Transcript: Are Banks A Good Investment?

Published in Investing on 10 April 2012

David Kuo chats to Motley Fool Share Advisor's banking specialist, Nate Weishaar.

You can download or listen to this podcast here.

David:

This is Money Talk, the weekly investing podcast from The Motley Fool. I am David Kuo, and today we are going to use the 'B' word an awful lot in this podcast – I am, of course, referring to banks. So if you want to know whether to dip your toes into banks, or to kick them into touch, please listen on, because here to explain the finer points of investing in banks is Nate Weisshaar, our banking specialist on our Share Advisor newsletter service. Welcome to Money Talk, Nate.

Nate:

Glad to be here.

David:

Well, I'm glad to have you back, because you've been on holiday for a bit, haven't you?

Nate:

Yes, lots of travel back and forth across the Atlantic.

David:

OK, so how does America look at the moment?

Nate:

Surprisingly warm!

David:

As compared to the UK. Well, according to Ben Bernanke, everything seems to be hunky-dory over in America?

Nate:

Things are looking slightly better than I get from over here, but I still wouldn't say they're out of the woods yet.

David:

It's amazing what you can do with a trillion dollars. When you pump that into an economy, something has to happen, doesn't it?

Nate:

You get a pretty good football team off of that.

David:

OK, so we're here to talk about banks, Nate, and I'd like to start at the very beginning by asking you to explain, what is a bank? I know it sounds like a stupid question, but what exactly is a bank?

Nate:

Well, at the most basic level, a bank is an intermediary. They essentially collect money from people who have excess money, and lend it out to people who need money. So savers put their money in this bank, and then companies or individuals who need money will go to the bank to access those funds, so the basic role of a bank is as an intermediary.

David:

It sounds very simple, doesn't it?

Nate:

It should be.

David:

It should be, so why are banks so complicated for people to understand? We have things like retail banks and investment banks – so how do these differ from the kind of banks that you're describing?

Nate:

Well, the basic bank that I was describing is essentially what a retail bank is. Investment banks take things to a different level. They deal with a certain type of saver. They deal mostly in capital markets. This is where companies go to issue debt or issue shares, in order to raise funds or expansion, acquisitions – whatever businesses may have to do, but investment banks don't deal with you and me. They deal with big sums of money, and people who wear much nicer clothes than I do.

David:

Why do retail banks and investment banks feel as though they need to actually sort of come together and complicate matters? Because the way you describe banks, it should be very simple. You have a retail bank that serves people like us, and you also have investment banks that serve companies, and yet somehow they manage to merge these two together to become an even more complicated system – why is that?

Nate:

The bottom line is profits. Retail banking, because it's such a simple business, isn't at its core very profitable. They make a decent profit, but everybody wants more. So investment banking, because it takes on a level of complexity that allows them to charge more for their services, it appeals to the retail bankers as a way of increasing their profits, and for an investment bank, the reason they would want to combine with a retail bank is that investment banking is very cyclical. They work within the business cycle, and so there's a level of stability that's brought to the table by a retail bank. Mortgages are generally a pretty stable business, and there's a relatively steady demand for that. So while the business cycle may be in a lull, lending out car loans, home loans, credit card lending – that'll generally be a little more stable, so if you combine a boring retail bank with the exciting world of high-profit investment banking, you get a more diversified product base, and a little bit more profit for one end, and stability at the other.

David:

Well, I'm glad you mention profits, and what I would like you to do is to try and explain to the listeners how banks make money? So we'll separate the two out: we'll have a look at the retail banks first – how exactly do they make money, and then we'll have a look at investment banks, so let's start with the retail banks.

Nate:

Retail banks, traditionally they operate under the 363 system. They take money from depositors, and pay those depositors 3% on those deposits, and then lend that money out at 6%, and then at 3pm, they go and play golf.

David:

OK, very simple, yes?

Nate:

Yep.

David:

So that's the retail banks, so in theory retail banks should be a fairly stable investment for people like ourselves?

Nate:

Yes – in theory.

David:

So then we overlay that with the investment banks – how do investment banks make their money?

Nate:

Well, they make their money mostly off of commissions and fees associated with the issuing of debt, or issuing of equities. Investment banks, they obviously have a lot of smart people crunching numbers, but they also have a network of connections, so they have access to people with lots of savings. So they cash in on this network, and if company A needs to issue debt, the investment bank takes not only their financial expertise in pricing the debt, which they charge a fee for; they also take their network of savers and say, "hey, we have, company A is going to issue some debt – are you interested in buying it?" So that assures company A that there will be people who want to buy their debt, because there's nothing more embarrassing than trying to sell debt, and not having any takers.

David:

OK, so I mean, that sounds very simple in theory. You have the retail banks, you have the investment banks, and the means by which they make money is also very simple. What went wrong?

Nate:

Well, when things are simple, people can copy you. So in order to continue to protect their profit margins, they had to come up with more and more complex instruments. At the worst of the financial 2006-2007, the very worst of the cycle, they were creating instruments that had no basis for value. They were just, essentially were going to create this piece of paper, and sell it to you for this, and the next person took that piece of paper, which was worth absolutely nothing, and sold it onto somebody else. And so when you push the system to the extreme, you've got, in order to maintain profits, you have people creating things out of nothing, in and of itself alone it's really nothing. Unless there's collateral backing that loan, there is no value to that loan, except for the cash payments back to the bank.

David:

Trust, in other words?

Nate:

Exactly.

David:

Trusting the person that has borrowed money from you is going to carry on repaying that, and during that time you should be able to make more than what you actually lent them?

Nate:

Yep, that's why even the most basic retail bank can make profit, because there's a level of trust there. Not anyone, you can't just walk down the street, and say, hey – lend me this money, and you won't get it. So that's why even the most basic bank model provides a little bit of profit, because there is a reputational value to being seen as a good lender, or someone people would put their money with.

David:

And also, the other point is that you and I can't really just go up to any stranger, and say, lend me £200,000 to go and buy a house. We have to go somewhere, in other words, we have to go to the bank, so again, that model is very simple. So what does it mean, when we are investing in banks? When we put our money into one of the big banks here in the UK, like HSBC or Barclays, or any of the other banks in the UK, what exactly are we doing?

Nate:

Essentially, we are funding the bank's operations. The bank gets money to lend through essentially three places: equity, shares that they issue to you and I; debt – we can also buy that, but mostly that's purchased by institutional investors, and pension funds and insurance companies; and deposits. So when we buy shares in a bank, we are providing a little bit of funding, but we are also buying a piece of that bank's reputation essentially, because, as I said, the only thing that makes the banking system work is that trust. So what we are buying is the trust that management knows what they're doing, that people are writing loans to people who can pay them back, and we're investing in the fact that the business will continue to do what it can do.

David:

As an ongoing concern?

Nate:

Yes.

David:

OK, so I remember looking at an article that I wrote about ten years ago, and at the time there were 11 banks in total. In other words, we put our trust into 11 banks, whereas today we've actually gone from 11 banks to just a handful, and I'm talking about banks like Egg, Northern Rock, Alliance & Leicester – these were banks that we trusted. So why have we actually gone from 11 banks in the UK to just a handful today?

Nate:

In some of those cases, those banks blew themselves up, so that's one reason for a shrinking number of banks. But another is that there is a rational argument for banks consolidating, because if you spread your lending over a broader geography, you're taking on less local risk. To take a very basic example, if a bank in a farming community lends to the six farms that surround that community, there's bad weather that wipes out all of the crops in that surrounding area, that bank is going to go under because all six of its customers have just lost their income. So you ideally, as a bank, want to spread your lending across as broad a footprint as possible, and the fastest way to do that is to buy up the bank from your neighbouring town, because they already have people in place, you don't have to build from the ground up. So that leads to one of the major causes of bank consolidation. A less viable one is the idea that bigger is better in banking, as far as, the biggest people can do everything more efficiently. To a degree, that's true, but as we've seen demonstrated, as you get extra large, the oversight tends to slip, and you also become so large that taxpayers have to bail you out, if something goes wrong.

David:

In other words, you become too big to fail?

Nate:

Well, yes.

David:

OK, so given that we've seen already a tremendous amount of consolidation in the banking sector here in the UK, can you foresee more consolidation? Can you see more of the weaker banks, say in Europe, consolidating?

Nate:

It's always possible. I think regulators at this point would be unwise to allow a whole lot more consolidation. Obviously, when you get too big to fail, it's hard to get too bigger to fail, but the odds that a too-big-to-fail bank has something go wrong with it increase as you go from five to four to three banks. It just is unwise to let things get too concentrated, because then you essentially guarantee the next round of bail outs will have to happen.

David:

Right, OK – so let's keep our fingers crossed that we're not going to get the next round of bailouts, because I don't think governments can actually sort of tolerate another round of bailouts. But let's have a look at banks in detail – how do we go about valuing a bank?

Nate:

Traditionally, when we value companies, we look at cashflows. With banks, it's a little tricky, because everything is cashflow essentially with a bank, cash flowing in and out every day. It's relatively tricky to figure out how to classify what where, but the traditional rule of thumb is to look at the book value – what the reported value of the bank's assets less its liabilities – its book value, so that would be what shareholders have a claim to. The problem there is, you're trusting the bank to accurately report its loan values and its liabilities. Liabilities are a little more reliable, because you've got third-parties that will actually make the claim that they are owed that money, but with the bank's assets, it becomes a bit of a, well, the trust game again. You have to trust that the guy who wrote the loan to company A actually expects all the cash that needs lending out will be paid back, plus interest. We've obviously seen instances, especially in the US, where that wasn't really the case. The sub-prime lending debacle was a clear demonstration that there were people writing loans with no real concern about actually receiving money back.

David:

So in other words, they were lending money to individuals, and saying that I value your house at US$200,000, when in actual fact that house was not really worth US$200,000, but considerably less?

Nate:

It could be that they were valuing the house at $200,000, and perhaps that was accurate, but they were working with no assumption that the cash would be coming back from the borrower. So at that point, banks are not real-estate moguls – they don't want to own houses. They write loans under the expectation they will receive cash back, so they don't want to take houses back. But with the securitisation of loans that has been developed, well now it's essentially frozen, but when you could write a loan to someone, and then sell that loan on to someone else with no recourse to yourself, that really reduces the strength of the underwriting taking place.

David:

OK. What authorities are trying to do now is to make banks more robust. In other words, they try and encourage them, or force them, to hold more capital. Now, we've been hearing an awful lot about these things, like tier one and tier two capital. Can you explain what this actually means in simple terms for people?

Nate:

Well, tier one capital is essentially shareholders' equity. It's the value of the common shares and retained earnings of the bank. It's the very basic claim that shareholders would get. It's really close, not exactly the same, because there are some adjustments, but it's very close to book value.

David:

So in other words, the tier one capital is the money that shareholders put into the bank?

Nate:

Yes.

David:

So what is tier two capital, then?

Nate:

Tier two capital allows some other forms of equity. They're a little less stringent, and some preferred shares would fall under tier two. There's also some dead instruments.

David:

Dead instruments?

Nate:

A bank can issue a note to raise money, and some of them have tricky little covenants that will turn the note automatically into equity in this instance, if the tier one drops below a certain level. But this note, that was once a guaranteed debt note, will now become equity, therefore infusing tier one to make it re-achieve the minimum standard.

David:

So will it address the problem? Will it make banks safer, by increasing the tier one and tier two capital?

Nate:

I personally just pay attention to the tier one. Tier two allows a little bit too much gaming of the system. So tier one – yes, I think if you force a bank to hold higher levels of tier one, it's no guarantee that nothing will ever go wrong, but it provides a break on the exuberance of their lending. So if they have to keep a 9, 10, 11% tier one capital, they know that they can't be issuing gobs of, or taking on gobs of short-term debt in order to grow at 10, 12, 20, 30% a year.

David:

But isn't that what shareholders want?

Nate:

Shareholders should want that from certain companies. I don't think shareholders should ever want that type of growth from a bank, because if an established bank is growing that rapidly, it means they are taking on loans at a rate that I question the quality of that lending.

David:

So what are the implications for banks over the long term? Are they going to be making less profit as a result of this?

Nate:

In general, with higher capital requirements, banks will be making less profit than they were making during the boom years of 2005/2006/2007.

David:

OK. Now then, most people in the past used to find bank accounts – and I'm talking about the bank's financial accounts – very difficult to understand. So in other words, they would try and use those shorthand methods to try and value banks, and they would just simply look at the dividends, because they would say, OK – money goes into a bank, money comes out the other end. What goes on in the middle, I have no idea, and that is really something that the banks have to work out for themselves. But what I do know, as an investor, is that I get dividends. So let's just look at the dividend yield, and say, how much dividends are the banks going to be paying me? Can we still use that technique today?

Nate:

Well, I think with any shortcut, there are significant risks. The big problem with looking at a dividend yield, and judging a share, any share, based on solely the dividend yield, is that you need to be assured that that dividend will keep coming. So if you know that money goes into the bank, and then something happens, and then money comes out of the bank, if that something that happens in the middle goes wrong, the money won't be coming out of the bank, and so the dividend yield will mean nothing. A dividend yield, as traditionally discussed, is backward-looking. It looks at the dividends that have been paid over the past year, and divides those into the share price.

David:

But isn't the dividend a share of the profits that the bank makes, that it's willing to give to the shareholders? So therefore, if a bank makes a profit, the only thing that the shareholder really cares about is the dividend yield itself, isn't it?

Nate:

Yeah, under the assumption that the dividend payout will remain the same regardless of how the bank is operating, but that assumption is not a good one, because if the bank gets in trouble, and it's making bad loans, then some of the profits that it has been booking will no longer exist.

David:

But aren't the bank accounts audited? Don't they have proper auditors to go and look at these banks? So that if the bank were to say, we made x billion pounds' worth of profits this year, of which we will retain x minus a certain amount, and the rest is going to be paid out as dividends, can't we just take that as being true?

Nate:

Well, if backward-looking, yes – you can take that to be true, but there's no guarantee that what they were doing last year is going to be repeated this year, or next year, or the year after that. And so we go back to that trust again – you have to trust that what the bank is doing this year isn't going to come back and bite it in the butt, two years down the road. If they're making loans right now to someone who is in a tenuous situation, even the interest that they're receiving this year is threatened. It's all about the quality of the bank's lending, and that's what you really have to pay attention to, much more so than the dividend yield. It's how fast the loans are growing, the number of loans that are no longer paying. It seems relatively simple, but it's a detail that a lot of people will overlook, in looking just at the dividend yield.

David:

OK, so in your opinion, what are the major threats facing the banks today?

Nate:

The major threats are probably regulators.

David:

The people who are actually trying to make them safer?

Nate:

From a banker's point of view, the threat is that they aren't going to be able to make as much money in the future, and the regulators are pretty determined to make that the case, and I think rightfully so. They were making way too much money in the boom times, and we're now paying the price for that, because they were lending irresponsibly, and taking actions that were not in the good of anyone except for themselves. So yes, from a banker's point of view, regulators are a threat, because higher capital ratios will reduce your profits, and here in the UK, the proposed ring-fencing, it's going to separate retail and investment banking, and it will make investment banking unattractive for several of the smaller banks.

David:

And that is a real threat as well, isn't it, Nate? Because the regulators aren't going to let go here, are they?

Nate:

I don't think so.

David:

So the regulators are going to carry on pushing the banks further and further back, until such time as the banks are going to squeal, aren't they?

Nate:

Well, they seem to be already squealing, but nobody's listening right now, since they're riding the taxpayers.

David:

OK, so we've looked at the threats facing the banks – what about the opportunities? Let's try and sort of look on the bright side, and have a look at what opportunities can banks take advantage of?

Nate:

I think the regulators are also offering up some opportunities. For a bank that realises what's coming, and focuses its business on either investment banking solely, or retail banking solely, the ability to deliver service, I mean, I don't know how many surveys I've read where the banking service gets a terrible rating from customers, so if you're a smaller bank, and you realise that you're no longer going to be able to play in the retail plus investment banking world, and you pick retail banking as your future, if you can deliver a good customer experience, this should be a perfect time for you to take up market share and deliver solid years going forward.

David:

But right at the very top of the podcast, you talked about the 363 rule of banking – in other words, you will pay a saver 3%, you will charge a borrower 6%, which therefore means that your margin is only 3%? A 3% margin is pitiful, isn't it, as far as a bank is concerned? So what rewards are there for shareholders, if all you're going to get is a gross margin of 3%?

Nate:

Well, that 3% is the net interest margin, which, with the leveraging of a bank, which ... leverage is a terrible word, I know, but with fractional lending, leverage is part of the banking world. It is, and we're not going to escape it, but if we keep it around 10%, or I mean 10 times, or in that area of the low teens, it's not unreasonable. We were seeing leverage ratios of 30 and 40 times, but a bank can be operated at a relatively safe level at 10 times leverage.

David:

So does that mean that you see the opportunities outweighing the threats as far as banks are concerned?

Nate:

For some, I think yes – I think there are some that are going to get stuck in the middle, and will not provide much of anything for anybody. But I think the banks that figure out their niche, and can deliver a high-quality product...

David:

You say "nitch", we say niche! So, I guess my final question for you, Nate, is, do you think banks are worth investing in today?

Nate:

I think some.

David:

Would you like to tell us which one?

Nate:

Well, one of the opportunities that I didn't get to is emerging markets, so the banks that have an international presence outside the UK, which is obviously struggling, and is likely to struggle economically for a good period of time. So the banks that have a global footprint would be more interesting to me: HSBC, Standard Chartered, would jump to the top of my list. I think, if you're looking for an investment bank, or a bank that will be playing in the investment banking realm for a long time, Barclays is probably the best bet for a UK-based bank.

David:

But what about those people who are looking at, say, the Royal Bank of Scotland's share price at the moment, and they say, well, the government paid somewhere round about 50 pence for those shares. Today, they're languishing at around 26, 27 pence – surely they're worth a punt? What do you say to these people?

Nate:

It depends how much of a gambler you are. They may achieve 50 pence, but when is still very much up in the air. So they could double, but if they double over the course of 10 years, that's not nearly as attractive as if they double over two. I'm more in the boat towards 10 years than two. The domestic growth is just not strong enough.

David:

It's very anaemic at the moment.

Nate:

And the regulators are actually trying to reverse the consolidation that we were talking about earlier, and they're bringing more banks into the market, so there's going to be more competition. Lloyds had to sell off 600, 700 branches in order to promote this increased competition, and Tesco's rolling out their bank – you're seeing all sorts of competitors enter the market. So I think banks that are focused domestically are going to see some harder times ahead, and that's not just because the UK economy is struggling along. It's going to get tougher, and those 363 margins are probably going to be under pressure, because as more people enter the market, you're not going to be able to lend at three, or borrow at three, because there will be more people competing for those deposits right now, or getting nothing on those deposits, so the bank that offers 1% will see tonnes of money flow in.

David:

And the final question, well this is the final, final question, which is: do you think people should have a bank in their portfolio? Is it essential to have a bank, to have a balanced portfolio?

Nate:

This time, I don't think it is essential. I think you want to have some diversification across industries, but the financial industry is so varied, and right now so troubled, that I don't think you're at a loss, for not having a bank in your portfolio.

David:

OK, so keep your powder dry for now?

Nate:

Yeah.

David:

OK, well that's wonderful. Well, thank you very much for coming in today, Nate. It isn't that far from your desk to the studio, but I know you've actually come back all the way from the States for this podcast, which is very, very sort of gratifying. Now, I have just one more chore, which is to sum up today's podcast with a suitable quote, and today's quote comes from a Hong Kong tycoon called Gordon Wu, who may also be the chairman of Hopewell Holdings in Hong Kong, a big construction company. He said: "Whenever there's a financial crisis, it is always the banks that get hit." And I think he just sums it up very nicely – when the times are good, you actually make quite a lot of money from banks, but when the times are bad, when there's a financial crisis, it's always the banks that get hit.

Nate:

Well, it's usually their fault.

David:

I don't think he said that! Anyway, this is Money Talk, I have been David Kuo, and my guest has been Nate Weisshaar from The Motley Fool Share Advisor newsletter service. If you have a comment about today's show, you can post it on the Money Talk web page, which you can find at fool.co.uk/podcast, and don't forget, you can now follow us on Twitter at @TheMotleyFoolUK. Until next week, have a great week!

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Comments

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ANuvver 11 Apr 2012 , 12:05am

An interesting discussion, for which thanks. I would be interested in opinions, however, on the ignored elephant here - the issue of state ownership in bailed-out banks.

Surely such banks have a hobbled upside, since the government is likely to be a relieved seller at a certain price? I expect, should or as things turn around, there would be much discussion about what the state's get-out price should be. Certainly not lower than buy-in, but inflation adjustment would no doubt be a part of the equation. As would the divisive political issue of the extent to which the state should be an investor on its citizens' behalf.

Since these banks must be scrutinised and regulated to within an inch of their lives, must operate within tough competitive minimal margins and struggle to pay a dividend to shareholders while there remains a substantial government stakeholding - and they have a controversial yet limited price ceiling, what exactly is the case for financing them by investing in them?

ANuvver 11 Apr 2012 , 12:20am

Incidentally, and flagrantly off-topic, re DGE as reported by both Yahoo and Google: has someone instituted global prohibition without telling me?

Hannibalis 11 Apr 2012 , 8:58am

It looks to me as though the UK government is willing to take a loss on the sale of its shareholdings in banks - along the lines of a recent (but uncompleted) deal reported recently in the press involving Middle East buyers. If so, this would potentially hold down the shareprice in future. A better approach may be to invest in the banks' corporate bonds, prefs or other fixed-interest securities (e.g. Halifax 2021 9.375% - yielding nearly 9%)
http://www.the-diy-income-investor.com/2012/03/9-yield.html

ANuvver 11 Apr 2012 , 7:21pm

What an appropriate responder to an "elephant in the room" issue! Like your site, btw.

I'm far from desperate to get into banking investments at the moment. On the financial side, Aviva is about as much rollercoaster fun as my poor heart can take - I'm a big fan of boring... (which certain banks probably should be, but aren't.)

I wonder to what extent fixed-income securities in partly nationalised banks become proxies for bills. Sovs are not an area I'm keen on either - strikes me that even linkers are up the spout at the moment. And I'm not lying awake at night worrying that I may miss out a miraculous banking renaissance! If I do, I shall take it with good grace and congratulate those did.

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