Risk and Reward: Wells Fargo, U.S. Bancorp, and BofA

From this CNBC Interview with Warren Buffett back in 2012:

"The profitability of banking is a function of two items. Return on assets and assets to equity.

And return on assets is not going to go up particularly. USB has done the very best on that. They're at about 1.7 percent. Wells is between 1.4 and 1.5 percent. But most banks are lower. Now, if you have 20 times leverage and you're getting 1.5 percent on assets, you're making 30 percent on equity.

And that was not lost on people a few years back. And they pushed balance sheets..."

He also added this:

"Banks were —banks were earning 25 percent on tangible equity not so many years ago. And really, that's kind of a crazy number. You know, for a basic semi-commodity business, you really don't want to allow that." 

and

"...people got to push and push it and push it, and then the government says, 'Listen, we got a vested interest in this. You're using our credit, in effect, and if you want to play, you're only going to have 10-to-1, or some number like that.' So the returns on banks have come down. It's still a good business."

Buffett on Banks: CNBC Interview

One limited way , but I think meaningful, compare the relative strength of banks is to look at what happened to these businesses (and, ultimately, their stocks) as a result of the financial crisis.

Let's say Wells Fargo's (WFC) stock was purchased at its pre-crisis peak price. As the crisis unfolded, that no doubt didn't feel like a brilliant move.

Those who did buy at that worst possible time pre-crisis would actually still have a rather solid (~ 60%) if not spectacular gain at this point (though some rather wild price action, to say the least, had to be tolerated). Stock performance has not been dependent on the shares trading at some speculative (high) price. Normalized per share earning power has increased substantially and the stock, give or take, reflects it.

So it's been mostly about business performance over that time. The acquisition of Wachovia resulted in additional shares outstanding but seems to have worked out just fine. The dilution that did occur as a result of capital that was raised wasn't without a real cost to continuing shareholders. Not all dilution is created equal. How market price compares to intrinsic value, as always, matters a bunch. The shares, like many banks at the time, were selling at a meaningful discount to value. So that was less than ideal but, overall, the bank's business and stock have performed rather well. Not phenomenal investment results if bought at the pre-crisis high but, then again, value conscious long-term oriented investors should have been able to buy at more attractive valuations.

At the other extreme, not surprisingly, those who bought at the lowest price during the crisis would have huge gains -- several hundred percent, in fact.

The results were mostly similar for U.S. Bancorp (USB).

In other words, the range of outcomes was from reasonably good to very good; from gains to even greater gains. A decent result even if the stock wasn't bought brilliantly. Realistically, what would happen in the real world to someone investing long-term in these banks is they'd have made purchases somewhere between these two extremes. That would have produced a very good result indeed. The focus should be on the strength of a banking franchise, price versus value, and long-term effects instead of near-term price action. The point being that there's no need to get the timing right nor is it possible to reliably do so.

Attempts to time things perfectly leads to missed opportunities.

What these banks have in common is the robustness of their core economics. They're better able to absorb losses during the tough times and produce above average normalized returns.

The same cannot be said for Bank of America (BAC).

Lets say someone similarly bought Bank of America's stock at its pre-crisis peak. Those who took that action would still now need the stock to more than triple to get back to even.

At the other extreme, those who bought at the lowest possible price would be up several hundred percent. So the best case was much like Wells and U.S. Bancorp.

In this case, the range of outcomes went from very bad to very good; from big losses to big gains. Those who had the misfortune of buying at the peak will likely have to wait until something like 2025 (and maybe much later) for per share intrinsic value to equal what was paid pre-crisis.*

By the time BofA's stock finally reaches those pre-crisis levels, the buyers of Wells at the somewhat expensive pre-crisis peak should still end up with a more than respectable annualized total return. That's under the scenario of having bought at the worst possible pre-crisis price! Obviously, it wasn't difficult to buy at much more attractive prices if the focus was on long-term effects instead of scary headlines and awful near-term stock price action.

Getting a good result investing in BofA was highly dependent on buying brilliantly; not so for Wells and U.S. Bancorp.

I'm certainly not downplaying how serious the crisis was. Without certain policies, and decisive actions, even the very high quality banks would not produced these investment outcomes. This is why investing in the common stocks of banks can be far more tricky than many other common stocks. Even when run competently these are inherently leveraged institutions that depend on system stability and the inevitable associated risks. These businesses are incredibly complex.

There are a number of more straightforward ways to get investment results. Sometimes I wonder whether it's worth all the additional work that's required.

Keep in mind that Wells and U.S. Bancorp were the "expensive" stocks pre-crisis. They were selling for roughly 14-15x earnings at the time.

BofA is the one that looked cheap at more like 11-12x earnings before the financial crisis.

The real emphasis here is on per share earnings since, there's no way to know when stock prices will reflect something close to per share intrnsic value. Wells has increased its per share earnings power meaningfully compared to pre-crisis peak earnings; U.S. Bancorp earnings has increased more modestly.

The key thing here is that, at least with these two banks, we are at least talking about increases to per share earnings.

In contrast, BofA is struggling to earn even one third as much as it did pre-crisis. Much of this comes down to the dilution that occurred as a result of necessary capital raising. The fact that they were forced to raise capital when their stock price was very low didn't help at all, of course. It did great damage to their per share earning power. Also, the acquisition of Countrywide has been incredibly expensive. There are other factors including reduced leverage and the regulatory environment more generally.

In any case, Wells Fargo and U.S. Bancorp are, for many reasons, just vastly more capable of generating an attractive return on assets and equity. As Buffett points out above that's what matters in the long run if at least a reasonable price is paid in the first place.

A bank with a 1.5 percent return on assets compared to one with, let's say, 1 percent return on assets may not seem like a big deal but it is. At 10x leverage that'd be 15% return on equity (ROE) versus 10%.

- ROE for Wells currently sits at 13.4%

- ROE for U.S. Bancorp is 15.1%

- ROE for BofA is in the single digits, though it should improve somewhat as earning power normalizes

So Wells and U.S. Bancorp continue to have big economic advantages over BofA. Compounded over longer time frames, if persistent, these superior economics will matter a great deal in terms of investment results.

It's not just about offense.

There's a defensive element to consider.

Wells Fargo, for example, should be able to roughly absorb an extra $ 10 billion or so of losses per year on its current asset base because of its ROE advantage. The not so good times will inevitably return -- likely under very different circumstances -- and a quality bank should be built to comfortably handle significant economic and financial stress.

So, for the better banks, not only are overall returns higher on a normalized basis, the risk of permanent capital loss is reduced because of a greater ability to absorb losses with earnings over time instead of cutting into capital. Most of the damage that was done during the crisis, for common shareholders, was due to costly capital raising (i.e. when the capital is raised at a price that is well below per share intrinsic value based on normalized earning).

Wells and U.S. Bancorp have been and mostly remain vastly superior in terms of the capacity to protect against downside.** 

In the end this makes for a very different risk versus reward profile.

So watch out for the "cheap" banks or, at least, those that appear to be cheap on the surface.

For now, my view is that the risk-reward profile still appears more challenging -- more risk for less reward. To me, BofA's risk-reward profile at the very least calls for a bigger margin of safety.
(There are many investment situations where no margin of safety is sufficient considering the investment specific risks; when the expected worst case outcome is intolerable.) 

BofA may yet develop more favorable core economics over time and the risk-reward profile may change. It will be interesting to watch as things evolve over time.

Much of modern finance theory still assumes that more risk must be taken to achieve greater reward. In fact, the formulas found in prevailing theory really only allow for a positive correlation to exist between risk and reward. So it's not just words. Of course, many times risk and reward must necessarily be correlated in a positive manner.

Other times, they're not correlated in such a manner.

The significance of this is sometimes underappreciated.

Risk and reward can be positively correlated; it's just not necessarily so.

As noted above, a bank can be both less risky and offer more potential reward. The same can be true for other businesses. Also, consider the impact of paying a lower price for a particular asset. Well, the lower price will simultaneously reduce the risk of permanent capital loss while increasing the potential reward.***

At least some of the prevailing modern finance theory seems deeply flawed.

Adam

Long positions in WFC, USB, and BAC established at much lower than recent prices. WFC and USB are long-term investments; BAC is likely much less so.

* That's if there's not another costly financial crisis. No bank -- not even the very best -- is immune to the financial system completely collapsing. Of course, if that were to happen, I'm guessing many of us will be focused on more pressing things than stock prices.
** Pre-tax pre-provision profit is a key consideration. It indicates how much in terms of losses a bank can absorb through earnings over time before cutting into capital. Asset quality, capital levels, stable funding and liquidity also naturally matters a bunch. 
*** Here's how Warren Buffett explained the correlation between risk and reward in The Superinvestors of Graham-and-Doddsville:

"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.

One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy. 

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million..."
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wells Fargo vs S&P 500

From the most recent Berkshire Hathaway (BRKa) shareholder meeting:

The intrinsic value of any business is the present value of all cash distributed between now and Judgment Day. - Warren Buffett

Stock prices can fluctuate -- and, well, almost certainly will fluctuate -- much more so than a fair estimate of per share business value over time.
(Jeremy Grantham, in this letter, provides a useful long-term chart along these lines. See Exhibit 1 on page 8.)

Investing well means mostly learning to ignore what end up being costly distractions. There's just too much coverage of, and energy spent on, what ends up mostly being noise.

Sometimes, it's worthwhile to step back a bit.

With this in mind, let's take a look at the S&P 500's earnings before the financial crisis:

2006 S&P 500 earnings = 87.72 (peak pre-crisis earnings)

S&P 500 at year-end 2006 = 1,418.30

P/E = 16.2

2013 S&P 500 earnings = 107.45

S&P 500 = 1,940.46 (yesterday's close)

P/E = 18.1

% increase in earnings from 2006 to 2013 = 22.5%

A snapshot of earnings -- whether a company or, in this case, an index of many companies -- is only useful if it serves as a reasonable representation of a normalized earning trajectory going forward (over many years); it's only useful if it's a reasonable proxy for all the cash that will be distributed going forward. I'm sure there are all kinds of opinions about how S&P 500 earnings might change over the next few years. Well, I certainly never try to figure out such a thing (that window of time is way too small to be meaningful) even if I think odds are rather good that, let's say 10 or 20 years from now, S&P 500 earnings will likely be quite a bit higher than now.

To me, it's better to ignore short-term predictions. Ditto for fluctuations unless they happen to serve the investor in some way.

Other than choosing to own quality businesses in the first place, it is price, at least up to a point, that can be used to manage risks.*

Sometimes -- in fact, I'd say often -- extreme amounts of patience followed by decisive action will be required to buy enough at the right price.

Consider the wide range of prices that have been paid for what is not terribly difficult to estimate normalized S&P 500 earnings.

Even if the earnings power of the S&P 500 happens to drop dramatically in any given year, its intrinsic value is based upon the estimated earnings trajectory on a normalized and conservative basis over the long haul.
(A 50% drop in earnings in the short run might lead to a similar drop in market prices. That doesn't mean intrinsic value changed by that much.)

Since estimates like this are necessarily within a range, when in doubt choose the lower end of the range to estimate value.

The market prices fluctuate far more than the combined intrinsic value of those many S&P 500 businesses. Again, instead of being a detriment, those sometimes crazy fluctuations should serve the investor. Wild price action simply offers more chances to make purchases at a nice discount to approximate present value or, alternatively, to do some selling when prices become rather high relative to value.

Now, lets take a look at the same sort of numbers for Wells Fargo (WFC).

2006 WFC earnings per share = 2.47 (peak pre-crisis earnings)**

WFC at year-end 2006 = 35.56

P/E = 14.4

2013 WFC earnings per share = 3.89

WFC price = 51.63 (yesterday's close)

P/E = 13.3

% increase in earnings per share = 57.5%

Back in 2006, Wells Fargo seemed more expensive -- based upon on price to earnings -- than some other big banks. That Wells Fargo multiple of earnings may not look particularly high compared to the S&P 500, but it certainly was relatively high compared to some other big banks at that time.

Now, imagine buying Wells Fargo at that relatively expensive looking price back in 2006. Despite the slight P/E multiple contraction -- from 14.4 to 13.3 -- Wells Fargo's share price still went up more than the S&P 500 (and paid out more in dividends despite the dividend temporarily being cut).

The returns, while hardly spectacular -- in part, due to the at least somewhat expensive price back in 2006 -- contrast greatly with some other large financial institutions.
(Beyond those that got wiped out completely, of course.)

Unlike Wells Fargo's 57.5% increase in earning per share since 2006, a bunch of the big banks that are still around earn less than what they earned pre-crisis; in some cases, a small fraction. Much of this is due to dilution, of course. So, even if things go rather well for them from here, it's unlikely that their common shares will get to pre-crisis levels anytime soon.

Wells Fargo, with superior core economics, proved much more resilient than most others despite its own challenges and mistakes.

My point is that the importance of durable and superior economics is not only the upside; it's also the protection it provides on the down side. The financial system will, unfortunately, at some point down the road likely experience some real difficulties again. It seems, at least, wise to assume that's the case.

Some will try to protect against the downside by attempting to cleverly time the market. Good luck to those that do. That'd be one of those good ideas mostly in theory. A more practical approach is owning quality businesses and staying focused on price versus intrinsic worth. For those who decide owning shares of banks is worth the trouble (and I often wonder whether it really is considering alternatives), it's better to stick with quality. What looks cheap might have all kinds of downside. A reasonable valuation certainly matters, but it's just that, when it comes to investing in what are inherently very leveraged businesses, sometimes it's best to be skeptical of what appears on the surface to be a bargain.

In fact, I'm especially wary of financial institutions that look cheap during the good times. What seems like a seaworthy ship when the ocean is calm and the skies are blue can prove to be anything but once the storm clouds arrive.

Now, imagine having bought -- whether it was good fortune or otherwise -- shares of the larger financial institutions when they were selling at or near their lows. I mean, the very best banks as well as the weaker banks saw their stock prices collapse during the financial crisis. Most of the bigger banks -- at least those that survived the crisis a bit bruised but not broken -- would have generated very nice results for those who happened to buy near their lowest market prices.

In the real world, of course, most of us aren't going to consistently be able to buy shares when they are at or near their lows.

Most of the big banks were just generally NOT built such that the investor who, at least somewhat unfortunately, bought at pre-crisis prices came out okay. The fact that a bank like Wells Fargo stock would have produced good or better results, whether purchased pre-crisis or during the crisis, is an indication -- albeit a simplistic one -- of the very different risk versus reward profiles among the bigger banks.

A stock price that declines while per share intrinsic value remains roughly in tact is not, at least in the long run, a real problem. It may not be pleasant to look at the quoted prices for some time, but a stock that drops further below intrinsic value is an opportunity not a problem for the long-term investor. Besides, temporary paper losses are an inevitable part of the investing process. Those that can't stomach such things really shouldn't be exposed to the stock market.

On the other hand, a stock price that declines along with per share intrinsic value is a very real problem.

The quality banks -- usually those with higher return on assets and equity that also possess other important but less easy to measure characteristics -- should generally sell for a relative premium.

Margin of safety still matters but, with banks, it's usually better to avoid the bargain basement.

I'll stick with the quality stuff and, maybe, pay just a bit more if necessary.
(Though, as always, at what is still a nice discount to intrinsic value.)

It's worth mentioning that even the best bank's common shareholders won't necessarily be protected against another very serious financial collapse.

There's no rule that says the most recent financial crisis is as bad as it can get.

These businesses have unique risks even when they are run brilliantly.

Something to consider.

Adam

Long position in BRKb and WFC established at much lower than recent market prices

* The investor has control over what they are willing to pay for an asset they like if not much else. Yet the price paid provides only limited protection against permanent capital loss for some investments. In certain instances, the worst case valuation is either unclear or such that no price is low enough to protect against the worst possible outcomes. Naturally, the price paid should be comfortably below the estimated present per share intrinsic value. My preference is to calculate per share intrinsic value based upon lower end of an estimated range of future free cash flow, discounted appropriately. Confidence in those estimates should be very high and, well, warranted.  If not better to move onto something else. Never get caught up in a compelling story. That's a great way to pay too much for promise that may or may not be realized.
** The 2006 annual report showed diluted earnings per common share to be $ 2.49 per share but subsequent reports have it as $ 2.47.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wells Fargo's 2013 Results

Here's a quick summary of Wells Fargo's (WFC) latest earnings:

Full year 2013
- Net income: $ 21.9 billion, up 16 percent from 2012
- Diluted earnings per share: $ 3.89, up 16 percent
- Revenue: $ 83.8 billion, down 3 percent
- Return on Equity (ROE): 13.87%, up 92 basis points
- Annualized net charge-offs as a % of average total loans were less than half than the previous year
- Average loans increased to $ 805.0 billion from 775.2 billion
- Average core deposits increased to 942.1 billion from 893.9 billion

Net interest margin continued to decline from 3.76% at year end 2012 compared to 3.39% at the end of 2013. In a vacuum that naturally is not be a good thing but, in the context of the current interest rate environment and relative to competitors, they continue to do just fine. Net interest margin remains a real relative advantage for Wells compared to other large banks which directly contributes to the bank's more than solid ROE.

One way to look at their performance overall since the financial crisis is that, despite that narrowing net interest margin and the year over year decline in revenue, they just earned $ 3.89 per share compared to $ 2.47 in their peak earnings year leading up to the financial crisis.

In contrast, some other large financial institutions are still earning only a fraction per share of what they earned prior to the crisis or, well, had a far worse fate.

I think it is fair to say that the decline in net interest margin is hardly surprising considering the current interest rate environment.

Any improvement to this environment could favorably impact net interest margin and, ultimately, Wells Fargo's overall earnings power. The good news for shareholders is the bank is doing just fine even if that does not occur anytime soon.

Of course, inevitably, the economic environment will erode some time down the road. When (not if) that time comes, what will matter is whether the bank is capable of handling it. That comes down to things like pre-tax pre-provision profit (PTPP)*, making quality loans, along with sufficient liquidity and capital.

The diluted average share count did decline in 4Q 2013 compared to 3Q 2013 due to buybacks (from 5,381.7 billion to 5,358.6 billion). We'll see if this continues. They did say in their news release that additional shares were bought back through a forward repurchase transaction that's expected to settle in 1Q 2014.

Net interest income after provision for credit losses increased to $ 40.5 billion from $ 36.0 billion, the biggest driver of the increase to earning in 2013. Net interest income was actually slightly down year over year but the reduction in provision for credit losses was substantial. This, more than anything else, was a key driver of the 2013 earnings increase.

Noninterest expense declined to $ 50.4 billion from $ 48.8 billion.

This also partly accounts for the increase to earnings.

On the other hand, noninterest income declined from $ 42.9 billion to $ 41.0 billion. This was the biggest hit to earnings and was driven by a decline in mortgage banking. It should be noted that 2012 was an elevated year for mortgage banking activity compared to 2011 and 2010. In fact, the noninterest income not related to mortgage banking were, in total, actually higher year over year.

With these 2013 earnings in mind, consider the following comments about Wells Fargo by Warren Buffett in the 2012 Berkshire Hathaway (BRKa) shareholder letter. In the letter, Buffett explains the "'non-real' amortization charge" that burdens Wells Fargo's earnings:**

2012 Berkshire Hathaway Annual Report

"...serious investors should understand the disparate nature of intangible assets: Some truly deplete over time while others never lose value. With software, for example, amortization charges are very real expenses. Charges against other intangibles such as the amortization of customer relationships, however, arise through purchase-accounting rules and are clearly not real expenses. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when calculating earnings – even though from an investor's viewpoint they could not be more different."

He later adds the following:

"A 'non-real' amortization charge at Wells Fargo, however, is not highlighted by the company and never, to my knowledge, has been noted in analyst reports. The earnings that Wells Fargo reports are heavily burdened by an 'amortization of core deposits' charge, the implication being that these deposits are disappearing at a fairly rapid clip. Yet core deposits regularly increase. The charge last year [2012] was about $1.5 billion. In no sense, except GAAP accounting, is this whopping charge an expense."

So there may be actually be more earnings power --  economically speaking, even if the accounting indicates otherwise -- at Wells Fargo than meets the eye.

In any case, what Wells Fargo does in any particular quarter -- or, for that matter, any particular year -- just is not that interesting. It may be for traders, it shouldn't be for long-term owners. Similarly, when and by how much interest rates will be up or down isn't something I'm going to try and figure out. Sometimes the environment will be favorable; sometimes it will not be.

What really counts -- since the environment inevitably oscillates between being more and less favorable -- is whether a banking franchise is likely to produce attractive relative and absolute results at less risk over the long haul. The focus is on whether the moat will remain wide (better yet, can it be widened?), smart management of risk, and the long run trend of normalized earning power.***

Banking is by its very nature a very leveraged institution (even if less so these days). The real question with any investment but especially leveraged institutions is whether it has been built to be resilient during times of severe -- especially if systemically destabilizing -- economic stress.

As some learned the hard way during the financial crisis, funding sources for leveraged institutions must remain stable; liquidity plentiful. A bank can look or even be profitable but that won't matter much if suddenly the balance sheet comes under real pressure.

The only thing worse than being forced to raise capital when prices are least favorable for owners, is seeing funds leave, en masse, and being unable to raise capital in a timely manner from other sources.

Quality management will do smart things during the good times that anticipates the not-so-good times.

Adam

Long position in BRKb and WFC established at much lower than recent prices. 

* Pre-tax pre-provision profit (PTPP) -- net interest income, noninterest income minus noninterest expense -- is the first line of defense for any bank against credit losses. Otherwise, those losses begin impacting the balance sheet (i.e. allowance for loan losses and/or shareholders' equity balance). PTPP is a useful measure of a bank's ability to generate sufficient capital to cover credit losses during the worst part of a full credit cycle. Morningstar provides an explanation here (page 3). Strong PTPP relative to assets (and equity) isn't just about the potential for greater returns. It's not just about the upside. To me, what is far more important is that strong core earnings provides greater capacity to absorb credit and other losses that will inevitably arise at some point during a credit cycle even for the highest quality bank. Knowing that pre-tax, pre-provision capacity to earn is strong reduces at least one form of risk (among many others). 
** see pages 12-13 of the letter.
*** Some might be tempted to trade around the environment based upon how more or less favorable it seems. Best of luck. I mean, no doubt there are exceptions who actually do this successfully, but an approach based upon the exception seems more than just a bit unwise to me.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Wells Fargo's 2nd Quarter 2013 Results

Some highlights from Wells Fargo's (WFC) latest quarterly earnings:

- The bank earned $ 5.52 billion in the second quarter, up from $ 4.62 billion. Revenue was $ 21.4 billion, up from $ 21.3 billion. Quarterly per share profit increased 20 percent in second quarter to 98 cents per common share from 82 cents per common share in the same period a year earlier.

- Net interest margin decreased to 3.46 percent from 3.91 percent. Not really surprising considering interest rate trends this past year or so. Though net interest margin is lower, the bank continues to have a meaningful advantage compared to other big banks.

- Return on equity was 14.02 percent, up from 12.86 percent a year earlier.

- Total average deposits is now at $ 1 trillion, up 9 percent from a year ago.

- Net loan charge-offs were $ 1.2 billion in the second quarter of 2013 compared to $ 2.2 billion in the second quarter of 2012.

- Average loans grew to $ 800 billion from $ 768 billion a year ago.

From the Wells Fargo quarterly release:

"Our results reflected the strength of our diversified business model. Compared with the prior quarter, we grew loans, deposits, and net interest income, and both our efficiency ratio and credit quality improved." - Chairman and CEO John Stumpf

The FDIC is proposing a higher leverage ratio -- a more strict standard than what's currently under consideration in Basel III -- for larger bank holding companies (BHCs).
(Covered in this previous post.)

Well, this Bloomberg article from last month had suggested that a 6 percent leverage ratio was being considered and pointed out that:

Among the biggest U.S. banks, only San Francisco-based Wells Fargo & Co. (WFC) would exceed the 6 percent threshold being considered...

They're currently proposing a 5 percent* leverage ratio for the BHCs.*

In the long run, a more strict leverage requirement -- whether it ends up being 5 percent, 6 percent, or even higher -- would seem to be a very good thing.
(Even if a challenge for certain banks in the shorter run.)

The 3 percent level proposed under Basel III does seem rather meager. Well, at least they appear inadequate in the context of the kind of losses that can occur during a serious financial crisis. After watching the kind of financial destabilization that occurred not long ago, and the resulting hugely negative economic impact, this warrants serious consideration.

Not all of what happened was the result of excessive leverage -- both visible and hidden -- but much of it certainly was.

The Basel III proposal belatedly introduces the concept of a leverage ratio but calls for it to be only 3 percent, an amount already shown to be insufficient to absorb sizable financial losses in a crisis. It is wrong to suggest to the public that, with so little capital, these largest firms could survive without public support should they encounter any significant economic reversals. - Thomas Hoenig, vice chairman, FDIC in this April 2013 speech

In any case, though very important, it's not just capital levels that matters. It's also the quality of a bank's core economics. That's driven by not only cheap stable funding, but also whether they put funds generally to intelligent use and in combination with other services that customers value.
(Services that help a customer manage their capital and liquidity needs, the management of risks, etc.)

That requires, among other things, the right kind of culture be in place.

Difficult to quantify but extremely important.

"And I tell you, sure as I am sitting here, that if banking institutions are protected by the taxpayer and they are given free rein to speculate, I may not live long enough to see the crisis, but my soul is going to come back and haunt you." - Paul Volcker speaking to the Senate Banking Committee

It also means that speculation with guaranteed money needs to be severely limited.

Adam

Long position in WFC established at much lower than recent prices

* Basically, it appears they'd like to see a 5 percent leverage ratio for the larger BHCs, and a 6 percent ratio for any insured depository institution that's a subsidiary of these larger BHCs. The Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve Board (FRB) have proposed doubling the leverage ratio on an insured depository institution owned by a BHC. So these "agencies are proposing to establish a 'well capitalized' threshold of 6 percent for the supplementary leverage ratio for any insured depository institution that is a subsidiary of a covered BHC..."

In addition, they are also proposing that "a covered bank holding company would be subject to a supplementary leverage ratio buffer of 2 percent, above the 3 percent minimum requirement for banking organizations using the advanced approaches under the new capital rule."
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

The 5% Leverage Ratio

Well, I'm not sure a 5 percent leverage ratio shouldn't really qualify as tightening the screws, but apparently some think it's too strict.

FDIC to Tighten Screws on Banks, Require 5% Leverage

It's a tougher standard, yes, but requiring a 5 percent leverage ratio for the bigger banks seems hardly unreasonable considering the implications of a larger one getting into trouble. The 5% leverage rule does seem far more adequate than the 3 percent leverage ratio proposed under Basel III.

In fact, it seems easy to argue it should be even higher.

From this CNBC article:

The asset number includes off-balance-sheet items and will not be adjusted for riskiness. The proposed rule for so-called "simple leverage" is 2 percent higher than the minimum simple leverage rule under Basel III.

This simply means that larger bank holding companies (BHCs) will need to have capital that's at least 5 percent of its assets -- including the adequate capture of what's off-balance sheet -- compared to the 3 percent under Basel III.*

Again, seems more than fair. Also, the sheer simplicity of this rule likely makes it more difficult to game than some of the other capital rules that are based upon risk-weighting. To an extent a banker has the latitude to set the appropriate risk-weights. Well, there's just too much room for subjectivity in that kind of system.
(The simple leverage ratio relies much less on these kind of subjective judgments though, of course, no one measure is ever going to be perfect or, for that matter, even adequate by itself.)

More from the article:

By piling off-balance-sheet items into the ratio, the regulators have made banks' capital burdens much heavier.

Even if this were to cause some near-term challenges for certain banks, the long run overall benefits would appear to be more than worth the headache it causes. Fed Governor Daniel Tarullo said the following about the Basel III leverage ratio:

"Despite its innovativeness in taking account of off-balance-sheet assets, the Basel III leverage ratio seems to have been set too low to be an effective counterpart to the combination of risk-weighted capital measures that have been agreed internationally."

The 3 percent level does seem rather insufficient to absorb losses that could occur during a serious financial crisis. That doesn't mean the Basel III leverage framework isn't useful; it just means that 3 percent is too low. If set at an appropriately higher level -- necessarily a judgment call though I'll take a slight bias in favor of a stricter rule -- something like the Basel III leverage framework (or something similar) appears to have advantages over some of the other capital requirements.

Not only does it attempt to capture what's off-balance sheet, the Basel Committee on Banking Supervision thinks that this kind of leverage ratio will be more transparent than the other capital requirements.

Basel Proposes 3 Percent Bank Debt Ratio

From this CFO Magazine article:

...it would be more transparent than other capital requirements, because banks would have to disclose the information in a common format.

Banking, at its best, is a vital utility. No standard is going to work perfectly but a high enough leverage ratio just might just help to protect against the inevitable excesses that occur from time to time. More from the article:

A simple leverage ratio would force financial institutions to hold the same amount of quality capital against any loan they make, regardless of the riskiness of the loan. That contrasts with other capital ratios that assign a "risk weighting" to loans to require a larger capital cushion for riskier instruments.

The quality bank can still make a nice return for investors at this kind of leverage ratio (and likely even a much higher standard for leverage).

Charlie Munger weighed in on bankers during this CNBC interview in early May:

"A banker who is allowed to borrow money at X and loan it out at X plus Y will just go crazy and do too much of it if the civilization doesn't have rules that prevent it."

And later...

"I do not think you can trust bankers to control themselves. They are like heroin addicts."

The system should be built to encourage more safe and sound traditional banking activities and less of the exotic stuff. Much financial innovation ultimately boils down to some clever way to increase leverage (both on and off-balance sheet) in ways that's not always transparent until it's too late.

"All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith in the book: A Short History of Financial Euphoria (Page 19)

It's not just less leverage and more transparency that's needed.

It's stable funding sources so financial institutions are more resilient and less likely to become liquidity challenged during the tough times.**

It's less speculation and what is, effectively, even pure gambling.

It's reduced emphasis on facilitating short-term bets of various kinds and a greater emphasis on long-term outcomes.

It's less complexity; fewer derivatives.

More real accountability and financial pain for those in charge if things happen to go very wrong. This necessarily requires wise changes to the prevailing compensation systems for key individuals.

Even small step in the right direction are welcome but, realistically, a good chunk of what's really needed is unlikely to be implemented quickly if at all.

No matter what, the system will always depend on bankers who know how to effectively manage risk with enough skin in the game and integrity to care about doing the job well. Money that's government guaranteed -- the FDIC insured deposits of clients, for example -- or, more generally, other people's money, shouldn't be funding the riskiest activities without some wise limits in place.

The world needs a banking system that's less involved in speculative zero-sum "casino" bets (including things like proprietary trading), and puts more into competently getting funds to good ideas and productive activities.

An emphasis on stability, intelligent risk management, effective capital formation and allocation, while getting as many of the other frictional costs out of the system as possible. For lots of reasons much of what would improve the system isn't happening anytime soon. That reality doesn't make it any less worthwhile to understand what changes make sense.

We'll see if real progress -- even if inevitably less than perfect -- continues to be made.

Reign in the excesses and get back to an emphasis on traditional banking: Reliably taking in deposits, lending those funds intelligently, and providing related services. Within investment banking, dial way back the casino-like activities. Instead, they ought to be primarily about capably raising capital -- at an appropriate cost considering the specific risks -- and so it efficiently gets in the hands of those who can put it to good use.

These things can be a great advantage to any economy if consistently done well over the long haul.

Banking might justifiably be viewed cynically by many considering recent behavior and the consequences of  that behavior.

Yet, with better system design and some wise limitations in place, banking can better play its vital role and become much more trusted.

Adam

* Basically, it appears they'd like to see a 5 percent leverage ratio for the larger BHCs, and a 6 percent ratio for any insured depository institution that's a subsidiary of these larger BHCs. The Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve Board (FRB) yesterday proposed doubling the leverage ratio on an insured depository institution owned by a BHC. So these "agencies are proposing to establish a 'well capitalized' threshold of 6 percent for the supplementary leverage ratio for any insured depository institution that is a subsidiary of a covered BHC..."

In addition, they are also proposing that "a covered bank holding company would be subject to a supplementary leverage ratio buffer of 2 percent, above the 3 percent minimum requirement for banking organizations using the advanced approaches under the new capital rule."

Raising the leverage ratio isn't enough. What ends up in the numerator and the denominator matters. The updated Basel III guidelines make significant changes to the denominator -- a bank's exposure. Leverage requirements that only take into account on-balance sheet assets make a bank appear better capitalized than it is. Some banks have derivatives that are significant compared to what's on their balance sheet.

The new leverage has to capture two important types of exposure related to derivatives. With derivatives, it's not only the exposure arising from the underlying reference asset that matters, it's also the credit risks of the counterparty.

The proposed guidelines require that the entire contingency liability related to a derivative be in the leverage ratio's denominator. With this requirement in place a bank seems more likely to be better capitalized and able to absorb an unexpected loss.

The new guidelines also require banks to disclose publicly the different components included in the leverage ratio. For any leverage ratio, a bank is going try and increase what's allowed in the numerator and try to get as little as possible included in the denominator. Disclosure makes all the difference if it is to be trusted.

The recommendation that U.S. bank holding companies have a ratio of 5% and that insured depository subsidiaries have a 6% ratio sounds good versus the 3%, but it comes down to what's required in the new measure. If it is based on the 2010 framework instead of something closer to the updated framework then it's a vastly weaker measure. In any case, the lobbying will no doubt continue.
** I'm speaking of the liquidity within leveraged financial institutions themselves so the system is more resilient and remains stable when under stress. In other words, more liquidity in capital markets to facilitate the hyperactive trading of marketable securities isn't needed, but what are fundamentally and necessarily rather leveraged financial institutions must be set up so the system overall can remain stable when certain short-term funding sources become less viable. If anything the world would surely be better a place with much less rapid fire trading in markets justified under the guise of liquidity benefits.

"It's a myth that once you've got some capital market, economic considerations demand that it has to be as fast and efficient as a casino. It doesn't." - Charlie Munger at UC Santa Barbara in 2003

Capital markets would be more useful and effective if a greater proportion of participants were encouraged to be long-term owners instead of being short-term renters of different kinds. Currently, the system appears built mostly for participants to make bets on price action and less for participants to invest with long-term effects -- increases to per share intrinsic value -- primarily in mind. That's too much of an internal focus. It should be designed, instead, with a focus on effective capital formation, wise allocation, and long-term outcomes in the real economy beyond the capital markets. It shouldn't be designed to mostly serve highly active participants who are there to profit from price action -- and maybe even profit from fee generation in different forms -- but are often otherwise least interested in the real external economic impact. With better system design, the various frictional costs in the current system would become much reduced and it would better serve its external purpose. There will always be a place for speculation, as well as the various forms of fee generation, in capital markets but the proportion does matter.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Big U.S. Banks Boost Dividends, Increase Buybacks

The Federal Reserve disclosed the results of the 2013 Comprehensive Capital Analysis and Review (CCAR) yesterday.

CCAR determines whether the dividend payment increases and/or buybacks proposed by individual banks will be allowed. Only 2 of the 18 banks had their planned capital actions rejected. 2 others were allowed to implement their proposed capital actions but were asked to submit another plan to address some weaknesses by the end of the third quarter.

The rest received no objection from the Federal Reserve on their planned capital actions.*

Wells Fargo (WFC) and U.S. Bancorp (USB) are two of the larger banks that had their capital plans approved outright who will be allowed to both increase their dividends and buyback more stock.

The largest of the U.S. banks in terms of assets, JPMorgan Chase (JPM), also has a capital plan that includes dividend increases and buybacks. The only difference being that -- according to JPMorgan's press release -- it is one of the two banks that must submit an additional capital plan by the end of the third quarter. The plan must address what the Federal Reserve views as weaknesses in their capital planning processes.

The Federal Reserve also did not object to the requested capital actions of Goldman Sachs (GS) but, like JPMorgan, it was conditional. Goldman was similarly asked to resubmit its capital plan by the end of the third quarter. One of the other very large banks -- Morgan Stanley (MS) -- did not ask to increase its dividends or buyback any stock. Morgan Stanley will, however, be allowed to buy the 35 percent of Morgan Stanley Smith Barney it doesn't already own.

Here's a quick summary of the three of the larger banks that were allowed to both increase dividends and buyback stock:**

Wells Fargo
Quarterly dividend increased from $0.25 per share to $0.30
New Annualized Dividend Yield: 3.2% (based upon yesterday's closing price)

Wells Fargo Receives No Objection to its 2013 Capital Plan

The bank said the following in their press release:

Wells Fargo & Company (NYSE: WFC) announced today that the Federal Reserve Board (FRB) has not objected to the Company's 2013 Capital Plan under the recently concluded Comprehensive Capital Analysis and Review (CCAR) of the nation's largest banks.

The Company confirmed that its 2013 Capital Plan includes a proposed dividend rate of $0.30 per share for the second quarter of 2013, subject to consideration and approval by its Board of Directors at its regularly scheduled meeting in April. The plan also includes a proposed increase in common stock repurchase activity for 2013 compared with 2012.

U.S. Bancorp
Quarterly dividend increased from $0.195 per share to $0.23
New Annualized Dividend Yield: 2.7%

U.S. Bancorp Receives Results of Comprehensive Capital Analysis and Review

The bank had the following to say in their press release:

The Company expects to recommend a second quarter dividend of $0.23 per common share, an 18 percent increase over the current dividend rate. At this quarterly dividend rate, the annual dividend will be equivalent to $0.92 per common share. Consistent with the Company's change in the timing of the annual dividend increase, today the board of directors of U.S. Bancorp (NYSE: USB) declared the Company’s first quarter dividend of $0.195 per common share, equal to the prior quarter’s dividend, payable April 15, 2013, to shareholders of record at the close of business on March 28, 2013.

Additionally, the board of directors of U.S. Bancorp has approved a one-year authorization to repurchase up to $2.25 billion of its outstanding stock...

JPMorgan Chase
Quarterly dividend increased from $0.30 per share to $0.38
New Annualized Dividend Yield: 3.0%

JP Morgan Chase Announces Capital Plan

From their press release:

Following the Federal Reserve Board’s release of 2013 CCAR results, JPMorgan Chase & Co. (NYSE: JPM) today announced that:

- The Firm is authorized to repurchase an additional $6 billion of common equity between April 1, 2013 and March 31, 2014.
- The Board of Directors intends to declare the first quarter common stock dividend of $0.30 per share.
- The Board of Directors intends to increase the Firm's quarterly common stock dividend to $0.38 per share, effective second quarter of 2013.

The Federal Reserve Board informed the Firm today that it does not object to the Firm's proposed 2013 capital distribution plan. The Federal Reserve Board also asked that the Firm submit an additional capital plan by the end of the third quarter addressing the weaknesses identified in the Firm's capital planning processes. Following their review, the Federal Reserve Board may require the Firm to modify its capital distributions.

Wells, U.S. Bancorp, and JPMorgan are each selling near multi-year highs. So the dividend yield against the prevailing and much lower market prices that were often available in recent years would be far more attractive.

The tough part, of course, was knowing which of the banks would ultimately weather the chaos of the financial crisis and come out in good shape.

As far as the other big banks go, both Bank of America (BAC) and Citigroup (C) said they will be buying back their stock but neither bank is boosting their dividends.

Bank of America Plans to Repurchase up to $5 Billion in Common Shares

BofA will also redeem roughly $ 5.5 billion in preferred stock.

Citi Statement on 2013 CCAR Planned Capital Actions

Citigroup's planned action is to buyback $1.2 billion of common stock through the first quarter of 2014.

A number of banks, generally somewhat smaller, also have capital actions that either increase dividends, allow for the buying back of their stock, or some combination of both.

Here's a useful summary of what all the 18 banks will (or will not) be allowed to do.

Adam

Established long positions in WFC, USB, and JPM at much lower than recent prices. Also, a very small long position in BAC.

* American Express (AXP) received approval to for its plan but had originally asked to buy back more stock until deciding to rein it in.
** Goldman Sachs received no objection on their proposed capital actions but the bank was not specific about whether the actions included dividends and/or stock buybacks.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Wells Fargo's 2012 Results

Prior to the financial crisis, Wells Fargo's (WFC) book value per share and earnings per share was as follows:*

Book value per share: $ 14.1
Earning per share: $ 2.47

Wells Fargo 2007 Annual Report

Those numbers reflect what was at or near the peak of the company's financial performance before the financial crisis.

So they hardly represented normalized earnings over a full business cycle.

Roughly five years later, those numbers are as follows:

Book value per share: $ 29.5
Earnings per share: $ 3.36

Wells Fargo Full Year and 4th Quarter 2012 Results

Book value per share is up 110% in five years. For many reasons, an imperfect measure of value but, within limits, still a useful proxy.**

Earning per share is up by 36% since the pre-crisis peak. Hardly explosive earnings growth over a five or six year period but, in the context of what has happened to the financial system since 2007, that's a pretty solid business performance from a bank. Of course, what matters more is what Wells Fargo does from here and the valuation.

For continuing long-term shareholders, as long as the business itself continues to perform well (that earnings continue to increase and for a very long time), the lower the normalized earnings multiple remains the better.

Other than a recession or another crisis, it'll be surprising if Wells doesn't continue to improve per share earnings. There's no way to know, of course. The next time the bank's earnings get temporarily reduced due to an economic downturn it's likely to become more valuable as a result. Much as it did in the most recent crisis.

Earnings is often temporarily and depending on the business, even substantially, reduced during a period of reduced economic activity. Stock prices, of course, usually follow. Yet, the fact is a good business often improves during an economic downturn. The strong become stronger. Intrinsic value is actually increased. So, in some cases, price will be moving precisely in the opposite direction of business value even though it doesn't seem so based upon the near-term earnings decline.

If Wells Fargo's share price were to remain near 10x normalized earnings (not peak nor crisis level earnings) or, better yet even less, any buybacks that occur should improve underlying returns nicely for continuing long-term shareholders.

Wells has had a pretty good five years or so but, like many banks, it raised capital during the financial crisis.

Unlike many banks, Wells was able to increase its per share intrinsic value despite the capital that was raised and resulting dilution. Some other banks will not equal pre-crisis per share earnings levels for a very long time, if ever.

Those capital raises certainly had an adverse impact on shareholders to the extent that the market price of common shares were sold below per share intrinsic value. Yet, the cost was modest compared to the increase in Wells Fargo's intrinsic value (and especially modest compared to what happened to some other large financial institutions). In my view, shares of Wells Fargo were sold below the bank's per share intrinsic value, but not so much so that it did huge economic damage to long-term owners. It's the shareholders of those banks that were forced to sell lots of shares (relative to existing share count) and at a very low price  that were hurt badly. Some of those same banks were also forced to sell off valuable businesses.

Sometimes a stock will drop in price because the mood has changed yet per share business value has not (or at least has not nearly as much as the price would indicate). It's psychological factors that determine near-term price action not necessarily changes to real business value.***

Sometimes a stock goes down because real business value per share has been destroyed.

When the former happens, it's a good thing as long as capital does not have to be raised while the shares are selling below intrinsic business value. That's what happened to many banks and, for many of them, it was probably more than well-deserved.

When the latter happens, the result is permanent capital loss or, at least, severe underperformance as business value "catches up" to the price paid over time.

It's not difficult to understand why those with a shorter time horizon react negatively to a drop in price. Otherwise, the reduced share price of a sound business due to primarily to near-term psychological factors is a very good thing for long-term owners.

Why Buffett Wants IBM's Shares "To Languish"

At least it is for a well-financed business with durable competitive advantages. The business with an earnings stream that's persistent (even if somewhat cyclical)  and, better yet, nicely increasing over time. The mistake of letting price action influence one's view of the underlying business is an easy one to make. Learning to ignore the daily quotes does take more than a little discipline.

It's correctly judging the underlying business prospects and whether the price paid provided a sufficient margin of safety that generally matters in the long run.

Adam

Long position in WFC established at much lower than recent market prices

* The peak book value per share number is from 2007. The bank's peak earnings of $ 2.47/share is a 2006 number.  In 2007, the bank earned $ 2.38/share. That drop was likely a small but early indication of the financial crisis yet to unfold.
** Some might prefer using tangible book value per share. On that measure, the increase in tangible book value per share has been an even greater percent over the past five years.
*** Usually grounded by real fundamental issues, but the price movements often end up being far greater, both on the upside and downside, than is warranted. Intrinsic business value just doesn't usually change all that quickly.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Buffett on Banks: CNBC Interview

CNBC's Becky Quick interviewed Warren Buffett yesterday.

Interview With Warren Buffett: CNBC Transcript

Earlier in the interview, Buffett said that:

"I think the stock market generally is the best place to have money..."

Then he added:

"...there's no question that worldwide there is some slowing down going on."

He also made the following comments about Wells Fargo (WFC), U.S. Bancorp (USB), and banking in general:

"In the last week, I bought some Wells Fargo."

Then he later said...

"But we only have 430-something million shares, so I didn't feel we had enough."

Here's his explanation why banks won't be as profitable (and basically shouldn't be if you want a safe and sound financial system) as they were (or at least seemed to be) going forward.

"The profitability of banking is a function of two items. Return on assets and assets to equity.

And return on assets is not going to go up particularly. USB has done the very best on that. They're at about 1.7 percent. Wells is between 1.4 and 1.5 percent. But most banks are lower. Now, if you have 20 times leverage and you're getting 1.5 percent on assets, you're making 30 percent on equity.

And that was not lost on people a few years back. And they pushed balance sheets, and they're still pushing them in Europe. But they've cut back on that here. So they will not be having the leverage in the banking system. It'll be even more restricted among the bigger banks as part of the new rules, and you won't be able to earn more on assets than before, and so with less leverage in the same return on assets, you will have a lower return on equity. Banks were —banks were earning 25 percent on tangible equity not so many years ago. And really, that's kind of a crazy number. You know, for a basic semi-commodity business, you really don't want to allow that."

Yet it was allowed. Then we all had the great misfortune to see what happens when huge leverage is combined with the use of other people's money guaranteed, explicitly or not, by the government and a lack of sensible oversight. More from Buffett:

"...people got to push and push it and push it, and then the government says, 'Listen, we got a vested interest in this. You're using our credit, in effect, and if you want to play, you're only going to have 10-to-1, or some number like that.' So the returns on banks have come down. It's still a good business."

A well run bank can still be a good businesses. He added that "...Wells is very well run. And it's a good business."

A bank with 10x leverage* that can generate 1.4 or 1.5 percent return on assets (ROA) naturally has a mid-teens return on equity (ROE).

That math is simple but I think it is fair to say investing in most banks is far from easy to do. A bank that has mid-teens ROE bought near book value should**, in the long run, produce something like mid-teens returns for shareholders.

Should, that is, if (and it's a big IF) the bank can keep itself from getting into trouble down the road (unstable funding sources, insufficient liquidity, unwise investments/trades, dumb lending practices, foolish use of derivatives, etc.) that ends up wiping out all or part of the bank's per share value for common shareholders.

With leveraged institutions, an awful lot value can be destroyed in a very short amount of time (as we saw not all that long ago).

One of the weaknesses of some banks is that they lack the core earnings capacity of a Wells Fargo or U.S. Bancorp.

Wells Fargo's ROE in the most recent quarter was 13.4 percent.

U.S. Bancorp's ROE in the most recent quarter was 16.5 percent.

Whether they'll earn those kind of returns over the long haul can't really be known but it does provide some indication of relative capacity to earn.

In contrast, with similar leverage, some other banks seem likely to, post-financial crisis, have persistent below double-digit ROE (this starts with having inherently inferior ROA then not being able amplify with leverage as much). To me, that's generally an insufficient return for what are still, even if less so than before the financial crisis, by their nature rather leveraged institutions.

The problem isn't just that the returns are subpar considering the risks.

The problem is more that banks with lower returns have less capacity to absorb credit and other losses (lower pre-tax pre-provision earnings for every dollar of assets).

Once the next inevitable economic downturn or financial crisis occurs, those banks generating lower returns, all else equal, are likely the less durable institutions (from a common shareholder perspective that is). It takes less stress to begin weakening their balance sheet and more easily results in the need to raise capital (or worse). Since stressed financial institutions usually have to raise capital when the share price is quite cheap, it usually ends up being materially dilutive, and very expensive, for existing shareholders to say the least.

The returns of a bank should be considered in the context of their ability to withstand potentially severe economic and systemic stress. Like any investment, buying common shares of a bank requires a  margin of safety. Yet, with a weaker bank, simply adjusting the estimated intrinsic value lower by some percentage or buying with a bigger margin of safety to arrive at an appropriate price to pay is usually not enough. Eventually, it's more a go/no go decision. There's a threshold where it's just better to avoid the common stock of weaker banks altogether no matter how cheap they may seem.

A higher quality bank, though selling at a seemingly more expensive share price, may be intrinsically well worth the additional multiple of earnings or book value that must be paid.
(Only up to a point, of course. Margin of safety is still all-important.)

The bottom line is reduced earnings capacity relative to assets can significantly increase the risk of permanent capital loss for the common shareholders of a financial institution. Like any commodity/semi-commodity business, it's better to own the one's that will still be profitable in tougher environments when their weaker competitors are struggling to do so. The stronger banks are not just less likely to destroy intrinsic value during periods of economic stress (when credit losses are at their highest). The one's in a position of strength should also be able to make strategic moves that actually increase intrinsic value while weaker competitors are in retreat.

So it's not just that Wells or U.S. Bancorp generate higher returns, it's that they should be able to do so at less risk. It's their relative and absolute capacity to absorb losses from loans/ investments/ trades that go sour (and other liabilities that may arise). Ultimately, they earn superior returns (via various fees, gains, interest income) on their deposits (generally lower cost stable funding) than many competitors.

To a certain, but limited, extent those comfortable reading financial statements should be able to figure out if a bank has an advantage in this regard. Yet, annual/quarterly reports and other filings is unlikely to tell the whole story. Unfortunately, investing in any bank requires a subjective judgment (some might say a leap of faith) about the quality of management and the culture of the institution. In other words, there's no way that all the possible troubles a bank may get into will be obvious just from reading SEC filings. That's true of any enterprise but, considering the leverage involved, misbehavior or stupidity has the potential to be much more expensive for a bank shareholder.

Wells and U.S. Bancorp may not be as complex as some other large banks, but they are still hardly simple to analyze.***

Later in the interview, Buffett added this on the European banks:

"The European banks still are leveraged to an extraordinary extent... But they aren't earning 1.5 percent on deposits either."

Some European banks not only still have too much leverage but also don't earn nearly as much on their deposits (and some have funding that's of lesser quality). So they are not just riskier investments because of the excessive leverage. They are also riskier because their inherently inferior earnings provides them with less ability to absorb losses before the balance sheet, and eventually per share intrinsic value, takes a hit.

Adam

Long positions in WFC and USB established at much lower than recent market prices.

* 10x is far more reasonable leverage for a sound bank (those with lots of stable deposits, outstanding liquidity, high quality equity capital, sound underwriting practices, etc.) compared to what was often the norm before the financial crisis.
** Assuming the market price of the shares in the very long run can be sold at or above book value. That's not an unreasonable assumption for a well run bank. The intrinsic value of the better banks should be comfortably higher than book value. Wells and U.S. Bancorp are no longer selling below book value and certainly not below tangible book value. There were, however, a number of occasions in recent years when shares of both banks were selling for less than their per share tangible book value. Also, any share repurchases, especially if comfortably below intrinsic value, will boost returns above what their ROE suggests.
*** There are many simpler investment alternatives with less difficult to gauge risks and reduced likelihood of big mistakes. Investing in a bank's common stock certainly require a lot more work than, say, one of my favorite minimally leveraged consumer businesses. The question is whether there's a good chance they will produce materially greater long-term risk-adjusted returns considering all that extra work. An investment with greater complexity that requires more effort should be plainly worth the trouble. For me, sometimes they have been worth the additional effort but it's often a closer call than I'd like it to be. In other words, considering the alternatives, I'm not sure investments in even the highest quality financial institutions frequently pass the "plainly worth the trouble" test. There are many other, relatively unleveraged, potentially sound investments available. With that in mind, it seems unwise for an investor to put capital at risk in the common stock of a bank unless they're highly confident in their ability to judge financial institutions.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.