Wells Fargo’s CFO Reacts to Dodd-Frank Act

In an interview with CNBC this morning, Wells Fargo CFO Howard Atkins comments on the Dodd-Frank Act which President Obama signed into law this morning.  Mr. Atkins focused on the consumer protection aspects of the law and was asked whether Wells Fargo should be considered “too big to fail”.  For a news story from The Wall Street Journal on the signing of the Dodd-Frank Act, click on this link.

For RSS Feed Subscribers, please click on this link for the video.

Disclosure:  No position in Wells Fargo.

Kansas City Fed President Hoenig Offers Alternative to “Too Big to Fail”

Over the past year, the notion that certain large financial institutions are “too big to fail” has become the conventional wisdom on Wall Street and in Washington.  Starting with the Bear Stearns rescue over a year ago, the Federal Government has taken various measures to deal with systemic risks to the financial system.  Many of these initiatives are now very unpopular and are seen as providing aid to companies and individuals who “rolled the dice” and should have to suffer the economic consequence of their bad decisions.

At a time when most government officials in the executive branch and at the Federal Reserve continue to support the “bail out” approach, Thomas M. Hoenig, President of the Kansas City Federal Reserve bank and a voting member of the Federal Open Market Committee, has put forward an alternative prescription to deal with the troubled financial system.  The text of Mr. Hoenig’s recent testimony before the Joint Economic Committee of the United States Congress requires close attention.

Success Depends on Failure

The central argument that Hoenig makes in his Congressional testimony as well as in the text of a speech given earlier this month at the Tulsa Chamber of Commerce is that failure must be an option even for systemically important financial institutions.  If failure is not an option for large firms and the shareholders, creditors, and management of financial institutions realize this, all kinds of perverse incentives will exist to take on unwise risks knowing that negative consequences will be mitigated.  Incentives will exist for marginal firms to attempt to expand to the point where they are in fact “too big to fail”:

… If any bank is examined and found to be insolvent, it needs to go through the resolution process with the owners losing their investment. However, the eventual outcomes for the institution can be different. A smaller bank’s assets and deposits will likely be sold to another bank. In the case of a larger bank, the firm might be temporarily operated as a bridge bank before either being sold or reprivatized. Regardless, it is important that the banks go through the same process or else an incentive will be created for banks to take on excessive risks in an effort to grow large enough to gain favorable treatment.

The key point that Hoenig makes throughout the text of his speech is that financial institutions, both small and large, need to be subjected to the same tests of solvency and that there must be a consistent definition of what it means for the bank to have “failed”.  Hoenig acknowledges that the resolution for large systemically important institutions might well be different from the resolution used to deal with smaller failures.  However, the principle that shareholders should be wiped out and the management and board of directors replaced should apply to failed institutions regardless of size.  Hoenig goes into some detail regarding the methods that could be used to resolve larger institutions citing the example of Continental Illinois in the 1980s and the Swedish response to a banking crisis in the early 1990s.

Bailouts Doomed to Fail

It is important to avoid creating moral hazard when resolving a failed institution.  If management is allowed to continue running the company and shareholders are insulated from the consequences of the failure, Hoenig believes that there is no reason to expect different outcomes in the future.  While acknowledging the pressures facing public officials at the outset of the crisis, he is very critical of the steps that have been taken over the past year and the failure to create a more consistent plan of action:

When the crisis began to unfold last year, and its full depth was not yet clear, we were quick to pump substantial liquidity into the system. In the world we find today, with the crisis continuing and hundreds of thousands of Americans losing their jobs every month, it remains tempting to pour additional funds into these institutions in hopes of a turnaround. We have taken these steps instead of defining a consistent plan or addressing the core issue of how to deal with these institutions that now block our path to recovery. Our actions so far risk prolonging the crisis while increasing the cost and raising serious questions about how we eventually unwind these programs without creating another financial crisis as bad or worse than the one we currently face.

When Hoenig states that another crisis as bad or worse than the current one could result from programs such as TARP, this is primarily due to the incentives the programs are creating for managements and for shareholders of the bailed out institutions.  It is naive to think that individuals will believe that the current policy is “one time only” and that future bail outs will not occur.  In fact, they will most likely believe exactly the opposite.  Hoenig notes that 46 smaller banks have failed in the United States since the beginning of 2008 and have been resolved through the process he recommends.

Principles for a Resolution Framework

In attachments to his Congressional testimony, Hoenig presents details of the proposed resolution framework.  In the section related to the principles of the resolution framework, he stresses the need for a free market system that requires business owners to capture the profits from successes and bear the cost of failure.  He also notes the need to have a transparent set of rules for addressing how a failed institutions will be resolved so that all market participants know in advance the steps that will be taken if necessary.

Two main principles for the resolution process should be to minimize the costs to the overall economy and to be equitable in the treatment of all financial firms regardless of size or location.  He goes into more detail regarding the specific prescription for a resolution process to be used with larger firms.  Much of this is modeled after the Continental Illinois and Swedish banking cases mentioned previously.

At a time when everyone is waiting to review the details of the government’s stress test methodology and public outrage over bailouts continues to grow, it is more important than ever to step back and consider whether the premise behind the current policy holds up to scrutiny.  As I wrote recently, shareholders of Wells Fargo and other banks will be waiting to see if regulators demand measures that will dilute current shareholders.  Hopefully the issues raised by Thomas Hoenig are being actively considered at the Treasury and Federal Reserve as the stress testing criteria are finalized.

Warren Buffett’s Comments on Wells Fargo Have Important Stress Test Implications

The financial markets appear to be on edge this week ahead of the government’s release of the methodology for “stress testing” the top banks which is set to be issued on Friday, April 24.  Much of the attention has centered on the levels of tangible common equity held by banks and the protection implied by Tier 1 capital ratios.  If government regulators regard the Tier 1 capital ratio of a “stress tested” bank to be insufficient, it is possible that banks will be forced to raise equity capital during a period of low share prices causing potentially serious dilution for current shareholders.

“Banking is a very good business unless you do dumb things”

In an interview today, Warren Buffett was asked about a number of topics related to the banking system in general, and regarding Wells Fargo in particular.  Berkshire Hathaway is the largest shareholder of Wells Fargo and Buffett has made positive comments about the company in the past, going so far as to make what I believe was a rare buy recommendation in early March very close to the low point for Wells Fargo and the overall market.

The entire interview is worth reading but what I found particularly interesting had to do with Buffett’s comments on tangible common equity given the upcoming banking stress tests:

You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that’s where people get all mixed up incidentally on things like the TARP. They say, ‘Well, where’d the 5 billion go or where’d the 10 billion go that was put in?’ That isn’t what you make money on. You make money on that deposit base of $800 billion that they’ve got now. And that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they’ll put out the money differently.

Essentially, Buffett is making the case that asset quality is the key criteria rather than the level of tangible common equity.  With Wells Fargo, he appears to believe that asset quality is good enough to provide a comfortable margin over the cost of funds even once provisions for loan losses are taken into account.  However, from a regulatory perspective he notes that there are difficulties due to the wide variation in asset quality and the difficulty of regulators discerning such factors.  Buffett had the following to say when asked for his metric for evaluating a bank:

It’s earnings on assets, as long as they’re being achieved in a conservative way. But you can’t say earnings on assets, because you’ll get some guy who’s taking all kinds of risks and will look terrific for a while. And you can have off-balance sheet stuff that contributes to earnings but doesn’t show up in the assets denominator. So it has to be an intelligent view of the quality of the earnings on assets as well as the quantity of the earnings on assets. But if you’re doing it in a sound way, that’s what I look at.

Risks of New Capital Requirements

It appears clear that much of the risk concerning investors in bank stocks today is that the regulatory requirements imposed by the stress tests will require new capital.  On this topic, Buffett had some comments that apply specifically to Wells Fargo but also should be considered by regulators when coming up with the overall stress test methodology:

But if you make them sell a lot of common equity it would kill the common shareholder. It wouldn’t increase the earning power in the future, and it would increase the shares outstanding. Wells, if they want another $10 billion in common equity or something like that in Wells, they’ll have it in a very short period of time at this dividend rate. [In March, Wells cut its dividend by 85%.] Wells will be piling up the equity while they’re paying nominal dividends. They could afford to pay the old dividend. But since they won’t be paying the old dividend, that’s $4 billion a year or something that they’ll be adding to equity.

Buffett is making the case that even if regulators determine that Wells Fargo requires additional equity, they should be allowed to earn their way to the desired level.  The dividend cut alone should allow Wells Fargo to substantially increase equity levels without issuing common equity at the cost of serious dilution to current shareholders.

Although most of Buffett’s comments in the interview were specific to Wells Fargo, regulators should think carefully before imposing requirements that punish existing shareholders if it appears that the bank in question is reporting quality earnings that will allow equity to rise to higher levels within a reasonable timeframe.  Of course, the difficulty for regulators will be to determine exactly how to evaluate the quality of assets and the level of risk implicit in a bank’s portfolio of loans.  Wells Fargo may be in a good position if one accepts Buffett’s evaluation but this is not the case in general.

One thing is for certain:  Investors will be looking for the stress test methodology on Friday to shed some light on the serious concerns related to dilution that are weighing heavily on this market.

Disclosure:  The author does not own shares of Wells Fargo directly, but owns an indirect interest in Wells Fargo through ownership of Berkshire Hathaway shares.