Friday, September 24, 2010

Bove: The Government's Killing Small Banks

Intelligent Investing
Alexandra Zendrian, 09.24.10, 1:00 PM ET

Before Richard Bove, senior vice president of equity research at Rochdale Securities, sat down with Steve Forbes to discuss the banks that have raided their loan loss reserves, Bove took the pulse of the banking industry for me.

Alexandra Zendrian, Forbes: How do you see the top banks doing overall right now?

Bove: It's clear that they're struggling. A look at the core factors that drive the core earnings of the banks certainly indicates a couple of quarters that things aren't moving in a positive direction. In other words, their earnings assets, which would be their loans and their security holdings, are not going up, they're going down. Their net interest margin, which would reflect the impact of interest rates on their businesses, also going down because they cannot cut their cost of liabilities anymore even as their asset yields are declining.

Non-interest income, which is being impacted by all of this Dodd-Frank bill, is also going down. The only thing that's going up is their expenses. They're doing an extraordinarily poor job in both controlling their both their compensation expenses and their noncompensation expenses. So if you take a look at their earnings just based upon the core, they're going down. In the quarter that just came out, where the FDIC trumpeted as showing how improved the bank situation is, in my view bank earnings went down 6.5%.

What's causing the earnings to go up on a reported basis, even though on a core basis they're declining, and the reason is because they're lowering their loan loss provisions. Why are they doing that? Because they're taking money out of the reserves and putting it into earnings. They reduce their reserves during the quarter, all the FDIC insured banks basically took close to $12 billion out of the reserves and they reduced their loan loss provision by $11 billion and that was why they got an increase in earnings. There was no increase in earnings whatsoever based upon their normal operating activities. There was a huge increase in earnings as a result of the reduction of their reserves.

What impact will the limits on proprietary trading have?

The trading sector is doing particularly poorly right now and there's a seasonal, secular and cyclical reason for it. The seasonal reason is, of course, it's the summer. The cyclical reason is that the economy's slowing down, the markets are not performing particularly well. The secular reason is because certain fixed income products don't trade anymore. You don't have all the activity that one existed in structured financial products because nobody wants to buy them. The trading sector on handling transactions for others is not doing well. Most of the big banks have been cutting back their proprietary trading for about 18 months now. They started doing it when the financial crisis hit at the end of 2008 and they've continued to do it. I don't think that proprietary trading is as big a deal as it's touted to be.

There was the recent Securities and Exchange Commission settlement with Goldman Sachs. What do you think of Goldman Sachs now, and do you anticipate any future similar cases?

I think Goldman Sachs is going to be in courts for years. I think there are all sorts of lawsuits being introduced against Goldman Sachs and the legal business servicing Goldman Sachs is a growth industry. So I don't think Goldman Sachs will be out of the woods from the legal standpoint for quite some time.

I think the bigger question is whether there's been a structural change in their business which is going to make it more difficult for Goldman Sachs to make money in the future as it did in the past, and I don't believe there has been. The company makes money because it has trading systems which I believe are the best in the world, and I think that it has a very strong position in the equity portion of the industry which is our most unassailable. They basically have a very strong IPO business, a very strong merger and acquisition business. But the key reason that the company is not likely to see a substantial reduction in this is money supply keeps growing. The world money supply does not shrink. Money supply creates financial instruments and financial instruments are what Goldman Sachs trades.

There was an article a few days ago concerning that there were $4 trillion being traded every day in currencies. That shouldn't be surprising because the size of the market continues to grow. If we're right, the convertible currencies market is $40 trillion in size and it grows at 6% to 8% a year. The same thing will happen with the bond markets, government debt markets, equity markets. There's just too much money around to just assume that trading activity has been hurt for the longer term.

So could the case against Goldman Sachs happen to another firm?

Yeah, certainly I think it could. I don't think it will if the SEC really understands what's happening in the markets at the present time. I think that the United States government has convinced investors that the market is a place to avoid. Whether it's the president, whether it's Congress, whether it's the regulators, statements proliferated during this debate on this banking bill that's basically argued that people on Wall Street are corrupt, the products that they create are fraudulent, that the markets are not operating in a fair and even fashion.

When you have the president on down making these statements, it's pretty hard for the guy sitting in his living room saying, "I really want to put money in the stock market because I really believe in America and I believe in our financial system and I believe in where we're going as a country." Since there is no belief of that nature and since the government has gone out of its way saying that the markets are fraudulent, they passed this big bill in addition of all of their verbalizing that the markets aren't safe, people pulled their money out, which they should have done.

And the fact of the matter is, now you have the markets controlled by a very small number of traders, and this order-stuffing issue is overwhelming. According to the press reports, on one day there were 89 billion orders to buy and sell stock and one-and-a-half billion traded, which suggests that the market is being manipulated and controlled--and why should people get involved?

How do the community banks generally look to you?

It looks as if the government is driving them out of business, and the reason I say that is because in the Dodd-Frank bill, there's something called the Collins amendment, which was introduced by the senator from Maine, and basically this amendment disallowed the use of a type of security called a trust preferred. Now the trust preferred is a hybrid security, and I agree that it shouldn't have been allowed in the first place, but the fact is it was allowed, and it's been used aggressively for 20 years. It's become the primary source of funding for small banks in the United States. So now they're being told that they can't use it any longer and as a result, as these trust preferreds mature, these small banks are going to be forced to go out and find something to replace them.

At the same time as they're going to try to replace the capital, which is maturing, they're being told to increase the amount of capital they hold as a percentage of assets. So they've got two demands from the government, which is to get more capital and to stop using the primary instrument for getting capital, the result of which is they're going to go out of business. What you can see if you look, I said that there are roughly 7,900 banks in the United States, the number drops at an incredible rate every quarter.

We lose one bank every day, and that's been true for over 25 years, which means that we've lost over 7,000 banks. And that has not stopped; it's accelerating. So the net effect is we have this cross purposes type of legislation. On one hand, we've got the government demanding that the too big to fail issue go away. And on the other hand, they're forcing the small banks out of business, increasing the concentration of assets in the big banks.