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Vol. I, No. 25

TOM BROWN’S
BANKING WEEKLY: 12/9/16
Financial Services Insight and Intelligence


FIRST WORD:
Will the regulatory abuse of Wells Fargo never end? Not quite yet, it seems. Reuters reported on Wednesday that the OCC is, out of the blue, set to downgrade Wells’s CRA rating from “Outstanding” to “Needs to Improve.” What an extraordinary, and ridiculous, development that would be.  For perspective, fewer than 10% of banks receive an “Outstanding” rating, and an even smaller number ever get the two-notch downgrade that Reuters says the OCC has in mind for Wells. The move will have a tangible effect on the company’s business. Wells won’t be able to make any bank acquisitions (which it wouldn’t likely do anyway) or open new branches (which might affect the company’s franchise in growth markets).

The OCC’s unusual move will come, recall, after its seemingly arbitrary decision last month to restrict Wells’s ability to name new directors or add new members to its senior management. All this abuse is happening, as far as I can tell, because the OCC and its head, Tom Curry, were embarrassed that they were blindsided by the Wells phony-accounts scandal. Now they’re getting even. It is an amazing overreaction.

Don’t forget, and regardless of what you think about the phony-account situation, the sum total of the damage to customers was less than $3 million. That’s with an “m.”  Customers have all been made whole. For this, the company paid a fine of $185 million. To put that in perspective, after First Niagara agreed to refund $22 million for improper overdraft fees it charged its customers, the company was fined just $2 million!

Wells Fargo is suffering regulatory abuse by the OCC, plain and simple. The agency was embarrassed that the company and other regulators uncovered the problems at Wells while the OCC remained clueless. Since the phony-account settlement became public, the OCC’s regulatory war against Wells has been ceaseless, in what’s been an incredible abuse of power.  I blame it all on Tom Curry who (of course) has never worked in the private sector in his life.

I had lunch this week with the chairman of one of ten country’s largest banks. This was before the Reuters story on the Wells Fargo CRA downgrade came out. He told me Curry was going nuts at the OCC, and that senior people inside the agency were leaving in disgust.  I can understand why.

FUELLING THE TRUMP BUMP: Over $49 billion flowed into equity ETFs in November, CNBC reports, the largest monthly inflow on record.  “[T]he post-election fervor has certainly made U.S.-based fund flows great again,” State Street Global Advisors said in a statement. Clever!

THE EXPECTATIONS GAME: Let the Great Bank Earnings-Estimate Raising begin! On Tuesday, bank analysts at Barclays, among the most capable on Wall Street in my view, raised their 2017 earnings estimates for the 26 banks they cover by an average of 7%, on account of rising interest rates and (if I’m reading their report right) “expectations for regulatory relief, corporate tax rate reductions, and faster [expected] loan growth.” Very sensible! Additional reactions by me: a) a 7% average estimate increase is a lot, no?  I remember when I worked on the sell side having my enthusiasm constantly reined in by supervisory analysts who preferred not to see my more exuberant projections make it into print. One thus might wonder whether that 7% average estimate hike is perhaps at the low end of what the Barclays people have in mind; b) We’re still a long way from being able to quantify the effect of “regulatory relief, corporate tax rate reductions, and faster loan growth,” so these estimate increases are, understandably, more hunches than formal, tallied-up estimates. Nothing the matter with that—-but another reason to think that they might end up being a tad conservative. More generally, it seems likely we’re headed into a period when earnings expectations for banks will be uncommonly fluid, and subject to steady upward pressure.

DENOMINATOR UNCERTAINTY: One more note on banks’ 2017 earnings (and 2017 earnings in general, for that matter): if estimates are in for  materially higher revision in coming months, then the rich stock valuations everyone lately seems to be complaining about may not end up being so rich, after all.

PRODUCTIVITY UNTETHERED: And here I thought productivity growth has been lagging because companies are sitting on their cash rather than investing in return-boosting capital projects. Silly me! It turns out Twitter and Snapchat are the problem:

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In 2015 for the first time, according to Kleiner Perkins, over half of users’ access to the internet occurred via mobile devices. That apparently works out to (Warning!: the following data point will make your head hurt) 2.8 hours per day of mobile users doing whatever it is they do online rather than sitting at their workstations keeping the wheels of commerce moving. It’s a wonder productivity hasn’t fallen by more.

HIGHER RATES, FEWER REFIS: Here’s one reason why higher interest tend to stunt economic growth, in a single chart. The 49-basis-point rise in mortgage rates that’s happened since the election means that the number of mortgages outstanding that can be profitably refinanced has fallen to 4 million from 8.3 million, says Black Knight Financial Services.

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A FITTING SENDOFF: It’s impossible not to savor the irony of the fact that the vehicle carrying Fidel Castro’s ashes broke down en route to the cemetery where El Jefe  was to be laid to rest.

NO CHARTERS FOR FINTECHS: The logic behind the OCC’s decision to grant banking charters to online lenders and other fintech companies eludes me entirely. Lofty expectations for them aside, as far as I can tell, the only innovation the fintechs have come up with is their development of a new, low-cost methodology for creating defaulted borrowers. Providing the companies with the imprimatur a banking license provides—and, heaven help us, maybe federal deposit insurance down the road—won’t do much to help credit creation and will, at the margin, make the banking system slightly less sound.

WHY GROWTH HAS STALLED: Gallup’s analysis of the long-term decline in U.S. productivity growth, which it published this week in conjunction with the U.S. Council on Competitiveness, is as close to being a page-turner as these sorts of documents get. Quick summary: GDP growth per capita in the U.S. has basically been at a standstill since 1999 on account of roaring inflation and zero productivity growth in three sectors in particular, education, health care, and housing. All three, you will notice, are highly regulated at one level of government or another. And productivity in all three can be jumpstarted easily enough if the government simply decided to do away with some of the more idiotic regulations it has imposed. If you doubt it, compare land use restrictions (and home prices) in California to those in, say, Tennessee. In theory regulatory rollback shouldn’t be tough to carry out but, political realities being what they are, it probably will be.

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KEY METRIC HEADED THE WRONG WAY: Related to the above: life expectancy in the U.S. dropped last year for the first time since 1993.

HOME FLIPS STILL HAPPENING: Home prices have recovered by so much from their lows that I’d assumed that the economics of house-flipping—that is, the purchase and resale of a house within a twelve-month period—were generally no longer viable. It turns out that’s wrong. Rather, flipping is still going on at a much higher rate than it did before the onset of the housing bubble 15 years ago. The difference now though, MarketWatch says, is that while the action early on was in the markets that were hardest hit by the housing crash, like Phoenix and Miami, now the best trades are in less flashy cities like Rochester, N.Y. Possible indicator the game may soon be up at last: Earlier this week Blackstone filed for an IPO of its home-rental unit, Invitation Homes.

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RETAIL BROKERAGE FOLLIES: Some bad ideas never seem to die. Like this one: Bank of America says it will trim the pay of Merrill Lynch brokers who fail to make at least two client referrals to other parts of BofA per month. Among financial-services cross-sell mavens, this strategy is an evergreen—except that it never seems to work. When I was at DLJ many years ago, the investment bankers were under constant pressure to refer the wealth management business of corporate clients’ top executives to DLJ brokers. The bankers would then move heaven and earth to resist. I can’t say as I blame ‘em. They’d spent years cultivating what were often very lucrative relationships with those executives, after all, and weren’t about to let some anonymous retail broker screw things up by providing lousy service or half-baked investment advice. The same calculation is surely going through Merrill’s brokers’ minds now. More than a few will surely prefer to take a pay cut rather than fork over their gold-plated referrals. P.S. If Merrill persists in this folly, look for an uptick in broker defections.  P.P.S. This doesn’t seem like the best time to be pushing cross-sell in the first place, right?

WRONG AGAIN: Donald Trump’s surprise election caught Wall Street analysts flat-footed along with the rest of us. Since election night, the companies that are least popular with analysts—that is, the ones with lowest percentage of “buy” recommendations within their sell-side coverage–are up by 6.5%, on average, according to Bespoke Investment Group, while analysts’ favorites, companies with the highest percentage of “buy” recommendations, are up by just 1.7%.

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CHEWING THROUGH CASH: Here’s a sentence it never occurred to me I’d ever write: in 2015, the last year for which data is available, UK consumers chewed or ate around £120,000 worth of British currency. Bloomberg, which provided the information, doesn’t explain why anyone would want to eat money, or why the Bank of England keeps track of this sort of thing, but notes instead that the BoE’s plan to introduce a new polymer 5-pound note, which is said to contain traces of animal fat, apparently has the UK’s vegetarian cash-eating community in an uproar. I have nothing to add.

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CONTRARIAN-INVESTING UPDATE: I am of course a sucker for back-of-the-envelope market predictors, so kindly humor me regarding this next item. BofA Merrill Lynch’s “Sell-Side Consensus Indicator” puts sell-side strategists’ average recommended equity allocation at a mere 51.5% vs a traditional benchmark allocation in the low 60s. But from a contrarian-investing standpoint, bearish is bullish, remember? “Historically, when our indicator has been this low or lower, total returns over the subsequent 12 months have been positive 97% of the time, with median 12-month returns of +25%,” the firm writes.

2016-12-09-bofa-merril-lynch-sell-side-consensus-indicator

The BOAML indicator doesn’t likely offer the same predictive certainty as, say, Newtonian physics, I’ll grant you, but it’s encouraging, just the same.

TO BUY OR NOT TO BUY: Bank stock rallies like the one going on now often lead to stepped-up M&A activity, as CEOs see their plumped-up stocks as an attractive currency with which to go out and do deals. But maybe not this time, says SunTrust CEO Bill Rogers. With interest rates rising and regulation set to ease, the fundamental outlook for banks is a whole lot better than it seemed just a few weeks ago. So why not just run the business? The new environment “gives everybody more capacity within their own company,” he tells CNBC. I see his logic entirely.

POST-ELECTION HOUSING SWITCHEROO: Republicans and Democrats really do live in different realities. Prior to the election, when Hillary Clinton was the overwhelming favorite, Republicans polled said they expected that 2017 would generally be a bad time to buy or rent a home or get a mortgage, while Democrats thought it would be a good time. Then after the election, Republicans said that, on second thought, 2017 would be a good time to buy or rent or get a mortgage, while Democrats said that no, it would actually be a bad time. Both sides presumably understood the economic implications of each party’s political platform, and would of course be participating in the same housing market and borrowing environment. The only thing I can think of that would explain their changes of heart was simply a shift in their moods. What a world.

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NEW YORK REAL ESTATE NEWS: Manhattan’s luxury residential market is apparently still soft. The 8,055-square-foot penthouse at the super-high-rise that just went up at 432 Park Avenue closed recently for $60.9 million. It was originally offered at $75.6 million.

OFFICE VACANCIES ELEVATED: It’s well-known that online retailers are remorselessly eating the lunches of traditional merchants, to the point that, since the end of the recession, retail vacancy rates haven’t recovered the way they typically do. Fine. We get it. The Searses of the world are doomed. But in a post last June under the catchy headline “The Coming Commercial Real Estate Bust,” fixed-income analyst Alan Gula notes that, like retail, office vacancy rates haven’t fallen much since the recession ended, either:

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“[T]echnology may be the prime culprit,” Gula writes, “considering that companies need fewer employees to produce the same output. Also, over-building may be a contributing factor.” Right. But the expansion is seven years old by now. Employment is up. There’s been plenty of time for overbuilt space to be absorbed. One wonders whether some more secular forces could be at work.

NEXT WEEK, TODAY: Three releases set for next week will bear watching. On Tuesday, the National Federation of Independent Business will release its Small Business Optimism Index for November. Surveys of everyone for consumers to corporate executives have indicated that optimism has surged since the election. It will be interesting to see whether the NFIB number follows suit. The consensus expects 96.6 vs 94.9 in October. On Wednesday is the FOMC Meeting. The consensus looks for the Fed to set the fed funds rate at a range between 0.50% and 0.75%. If it’s anything less than that, the world might stop spinning on its axis. Finally on Friday, November Housing Starts will provide an update on the state of the housing recovery. The consensus expectation is 1.230 million vs 1.323 million in October.

THE LAST WORD: Allow me a brief, bipartisan political rant. It’s the holiday season, the market is setting record highs, and financial stocks are leading the way. So of course I’m very happy–but also, because of one spectacle I saw on cable news this week–disgusted. I grew up in a family that was fairly politically active, and have always been of the view that a legislature made up mainly of full-time, career politicians is a bad idea, regardless whether those pols are conservative or liberal, Democrat or Republican. Professional legislators inevitably end up being more concerned about their own long-term careers rather than the interests of the voters who put them in office. That’s a recipe for bad laws and public policy.

Maybe the most compelling example of this—and this gets me to that disgusting spectacle—is Sen. Harry Reid of Nevada, the outgoing Senate minority leader, who’s retiring this year. In my argument against professional politicians, Reid is Exhibit A. Reid worked in the private sector just two years over his entire career, yet he’s retiring a wealthy man. How do you suppose that happened? He changed time-honored rules of the Senate, gutting the filibuster in particular, in order to gain a temporary, near-term political advantage. His ad hominem attacks against opponents from the Senate floor further cheapened Senate tradition and our political culture generally. And Reid was so brazen about it all. When asked after the 2012 election whether he regretted lying  about Mitt Romney not having paid income taxes, he simply smiled and said, “No. It worked, didn’t it?” What a hack. And now with the Senate under Republican control again, Reid’s Democratic colleagues in the Senate must surely regret that they ever put him in charge of their party’s caucus.

Harry Reid is a bad guy who only survived as long as he did because of the power of incumbents in a small state that doesn’t mandate term limits.  But the really disgusting part of all this was watching Reid’s Senate colleagues, both Republicans and Democrats, most of whom are of course also career pols, heap praise upon him this week for his years of “public service.”  What a farce. If would-be reformers were really serious about “draining the swamp” in Washington, they might start by pushing for rules to ensure that no more Harry Reids happen. You’ll have your own ideas about how to do that but, for me, I’d start by instituting term limits for both houses of Congress, and also set up a process for drawing Congressional districts that minimizes the opportunities for gerrymandering. That way, people who really are interested in public service might have a chance at being elected to Congress—and the federal government might end up serving voters once again rather than the satraps in Washington D.C.

Questions, comments, or observations? Pass them along!

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Edited by Matt Stichnoth

Copyright © 2016, Second Curve Capital LLC

Tom Brown
CEO Second Curve Advisory Services
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