# Banking on Trust-III

This is the third and final post on the Banking on Trust series. While the previous post winded down to an extraordinary length I recognise it lacked the practical treatment. I hope to set it out right this time. For the first part see here and the second part take a peek here

The last post, Banking on Trust-2 can be summarised in four words- “Management maketh, Management breaketh.”

Due to the highly discretionary job of risk management and a fragile business model (need plenty of other people’s money to even work) a good management can be the invisible asset for a bank.

And I argued, though admittedly without much proof, that Wells Fargo Corp’s management has been extraordinary in its handling of the business.

Let us attack the issues one by one.

What separates a big 4 bank (Wells Fargo, JP Morgan Chase, Citigroup and Bank of America) from community banks?

Being larger in size Wells Fargo and Company (WFC) is able to keep  its fixed costs per unit of loan disbursed far lower than its local competitors.

With lower fixed costs, it is able to charge lesser interest on loans disbursed thus winning the first battle in a commodity business.

Another question.

What prevents the community banks from growing into a big 4 bank?

The incumbent banks have been able to offer full services at a lower cost (due to scale) than community banks. As a result for a customer it is difficult to find a substitute of such a bank which offers all those services at lowest prices. And hence community banks stay ever small.

The management of WFC understands these ideas very well. Yet they have taken their execution to a completely different level. By being one of the first banks to repeatedly  innovate its financial offering (keeping in view changing regulations as well as customer needs) it has performed extremely well.

Peruse this:

#### A history of success of WFC

1967: WFC introduces a Mastercharge card as a new form of credit card.

1968: Under high inflation, FED restricts overseas spending. But outbound customers and expats need a solution to this new regulatory development. WFC recently opened London subsidiary WESTERN AMERICAN BANK swings into action- servicing the clients and turning in better than expected performance.

Converts to a federal bank charter (Community Banks- 0, WFC-1)

Mastercharge credit cards which turn out to be a success. Adopted in 37 States and used by 13million cardholders. These numbers generate substantial benefits for WFC. Accepted by virtually every major oil company.

1970: WFC organised as a bank holding company to broaden their services. New branches opened in Sydney, Hong Kong, Luxembourg, Mexico City, Managua etc.

1975:  Its market share of the retail savings trade increased more than two points, a substantial increase in California’s competitive banking climate. With its increased deposits, Wells Fargo was able to reduce its borrowings from the Federal Reserve, and the 0.5% premium it paid for deposits was more than made up for by the savings in interest payments.[from wiki]

1978: Fed allowed banks and thrifts to offer savings intruments with interest rate linked to T bills (savings rate deregulation). Wells Fargo quickly              deregulates its own savings rate. Launches two new plans in response to this. Automatically allows savings account interests to be moved into checking accounts.

1978-80: Wells Fargo’s investment services becomes a leader. More accounts garnered than any other money manager. Wells Fargo’s early success, particularly with indexing—weighting investments to match the weightings of the S&P500—brought many new clients aboard.

In short,with a rise in offerrings WFC is constantly increasing the search costs for customer. But the management of WFC has one more ace up its sleeve.

#### A mental model to analyse Mastercharge

But wait a second here!

Are we missing something?

Yes surely we are! We missed an important development.

In 1967, WFC launched a system of transaction where customers can take credit from their banks for purchasing items. It was named Mastercharge.

Lets first explore, the success (if any) of Mastercharge as of 1969.

37 states out of 51 adopted it.
13mn customers use it.
Almost every major oil company supports it.

Can we make a reasonable guess on the future of Mastercharge? Its benefit to WFC?

Surely we can. Mastercharge is nothing but the first credit card offering in the world. It is essentially making its customers dependent on itself!

Thats the classic case of moat. Think about it! Marlboro, Coke, See’s Candies. All are businesses which will be sorely missed by its customers.

Lets attack it from another perspective. Lets check if it can be lodged off from its perch (13mn cardholders, acceptance by major oil co.) by a new competitor.

Have you heard of Replicator Dynamics? It is an interesting mental model.

Its in essence a system which says- folks adopt those behaviours more readily which has the more payoff (the material aspects) AND is copied by more number of people. So we can see- people switching and adopting new behaviours. Something like people coming from different cultures quickly adopt the cultures of their new country.

Lets apply it here.

Assume that Mastercharge gets a new competitor called Surcharge. It is the new kid on the block. Zero people use this and no states have adopted it, yet.

Now Alex wants to enroll in one of the two credit card companies- Mastercharge or Surcharge.

What does Alex see? Alex sees around him 13mn customers already using Mastercharge.

13mn cardholders of Mastercharge!

It effectively means wherever Alex looks, he sees every card holder as a Mastercharge holder. He is surely going to adopt that behaviour which is being followed by others [Replicator Dynamics].

But when 37 States and all the major oil companies have adopted Mastercharge, what does it imply?

A large number of vendors are already using it. So for Alex, Mastercharge has clearly become significantly beneficial.Its the classic Network Effect at play.
Each new vendor when joins the network makes the network more valuable to its individuals (Think Facebook in 2006 and 2014).

So for Alex, not only does it make more sense for him to adopt Mastercharge than Surcharge, it also makes it more profitable to him (i.e. gives him disproportionately large material benefits than Surcharge).

Thus we see, Mastercharge owning the market, like a boss!

Mastercharge finally became -> this

#### The management perhaps thought, if I am indeed locking away the community banks in services why not go the entire way!

Lets lock them out of physical proximity to customers as well!

Take a look:

Dotting the California: New Branches opened or pending in 1968

Its opening new branches so close to each other that it is effectively crowding out community branches.
In the same year it merged with Bank of Pasadena (a 10mn $deposit bank), Azusa Valley Savings Bank and First National Bank of Azusa (combined 11mn$ deposits).

It acquired Sonoma Mortgage Corp.
In 1969, Wells Fargo has 19 offices in Southern California, the deposits exceeded 165mn$and loans topped$230mn.

Offices in South California

In 1970, the conquest of Los Angeles and Orange counties(right) is shown. And also take a look at the San Jose metropolitan area expansion

The Conquest of South-West America aka LA and California

So we see an all out attack to disproportionately increase the search costs in every way possible.
The qualitative aspects are done, let us train our guns on perspectives.

Is the management really running a tight ship?
Is it keeping its costs down?

In contrast BofA had an overhead margin of 47% in 1998 inspite of 100 years+ of experience

#### The management- does it go bonkers in good times?

With the qualitative aspects out of the way, let us consider the quantitative aspects of management i.e. its ability to make conservative loans, predict their vulnerability and make the right amount of provisions so that, I repeat, so that the net operating profit after tax is smoothened.

Take a look at this:

The NOPAT barely nudged even in a downcycle

What I did was simple.
I took the Net Interest Income subtracted only the charged off loans so that I get the true picture of ‘damage’ in the current year and added back the loan provisions.

Remember loan provisions exist to smoothen out bad loan losses. So ideally management should have anticipated the loan provisioning properly so that charged off loans are fully accounted for.
But probability of loan going bad is a combination of expected and unexpected developments.

Hence how good a management is, can be checked by how good its predictions are.
In turn, how succesful it had been in making its NOPAT smooth.

Since provisioning is tax free, I adjusted the tax accordingly. Taxes paid in real is the second row, and the last but second row are the taxes applicable on our adjustments, given the same tax rate.

Take a look at NOPAT levels again.
Remember in the period from 1970-72 US entered a recession.
With each economic downturn banks are the first to suffer losses.
And yet, Wells Fargo’s NOPAT has barely nudged.

What do we conclude?

We do conclude that Wells Fargo’s management has been extraordinary capable of cushioning the bank’s fortunes from macro economic shocks. WFC- 1 , Competitors – 0

So now it comes down to valuations. Lets take a look!

#### Valuations- Valuing the Wells Fargo!

It went public in 1972, and its average market cap for that year was around $1.5bn. What growth expectations are we attaching to Wells Fargo? Lets first try to establish a way to value this company. We adopt the Economic Value Added (EVA) methodology to analyse this bank. EVA = NOPAT – Shareholder Equity * Cost of Capital Market Value of Enterprise = Shareholder Equity + Future Value of all EVAs Using this framework, lets try to find out the EVA from 1967-1971. The cost of capital for a shareholder is merely the opportunity cost.The second best idea is investing in index, assuming a blank portfolio.Consider it to be the historical growth in index DJIA from 1940-1970. Thus the cost of capital equals 8%. Hence plugging it in and assuming a 20% growth rate for the next 30 year, we arrive at its 1972 valuations of$1.5bn.

20% growth rate in EVA, discounted at 8% for the next 30 years.

Is it too costly?
Well it is if you see the time duration involved. Growing at the rate of 20% for the next thirty years is not a mean feat!

However if you consider that this is a good business, with  a responsible management at helm, with very interesting offerings like Mastercard and a deepening moat, then you might like to reconsider your position.

But I will be fair. Had I been in 1972, I wouldnt have dared to buy it. But given the mental model working in my head now, I would have surely stalked this company very closely.

#### Three Years ahead- August 1974

Let us consider three years ahead.

Has the position worsened?
Lets see.

In 1974, Wells Fargo NOPAT was $66mn. Equity stood at approx 450mn$.
At a cost of capital at the same 8%, we have EVA of Wells Fargo in 1974 at $30mn. If we assume the growth rate in EVA to be about 8% for the next 30 years, the future value of all EVAs come to$0.9bn. With the shareholder equity standing at $450mn, the market value of the enterprise comes to$1.35bn.

In 1974 for about 4-5 months (from August-December) it traded at a marketcap of $860mn. #### Fours more years ahead- 1978 Let us go four more years ahead. How well would we have fared in our assumptions? Constantly increasing Earnings and Dividend per share It clocked an average of 18% growth in the last 5 years. Topline growth has clocked an average of 17%. And has the moat deepened? Everincreasing return on shareholder equity! What else is it other than deepening moat. And this has come at the cost of dumb competition. Remember Walmart? Walmart did the same with mom and pop shops. But ladies and genetlemen, I will completely understand if you are hungry for some more. Take a look at this: Increasing return on assets for WFC. Almost a vertical line! And take a look at its effect on leverage: Falling leverage implies better asset utilisation and deepening moat. It just shows one thing- Wells Fargo and Company will continue to make a heck lot of a money for its shareholders. In fact, from 1974, if you would have bought and held WFC it would have returned 29400% ; compounded yearly at the rate of 15% for the next 40 years. Think about it. Recommended Reading: 1. John Hubers excellent posts on Wells Fargo which has served as an inspiration to conduct this study. here, here and here 2. Annual reports of Wells Fargo from 1968-71,1978,1988,1998 3. The featured image is taken from John Huber’s wonderful blog Base Hit investing Advertisements # Banking on Trust-II In the last post Banking on Trust-1 we discussed Bruce Berkowitz ideas on bank as an earning machine, how it can be an earning machine (by turning into a franchise) and Wells Fargo’s success in the same. I ended the last post by promising we will be discussing Berkowitz’s idea of WFC’s management. But before I go forward I want to make a detour. I am going to talk about banking business in general and then in the last few paras talk about Berkowitz’s observations. Financial sector is often the least understood sector. Investors and laymen alike find it increasingly difficult to make sense of banking as a business. When I first started this series, I wanted to build my circle of competency in this sector as well as keep a public record of my understanding for others to learn and correct. So without much ado, here it is. In a business like banking it is important to understand the driving factors in its success. To explore this idea let us try to understand the problems of its CEO. If we explore this idea, then lots of factors become clearer. Better yet, let us try to form a financial business from scratch. Each case will be taken up as a case study #. Lets get started: (Note: In all previous financial statements, the balance sheet preceded the income statement by 1 year) ##### Case Study #1: We have 1000$ invested in a bond portfolio, which yields 22% annually and matures in 10 years. The loan portfolio is completely riskless.

In this case, the balance sheet and the income sheet looks like this:

A simple credit financing operation

But note, that we would like to enhance the Return on Equity. The RoE of the operation is not very high. As a result, we would like to employ DuPont methodology for analysing RoE.

It says:

#### ROE = Profit Margin X Asset Turnover X Leverage

So employing this we understand that, increasing profit margin will either require taking more risk on the loan book or procuring cheaper capital. Both of which is say for the sake of argument not possible. Since the portfolio churns once in 10 years, increasing the asset turnover is also not possible. So the only way is to take in more debt.

##### Case Study #2: Intaking a debt of $500 at the rate of 2% to the existing operation. As a result the balance sheet and income statement will look like this: The leverage is mere 1.5 and ROE has also jumped by a similar level. However in two aspects this scenario is divorced from reality. Consider this, when a financing entity offers me loan at 2% which is risky asset, how can this credit financing operation find riskless assets at 22% yield? So it will be prudent to recognise, understand and acknowledge that the bond portfolio cannot be riskless and definitely the interest spread cannot be this high. Analogously, if risk and yield are correlated, then undertaking investments in riskless assets will lead to negative spread. That is cost of funds will exceed the yield from those funds. So let us still for the sake of argument continue to believe that they are riskless, however reduce the spread from 20% (22%-2%) to 1%. In other words, the yield on commercial loans we make here is 3% ##### Case Study #3: The yield on commercial loans is 3% Ouch! The ROE has fallen once more! And this reflects a more practical scenario. So is banking business doomed with rock bottom ROE? No, not at all. Remember , we can pull the leverage couple of notches. Now its mere 1.5x leverage. Lets jack it up! Lets make it 20:1, no 25:1 leverage. ##### Case Study#4: Effect of 25:1 leverage on ROE Note, the increase on ROE. The ROE is now 19.60%. By now quite a few ideas have started coming to your brain, I am sure. But lets explore a bit more. We need to consider the inherent riskiness of the loans as well. So lets do it. Lets indeed treat the loans as risky assets. Which implies, there is a definitive probability of certain loans going bad. Now as we can foresee, if we leave the entity (financial entity) to run as it is, with no difference made to account for the riskiness of the loans, we can face these problems: • The Net Interest Income(NII) will be extremely volatile. • In good times when cost of fund is cheap, the banks will how high profits and in bad times when the default rate rises the profits of banks plunge- making banks extremely coupled with the economy and more risky to own during the downtimes. • Excess leverage of the banks make their balance sheets “fragile”- a small amount of default can wipe their equity portion and may even hamper their debt part. These reasons and more, make it evident that “business as usual” is not wise. We will have to protect ourselves against bad loans while making some kind of provisioning to account for the riskiness of the portfolio. If we think a bit more deeply, we can say for a bank the level of interest it can charge can be gleaned from this relationship: $r_{l}=r_{b}+E(d)+k+c$ Here $r_{l}$ is the interest charged from the debtors, $r_{b}$ is the risk free rate, $E(d)$ is the expected annual default rate, $k$ is the risk premium and $c$ is the operating cost per unit of loan disbursed. Thus, if $L$ is the loan disbursed on average, the cost of funding is $r_{d}$ and $\Delta BL$ is the bad loans charged off (i.e completely written off), then the NII for the bank in any given year will be: $NII = \tilde{L}*((r_{b}+E(d)+k)-r_{d}) - \Delta \tilde{BL}$ Note: Here we are using $\tilde{L}$ and $\tilde{BL}$ to imply that these are not constants but are changing variables. Also we have not used the cost per unit loan in the above equation because we are considering Net Interest Income (i.e post overheads). This is a situation which considers that there is no provisioning. As a result $NII$ will keep on changing as per the whims of $\Delta BL$. In bad times when the bad loans increase Net Interest Income will plunge perhaps even going into losses, and in good times when bad loans are below the $E(d)$ rates, Net Interest Income soars. So remember we are the CEO of this investment operation. It is our duty to see that the health of the business is not adversely affected in any case. We have to thus protect ourselves from the bad loans coming to bite us. Especially in the bad times. Let us create a separate account, where part of the net interest income will be kept aside to cushion the fluctuations in $\tilde{BL}$ (bad loans). Hence let us keep aside a fixed proportion, $\gamma$ annually of the value at risk. What is the value at risk here? Naturally it is expected rate of default $E(d)$ times the loan disbursed $L$. Hence, provisioning equals $\gamma * E(d)\tilde{L}$. So for each year, we will set up the amount by which provisioning exceeds $\Delta BL$. As a result the Net Interest Income will look like this: $NII = \tilde{L} \cdot ((r_{b}+E(d)+k)-r_{d})-\Delta \tilde{BL} - (\gamma \cdot E(d) \cdot \tilde{L} - \Delta \tilde{BL})$ On manipulating, we can find something interesting. We find: $NII = \tilde{L} \cdot [r_{b} +k - r_{d}] + (1-\gamma)\cdot \tilde{L} \cdot E(d)$ $if LLP > 0$ Here LLP implies Loan Loss Provisions. In case $LLP=0$ , the situation reverts back to the representation where there was no cushion. So what do we see with all this? We see, the cyclical fluctuations in $\Delta BL$ , bad loans i.e. is completely removed. We also see, that it is a pseudo-expense. Just like a manufacturing company can eschew depreciation completely and every few years it can show an extraordinary expense to replace the machinery, similarly without LLP the bank will show extraordinary losses every few years. By using provisioning (which can be thought of as banking equivalent of depreciation), the CEO are able to smoothen out the profits and cycles Thus let us account for the riskiness of the assets. Let us consider that expected value of defaults is 10%, and loan amount as per the previous case study was$26,000. Thus the value at risk is $2600. We set aside a proportion of this value at risk say about 1% as provisioning. Furthermore let us assume there is no charge off this year. ##### Case Study #5: With 1% provisioning of VaR Now we are getting closer to our ideas here: What do we observe here? 1. Prudency demands we should be good at predicting the quality of our loan book, and honest in reflecting the same in our provisioning calculations. 2. In bull runs, there are additional pressure from market, from shareholders to constantly beat the expectations. And it is that crucial time when CEO has to shut out the noise and allocate provisioning capital liberally. Because when economy contracts the bad loans will have to be offset from this. 3. CEO should build moats around their operation, so that customers dont switch easily at the drop of a hat and some amount of premium pricing can be charged for the services. . 4. CEOs should be extremely low cost operators, so that the margins can be increased. In this light it is important to note that the management of Wells Fargo have been prudent in recognizing risks,honest in acknowledging them and cautious in accounting for them. So what do we see, when Wells Fargo is hit badly by California Real Estate shock of 1990. The management errs on the side of caution by high provisioning for the loan losses. So much so that, the earnings power of WFC is completely disguised. Secondly, a manager who over reserves is one who will understand the price of risk. In other words, it is an indication of cautious, responsible and able managers. Banking is a business where there is no place for gung ho managers. Being a business so fragile a tiny amount of neglect towards risk can wipe out the bank. Berkowitz at one point drives home harder the fact that Wells Fargo has captured the markets so heavily, mark my words, he says if Wells Fargo is to close down tomorrow then there would be significant shortfalls. That, my friend is the mark of a company which has locked out any competition on its turf. In short it has got a moat around it! What does it imply? One thing. Management is the best as they come. Wells Fargo is also the most efficient bank out there and has an ROE of 20% (as of 1990). Bruce Berkowitz at this point introduces PTPP Earnings, that is core earnings for a bank. It is called pre tax pre provisioning earnings. He points out that PTPP earnings of WFC stands at an astonishing$33.

And their provisioning which is extremely conservative, and assumes a complete charge off is not so. In fact their non performing assets are earning  a modest amount of interest.

Buffett reflects Berkowitz idea toto. He echoes that management of a bank is the singlemost make or break factor. The next important factor is costs. Wells Fargo has an average cost of deposits at 0.36%.

Similarly its return on assets stand at 1.43%, return on equity at 13% and return on tangible equity stand at 18.3%. Compared to any cheap community banks Wells Fargo is far better in quality and far better in value.

This post has stretched far beyond usual ones. For now taking your leave. Adios.

In the next post of Banking on Trust series, I will be discussing the business aspects of Wells Fargo- its competitive advantages etc.

# Banking on Trust – I

This is the first part of a three part series on investing in banks. This is not a tip blog post, this is a discussion of different salient features which drive banking business. The method of analysis will be part inspiration and part plagiarism.  In 1992 Bruce Berkowitz gave an interview to Outstanding Investors Digest (OID) regarding Wells Fargo. These are some of the ideas presented by him and an exposition by me.

Wells Fargo is an American banking company with head quarter in South California. Its the second largest bank in US in terms of assets and the largest in terms of market capitalisation. It extensively takes home financing. In February 2014 it was ranked as the most valuable bank in the world for the second time in a row. Wells Fargo is owned by Berkshire Hathaway. At different points of time it was owned by some of the most stellar value investors of present era.Munger went to the extent of  calling Wells Fargo his investment filter. He implies that he constantly asks himself if he should put his money on a new investment when Wells Fargo is as a good and as cheap as it is.

But how do they think about a business as difficult as banking.

### “Its a simple case of a bank with tremendous earning power”

Bruce very early in his interview makes it clear what is the Big Rock in his thought process. He underlines that Wells Fargo is a bank with a tremendous earning power. Wait a second!  What does it even mean?

How do we identify the earning prowess of a bank?
Or rather what are the driving gears of a bank?

At the very core of its operations a bank is at the end of the day a commodity business. The commodity is not some agricultural produce but it is an economic produce- MONEY!

People go to banks to deposit their money and avail loan services. So when banks take deposits they incur expenses . Similarly when they disburse loans the interest income is their revenue.
No significant differentiator with respect to any other competitor. Of course a bank can raise the interest offered on deposits to attract more customers but it will be akin to making higher payments to your supplier. So higher interests offered to deposits imply lesser profits.
Compare this with a coal miner- another commodity business:

1. He has no pricing power- that is his price is dependent on the lowest price offered in the market.
2. The fruits of innovation is never going to create a unique production process for his own firm.

3. As a result, margins are going to be just enough for producers to survive.

So a bank can attract loan availing customers by lowering interest rate. However this is not going to make him any profits. It will be a value destructive growth.

However there are times when a bank can move away from a commodity business to a franchise model.

A related question here is- can we think about banking business in a different way?

### So many people are dependent…

A Bank can also be thought of as a platform!.  This is an incredible insight. Think of it, two persons walk in to a bank to avail loans. One of them is already a client in the bank having his own deposit. The other doesnt. Guess which one of them will walk out of the bank first with a loan in his hand?

Banks started loaning out to people they know to control their risks, but it has now spawned into a lock-in system. If you do business with this bank, your working capital loans of your business is given by this bank then you can’t shift away your deposit savings account to another competitor providing competitive rates!

And vice versa. If you do have a deposit account then selling the loan services to you is going to be easier from your as well as bank’s  perspective.  This is a way of thinking. In developed and matured economies the difference in convenience is not going to be huge, however my common sense says it should be present.

Now lets try to think a bit more through it- what if a bank has a branch at every corner of the road? The stupendous distribution system itself is going to lock away other competitors from even trying to enter this business. And that is one excellent reason why community banks thrive in US.  And that is the reason why local moneylenders thrive in India.

So a bank with the biggest number of branches is going to win. However, branches imply growth and the margins of this business is low (why? because at its core its a commodity business). Hence it is imperative that the efficiency of the bank is as high as possible.

Thus for a bank to reinvent itself as a franchise- it has to have an excellent cost structure, low cost of funds, excellent footprint and the efficiency gains which come from scalability.

In as many words, when OID asks Bruce Isnt that a contradiction in terms- a bank with a franchise?” He replies-” If I give you a billion bucks and let you pick your management team, how could you rationally hurt Wells?

Indeed how could you rationally hurt Wells Fargo when it has a 9000 branches spread all over US?

Footprint of Wells Fargo in US

Its scale leads it to earn a ROE of 20% and a NIM of 5.5% (at that time) and a 3.5% (today).

Additionally, Bruce points out that the banking structure at the upper reaches of the pyramid (that is where WF resides) is completely oligopolistic. WF forms the one of the banks in the quartet- Bank of America, Citigroup and JP Morgan Chase being the other three.

In the next post we will discuss on how Bruce talks about management quality, Warren Buffett’s views and some other accounting techniques and ideas