Tragedy of the Commons in M&A

Attached is a piece on the tragedy of the commons in banking. It refers to a chain reaction (AKA herding?) in which the action of one bank triggers reactions from other banks leading to a dangerous race to the bottom in risk standards. It underlies the boom and bust cycles in many deal markets including M&A. As Ralph has noted in his anticipation article, once one competitor starts buying firms, others in the industry react. Early buyers tend to get better prices than late in the cycle buyers. Nonetheless, late in the cycle buyers are under pressure to “do something” so as not to be left behind. Hence they make over priced acquisitions. The key takeaway is firms do not operate in a vacuum and are influenced, sometimes negatively, to respond to competitor actions.

j

Bank M&A: He Who Hesitates Is Lost

Attached is a recent American Banker article. The idea is that M&A waves follow major legislative changes which change the rules of competition. The current changes, similar to those in the 1990s, have or will trigger consolidation waves, which is particularly well suited to M&A. Yet, bank M&A remains modest. One of the reasons for the weak volume is many bankers still believe M&A is a mug’s game. The problem with assuming all M&A is bad is it assumes managers are either stupid or under some collective behavioral cloud.

I admit I used to believe that as well. Ralph's Paper on the possible miss measurement of M&A gains forced me to re examine my position. Once the anticipation effects before the bid announcement are included, M&A starts to look better. Illustrating again that business men are sometimes smarter than academics believe, Ralph excluded.

The other aspect is over caution regarding a possible over priced deal has competitive consequences. Banking is undergoing a metamorphous. Banks refusing to participate will suffer. There will be no second place prizes.

j

Banking 2.0: Disrupting the Industry

Community banking has been called into question again. I agree there are far too many small banks. Of the 6700 banks over 2000 have less than $100MM in assets. Additionally, hundreds of small banks failed or were merged during the financial crisis. Nonetheless, community banking, if not community banks, has a bright future. Changing technology promises to upend the branch orientated delivery-there are over 85,000 domestic branches. The technology will supplant the branch system in ways not yet fully understood.

This disruption will cause a massive change in strategies. Institutions, both bank and non bank will struggle to adjust. Those adapting will probably divest branch networks and acquire new technology and consolidate thru mergers to succeed. See Community Banks recently published in the American Banker for a discussion.

Happy New Year.

J

Risk Based Capital: The Good, Bad and Mostly Ugly

The Basel capital framework categorizes assets by risk level. Safer assets receive lower risk weights than higher risk assets. The sum of the weighted or adjusted assets is then compared to existing capital to determine capital adequacy. Supporters believe risk based capital (RBC) is a superior measure of bank strength compared to non risk adjusted accounting based measures like the leverage ratio. Unfortunately, the facts do not support this belief Hogan,etal.

The flaws plaguing RBC are well known Hoenig and Admati and Hellwig Chapter 11. The weights are far from scientific. They are heavily influenced by politics and tradition. The more serious problem, however, is their mechanical attachment to history based on the use of flawed Value at Risk methodology, which confuses history with science. If the future deviates from history, then the resulting risk weights are incorrect. For example, using 25 years of pre crisis data from the “Great Moderation” presents a misleadingly low level of mortgage risk. It is like meteorologists without knowledge of storms trying to forecast long term weather.

Next, RBC fails to recognize that banks do not passively accept regulation-they react to it by adapting their behavior. They will engage in regulatory arbitrage to shrink their capital requirements without trimming actual risk by inappropriately risk weighting assets. This is made easy by RBC reliance on bank internal risk models to set lower risk weights. This flexibility allows banks to have vastly different risk weights for the same assets. The gaming of results leads to risk weighted assets (RWA) to total asset ratios of less than 60% at many large banks. Furthermore, the ratio is falling as total assets continue to grow faster than RWA. This opacity underlies investor mistrust of big bank balance sheets. No wonder many of them trade at discounts to their breakup values.

The problem will worsen under Basel III’s new higher nominal capital requirements for RWA. The higher capital standards increase the incentive to manipulate models to reduce RWA. The lower RWA only appears to make risk disappear while actually creating stealth leverage. The London Whale situation in which the models and inputs were changed to fit the desired low risk weights may be just the start of this development.

Risk standards should be objective, forward looking and do no harm. RBC fails on all accounts. Worse than ineffectual, RBC serves to increase systemic risk. It causes herding into portfolio concentrations of incorrectly classified low weighted assets. Next, it breeds over- confidence and a false sense of security by substituting models for judgment. The biggest risks faced are those believed to be mistakenly under control. Finally, RBC is pro cyclical. Thus, banks appear well capitalized in calm periods. Consequently, they are encouraged to return capital via dividends and share repurchases just as they did in 2007 and 2008 leaving them undercapitalized during the crisis.

The conceit of RBC is it assumes regulators relying on bank models and inputs can predict risk. In reality, the future is uncertain. Substituting a probability distribution for uncertainty does not make us safer. Instead it can cause a risk misdiagnosis leading to the acceptance of low probability high impact adverse events-black swans-which become evident during a crisis. Probabilities are of limited use when dealing with black swans. A 1% chance of failure does not mean that 99% of the bank survives if it occurs. Prudence trumps prediction when dealing with black swans. RBC models capture only particular risks. Consequently, they are inferior to less elegant, but more practical simple measures like the leverage test that can serve as an early warning indicator. Thus, the preferred approach is to abandon an over reliance on RBC. Instead, use RBC only as a supplement to a meaningful leverage test, not the inadequate 3% leverage ratio proposed by Basel III. These actions combined with traditional judgment based safety and soundness supervision would present a more accurate measure of capital adequacy.

RBC has a weak empirical foundation which was exposed by the financial crisis. Its supporters need to keep an open mind and address this ugly fact, recognizing that no map is better than a wrong map. Only then can we prevent RWA from standing for Really Wrong Answers.

J

No Do-Over's in M&A

Both Ralph and I have highlighted the perils of bad acquisitions and bad governance. Bad acquisitions share common characteristics including:

1)     Over Priced: reflected in high purchase price premiums and substantial goodwill and earnings per share (EPS) dilution. This is especially true for winning bidders in an auction (AKA the winner’s curse).

2)     Large Transformational Transactions: trophy deals driven by delusional CEOs with weak Board oversight.

3)     Serial Acquisition Program: some initial success breeds hubris. Eventually a “bump-in-the-road” exposes the real risk.

4)     Stock Used to Fund the Transaction

5)     Occurs Later in the M&A Cycle

A near perfect example of bad acquisitions is First Niagara (FN) an acquisitive rapidly growing Buffalo, NY community bank. They replaced their CEO, Koelmel, in mid March. He had embarked upon a serial acquisition program including 4 acquisitions in 3 years upon becoming CEO in 2006. FN grew from $10B to over $35B in assets during his tenure. Unfortunately, his growth for growth’s sake strategy proved disastrous for shareholders. The stock peaked at $15 per share in February, 2011 before falling to its current $8.50 level. During this same period the KBW Bank index rose by over 30%.You know it is bad when your stock increases 4% upon your CEO’s resignation. The stock is trading at 67% of its book value with an equally depressed price-to-earnings ratio.

Koelmels’s first few smaller acquisitions were moderately successful. They occurred during the peak of the 2008/2009 crisis and were attractively priced. Confusing luck with skill, he met his Waterloo with the mid 2011 $1B+ purchase of HSBC’s $10B+ in deposits with 195 branches up state NY franchise. The premium paid for the deposits was 6.67% compared to the expected 3.5-4 % range. Koelmel felt the premium was required to beat the much larger $85B in asset rival Key Bank who was also a bidder. The premium created significant goodwill and depleted FN’s regulatory capital.

Subsequently, FN sold 37 branches to Key Bank to satisfy antitrust concerns. Key paid only a 4.5% premium and turned out to be the real winner. As luck would have it, the market worsened after the announcement due to the beginning of the Euro crisis during the summer of 2011.This caused a substantial decline in operating performance. FN failed to obtain committed financing and decided to postpone a needed equity raise until May, 2012 when the deal eventually closed. Its stock price collapsed during that period resulting in a highly dilutive $467MM common stock raise at a 30% discount to the prior year price. They additionally raised $350MM in preferred stock with an 8.625 dividend rate compared to an expected 6-7% rate.

Integration problems compounded weak operating performance resulting in losses. Their dividend was cut for the first time.Koelmel’s credibility with investors and the Board was shattered and he had to go. He walked away with a $5MM+ severance package after nearly destroying FN in his vain attempt to become the 21^st century version of Hugh McColl who created the modern Bank of America through acquisitions in the late 20^th century.

Unfortunately for shareholders there are no “do-over” in M&A.Thus, it is critical that Boards have the strength to say “no-do” to strong CEOs before they embark on ill-fated acquisitions.

j

Increase Bank Dividends? Not So Fast

In a recent article published in the American Banker, I take a skeptical view of the practice of many banks that are currently seeking to return capital to shareholders via dividends and share repurchases.  

Although it was unthinkable a few years ago, some bankers and pundits believe banks have excess capital that should be returned to shareholders through dividends and stock repurchases. Banks have rebuilt capital positions from their depressed crisis levels largely through improved earnings from reduced credit costs. Lackluster returns on equity, limited investment opportunities and crisis-related curtailed payouts have raised the call for the return of perceived excess capital to improve ROE. ..... "   See the complete article at:  American Banker

J 

Herding Cats - Bank Governance

A recurrent theme in this blog is the need for strong governance from the Board of Directors in the acquisition process. The banking industry has suffered from poor governance for years. Directors are chosen by senior management and are more like puppy dogs than guard dogs. That is one of the reasons why bank stocks, big banks in particular, lag in valuation post crisis. Their balance sheets are opaque and difficult to understand from the outside. If regulators cannot figure it out, then investors do not have a chance. In banking, you never have excess capital for too long. The question is how they will lose it-bad loans or bad acquisitions, and sometimes it is both e.g. Citi. One of the best ways to increase bank value is through better governance and transparency - just what the regulators want and just what shareholder need.  Barbara Rehm makes this point in an interesting article in yesterday's American Banker: Big Banks Flunk OCC Risk Tests.

Joe