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Perfect Storm or Perfect Nonsense:
Rethinking of an Industry Under Siege
By J. Rizzi
Draft #7, 7/28/2008
Introduction: Where are we?
The banking industry is suffering record losses and collapsing share prices. The industry
lost over $250B in shareholder value during the first half of 2008 alone. Understandably,
institutions are pre-occupied reacting to events. They are focusing on short-term survival actions
including dilutive capital raising and cost cutting. They are hoping these actions will allow them
to outlast the crisis, and then return to business as usual. The new usual will not be the same as
the recent past.
The industry, however, faces a long term strategic crisis in adapting to a structurally
changed business environment. Old business models and asset combinations have become
obsolete. The financial and credit results are merely symptoms of a deeper underlying declining
banking business model. Failure to recognize this cause, and develop appropriate responses, will
depress long term returns. In fact, short term write-downs are less concerning than long term
profitability. The search for a solution to this problem requires a clear understanding of the
causes and consequences of what happened.
Where Have We Been?
The 1990’s technology based stock price bubble was followed by the 21st century
residential property boom. Inflation adjusted housing values grew at five times their historical
average during the 2000-2006 period. This development fueled the mortgage and construction
lending based increase in bank earnings. During this period, banking stocks as a percentage of
the overall S&P Index more than doubled to over 20% in the years up to early 2007.
Strong GNP growth, moderate inflation, limited regulation, and ample liquidity helped
fuel the growth. Equally important were technological innovations. Internet based automated
underwriting techniques and structured finance driven distribution ushered in the originate-todistribute (OTD) business model. This model greatly expanded mortgage industry capacity. For
example, new nationwide models like Countrywide and WaMu arose, and the number of
mortgage brokers grew to over 50,000. This crowded out traditional mortgage originators
including community and regional banks, who moved into residential construction and
development loans (C&D) as a replacement income source.
The OTD model advantage over traditional portfolio lending was based on two factors.
First, capital velocity increased. This allowed institutions to release capital for reinvestment.
Next, underwriting or warehouse risk concerning individual mortgages awaiting distribution was
deemed low. Consequently, it enjoyed favorable regulatory capital treatment relative to
traditional portfolio lending.
Eventually, competition outgrew market opportunities. Profit margins became pressured,
and growth slowed. Preoccupied with continued earnings growth, institutions embarked on a
higher risk asset heavy carry trade strategy. This involved taking large concentrations in illiquid,
high risk long duration assets. Larger banks focused on structured products like Collateralized
Debt Obligations, while smaller institutions concentrated on C&D loans. The excess
competition for these products strained margins requiring banks to increase leverage levels to
maintain margins. In effect, many banks adopted the failed savings and loan strategy of the
1980’s with predictable results.
Institutions moved further out on the risk curve to manufacture nominal earnings growth.
Risk was deemed under control based on the twin illusions of liquidity and risk distribution. In
fact, rather than distribute risk, they had concentrated risk. Liquidity evaporated once their
leveraged positions began losing value in mid 2007. Banks then discovered they had assumed
risk beyond both their ability to tolerate and understand.
Shareholders, rating agencies and regulators missed the higher risk strategic shift.
Earnings were at record levels and risk models failed to register increasing risk levels. Thus, the
capital required to support the increased risk was underestimated. The current $150B plus
capital raise indicates the level of undercapitalization. Boards failed to recognize the rise in
under compensated tail risk exposure by confusing returns with skill instead of higher risk.
Where Are We Going?
Existing downsizing and recapitalization efforts at many institutions are remedies and not
strategies. Capital alone is insufficient as evidenced by the continued stock price declines
following record capital increases. Investors require new strategies to generate replacement
revenues to offset the declining structured finance business at larger institutions and the regional
and community bank C&D business models. These discredited toxic business models had
generated the majority of their income growth.
Complicating this effort is the reduction of leverage formerly used to maintain and grow
returns. Paradoxically, while many institutions are undercapitalized, the industry is
overcapitalized relative to available return opportunities. Until this excess capacity is eliminated
through consolidating acquisitions or failures, earnings growth will be limited. Community and
regional banks are too small to bail out. Large institutions are, however, protected as too big to
fail. Consequently, in the near term, banks can only grow by taking market share from others.
This promises to make individual banks growth more difficult.
This difficult operating environment will reduce short-term returns and constrain already
depressed valuations unless, institutions become smaller and more focused. New shareholders
who infused over $65B in new capital this year have already suffered significant losses. Besides
complicating future capital raises, these shareholders will undoubtedly press governance actions
to improve performance including management changes. The market environment, which ended
in 2007, favored growth addicts and risk takers. Value creators and risk managers are needed for
the current environment. This will entail a substantial human resources change in CEO
succession, management development, and executive compensation.
An additional development is the decline of the OTD model relative to portfolio lending.
The factors underlying the ascendancy of OTD model have been significantly reduced. Velocity
is falling as investment opportunities have diminished. Also, regulatory capital requirements
will undoubtedly increase given warehouse period losses. Finally, regulatory concerns will
cause wholesale funding, including securitization and trust preferred, to decline in importance.
This will pressure banks to develop more stable higher cost core deposit funding.
The current crisis is more strategic than credit. It represents an ongoing adaptation to a
rapidly changing bank environment. This issue had been obscured by undetected risk appetite
increases inherent in leveraged asset carry strategies. Subprime may have been the trigger, but it
is not the cause of the problem. Thus, we need to move beyond crisis management, and address
the underlying strategic issues.