Sunday, April 26, 2009

Is Tangible Common Equity Overhyped?

Some, including Warren Buffett, seem to think it is. I covered this to an extent in a recent post.

From this recent article by Tom Brown on the limits of tangible common equity (TCE):

Coca-Cola, Buffett notes, has no tangible equity at all, and nobody seems upset. Yet for some reason the number has become the most important statistic in banking. As regards Wells Fargo's notoriously low TCE ratio, in particular, Buffett isn't bothered:

"To the extent that [Wells Fargo's] tangible common equity is low, a) nobody was even talking about that a year ago. And b) they should be talking about earning power."

Precisely. And earnings power, in turn, is determined by the cost and stickiness of your deposits and the quality of your assets. What you name the various slices of your capital base is pretty much beside the point.

Or would be beside the point, except that the market's new emphasis on tangible capital now threatens to lead to a government semi-takeover of some of the country's biggest banks.


Tangible common equity (TCE) is just one measure and totally insufficient as "the" measure of bank health. It's just one static frame in a movie that tells you little about a bank's asset quality or capacity to use earnings over time to absorb future losses.

Warren Buffett on Wells Fargo

Example - Bank A could theoretically still have a high TCE but a bunch of poorly underwritten, risky, asset time bombs on its balance sheet while bank B has low TCE but incredibly rigorous underwriting standards and a balance sheet full of low risk assets. Also, all else equal, Bank A may have an expensive deposit base and lower net interest income (i.e. lower return on assets) while bank B has a low cost deposit base and high net interest income (i.e. higher return on assets). In this case, bank B would clearly be the stronger bank but if static TCE is the main criteria it would do worse on the stress test. That makes no sense.

What makes sense to me is this: If a bank demonstrates it can build capital the old fashioned way (via earnings over time using the harshest stress test assumptions) it would not be required to raise capital even if the current capital ratios are a bit on the low side.

Adam

Long position in Wells Fargo

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