “headline risk”, meaning being on the front page for doing something wrong. They have now got themselves off the front page, but perhaps in doing so have lost some of their bite.
