Is Bank of America Too Big to Manage?

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too-big.jpgLast week’s news that Warren Buffett was putting $5 billion into troubled Bank of America Corp. (BAC) might have brought a sigh of relief from those folks who were concerned that the country’s largest bank was in danger of failing, although I doubt the actual risk of failure was very high. I think we can safely assume that the regulators in Washington have been overseeing BAC with the same level of care that the Nuclear Regulatory Commission might give to an ailing nuclear reactor–and I don’t think the dooms-day metaphor is inappropriate here.

If you read the financial headlines or watch the business news shows, you know that BAC is struggling to extricate itself from a host of mortgage-related problems, including continuing credit losses from its 2008 acquisition of Countrywide Financial Corp., which has turned out to be a hellish disaster for the bank. Institutional investors had become increasingly concerned that BAC was undercapitalized and drove the stock price down to around $6 a share. The low share price might not have been an accurate reflection of BAC’s true financial condition, but this is one of those situations where perception can quickly become reality. If enough consumer and business customers had become spooked by the falling share price and began to pull their deposits out of the institution, or if other banks had stopped funding it in the interbank lending market, the result could have been a dangerous liquidity crunch.

And that would force President Obama, Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Tim Geithner to make a really tough call: With the weak U.S. economy in danger of falling into the second trough of a double-dip recession, would they prop up the nation’s biggest bank—or allow it to go under? Supposedly the Dodd-Frank Act brought an end to the unofficial regulatory policy of “Too Big to Fail” by providing the Federal Deposit Insurance Corp. with new liquidation authority that will allow it resolve the failure of a large and complex institution in an orderly manner. But would the White House and the Fed be willing to take the risk that such an event wouldn’t push the economy into another ditch? Would they flinch?

Hopefully, we’ll never find out.

The real significance of Buffett’s $5 billion capital infusion is that it offers BAC a much needed vote of confidence from one of the world’s most successful investors, and that seems to have stabilized the bank’s share price for now. Interestingly, Buffett’s money does little to strengthen BAC’s capital position from a regulatory perspective. What Buffett actually purchased was preferred stock, which won’t count towards its Tier 1 capital ratio. Buffett also received warrants to purchase 700 million shares of BAC common stock at $7.14 a share, so he will most likely be handsomely rewarded for his public service.

The interesting question to me is whether BAC, with $2.26 trillion in assets as of year-end 2010, is simply too big to manage. The bank scored 127th out of the 150 largest publicly owned U.S. banks and thrifts on Bank Director’s 2011 Bank Performance Scorecard, which is a measurement of profitability, capitalization and asset quality. The company scored poorly in all three categories. (To see the 2011 ranking, view our digital issue). CEO Brian Moynihan, who was not responsible for the Countywide acquisition, is trying to revive the bank’s profitability through a program of asset sales and layoffs, although the continued decline in housing prices nationally makes BAC’s home mortgage exposure look like a cosmic black hole.

I think it’s fair to say that risk diversification is viewed by most experts as a good thing. The great majority of banks that have failed in recent years were small institutions that had a high concentration of commercial real estate loans on their books. A little more diversification would have been a good thing for them. But diversification is a double edge sword than can cut both ways. BAC is so big and so diversified that it’s hard to find a meaningful banking business in the consumer, corporate or capital markets sectors that it isn’t in, or a financial product that it doesn’t offer. So when the U.S. economy goes into a deep recession as it did a few years ago, a large and highly diversified financial institution often ends up with an impressive assortment of afflictions that are Job-like in nature.

Perhaps BAC is simply too large for any management team and any board of directors to run effectively. I don’t believe that Congress or the regulators should break up the company into smaller pieces. In a free market economy, BAC should be allowed to seek its own destiny. 

But the company’s performance might be twice as good if it were half as large.

Will clearXchange Be a P2P Game Changer?

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mobile-payments.jpgIt looks like there’s going to be a big rumble in the person-to-person payments jungle.

An announcement last week that three of the nation’s largest banks—Bank of America, J.P. Morgan Chase and Wells Fargo—had teamed up to offer their customers a new person-to-person (or P2P for short) service called clearXchangesignals that these institutions are serious about taking on the industry leader, PayPal

Although details about the new clearXchange offering are somewhat scarce at this point, the three banks’ customers will be able to send money directly from their existing checking accounts to another party using just an email address or mobile phone number. This is pretty much what consumers have already been able to do through PayPal, which has used its Ebay Inc. connection to build a customer base of some 85 million users.

Not to be outdone, Google Inc. also announced last week plans to create a digital wallet that will permit consumers with Android smartphones to pay for their purchases with their credit or debit cards by waiving their phones in front of a special reader at the cash register. The card information would be linked to a special chip in the phone.

Both initiatives will most certainly accelerate the growth of mobile payments, which my colleague—Executive Vice President Al Dominick—has written about in several recent posts. But from the banking industry’s perspective, clearXchange offers the best hope to date that the fast-growing P2P market won’t end up being dominated by e-commerce heavyweights like PayPal and Google.

Hank Israel, a partner at the New York-based consulting firm Novantas, explains that the value of any payments network “is defined by the number of endpoints that it has.” Those endpoints are in fact customers, and Israel estimates that the three banks combined have about 25 million customers (minus some overlap for, say, BofA checking account customers who have a home mortgage with Wells or Chase credit card). With 85 million endpoints (i.e. customers), PayPal is still the “big bad gorilla” in the P2P market, says Israel.

But by all indications, clearXchange intends to open itself up to other banks in an effort to create as large a network as possible—which will be critical to its success. “It wouldn’t be in [clearXchange’s] advantage to say there’s a group of banks that it doesn’t want to be in the network,” says Steve Ledford, also a partner at Novantas. “The value of a network to everyone becomes greater—exponentially greater—the more participants you have.” A BofA spokesperson confirms that clearXchange is in discussions with other banks about joining the network.

Indeed, there are approximately 280 million individuals with checking accounts in the United States, according to Israel. And the average checking account has 360 transactions a year, compared to just 13 for PayPal—which means that a large bank owned network could eventually generate a sizeable customer base and very significant volume.

According to Israel, clearXchange would do well to embrace the digital wallet concept and incorporate additional payments options including credit cards since this would greatly increase the service’s utility. PayPal already allows its users to send P2P payments using a variety of mechanisms including multiple credit cards and transaction accounts.

While PayPal and Google would be formidable competitors for any fledgling e-commerce venture, clearXchange has other important advantages. PayPal requires its customers to set up a separate PayPal account in order to use its P2P service, while clearXchange’s bank customers will simply be able to use their existing credit and debit card accounts, which would appeal to those P2P users who prefer to deal with a single entity. And initially at least, Google’s new offering will be restricted to smartphones that use its Android operating software, and will also require merchants to install new point-of-sale technology. These factors may limit how quickly Google can build a customer base for its digital wallet.

Despite PayPal’s clear lead in the P2P market, Israel believes that clearXchange has a good opportunity to catch up. “To the extent they can work collaboratively, I think they’ll be very successful.”

Community banks will still offer free checking, and here’s why

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money-checks.jpgAt the biggest banks in the country, free checking is becoming a little less free.

  • Pittsburg-based PNC Bank, the fifth largest bank in the country by deposits, was the latest to whittle away its free checking account last week. Customers will no longer get reimbursed for out-of-network ATM fees if they don’t maintain at least a $2,000 average daily balance and they won’t rack up points for rewards on a PNC Visa credit card. But PNC Bank has decided to keep free checking, for now.
  • Bank of America hasn’t had no-strings attached free checking in years, according to a spokesman for the bank.
  • Wells Fargo & Co. did away with it in July of 2010. After acquiring Wachovia in 2008, Wells Fargo has been getting rid of free checking for Wachovia on a state-by-state basis as it consolidates the two banking organizations.
  •  Citigroup doesn’t have free checking for new customers, either.

With Congress regulating away tens of billions in fee income from banks in the last couple of years, including a rule that will slash large bank interchange income on debit cards by as much as 85 percent, banks are looking to do away with unprofitable deposit accounts.

Mike Moebs, an independent researcher who tracks account activity for bank clients and federal organizations such as the U.S. Government Accountability Office and the Federal Reserve Bank of Chicago, says the move away from no strings-attached free checking at big banks is opening up a lucrative way for community banks to steal customers from the big Wall Street and regional banks.

Most of the nation’s smaller banks and credit unions still have free checking, he says. They have smaller operating costs than big banks, so they can afford to keep offering it, he says. The average cost of a checking account is about $200 to $250 annually for a community bank, Moebs estimates. That’s compared to a cost of about $350 to $400 for a big bank, which has more branches, more employees and tends to operate less efficiently, he says.

Moebs estimates banks with more than $50 billion in assets controlled 45 percent of all checking accounts as of 2009, but that will drop to 35 percent by the end of this year, he says. That’s a loss of about 13 million checking accounts that will migrate to smaller banks and credit unions, he says.

Some credit unions have even added free checking to take advantage of that switch, Moebs says, going from 75 percent of all credit unions offering free checking in July of last year to 84 percent last month.

Banks with fewer than $50 billion in assets stayed about the same since July, with 62 percent of them offering free checking. Only about half of big banks had free checking last month, down from 64 percent last July.

Moebs said smaller banks can make free checking pay by selling other products such as automobile loans or mortgages. They also can attract small business owners, an important clientele for community banks, using the free personal checking account to nab their loan business.

While community banks may end up stealing some customers from big banks with free checking, the convenience of branch banking still will be a significant hurdle to overcome. A recent survey by J.D. Power and Associates found that advertising and branch convenience remain top concerns for customers looking for a new bank, and fees play a less important role.

Plus, big banks may succeed in holding onto the vast majority of deposits, even as they lose account holders who kept small amounts of cash in the bank.

Free checking may help community banks steal some customers. But it won’t make them profitable. That’s up to the bank.

Will 2011 be the year for bank stocks?

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The bad news seems endless. Unemployment remains high. Bad real estate loans continue to hurt banks. Increased government regulation and caps on fees will hurt bank income in the future. And yet, so many bank analysts are so bullish on bank stocks in 2011.

Why?

Profitability is returning or will return this year to many mid-sized or small banks, several analysts say.

Stronger banks will be able to buy weaker rivals and grow market share. Even the investors of struggling banks stand to gain after years of misery. Their banks will get bought out at premiums compared to the disappointing prices of the last two years. 

Here is a review of what bank analysts are saying about the outlook for bank stocks in 2011 and their favorite picks:

mmosby.jpgMarty Mosby, a bank analyst at Guggenheim Partners in Memphis, says he thinks all of the 15 large-cap banks he covers will be profitable by the middle of this year and he projects a 30 percent stock market gain on average for his group, which includes Winston-Salem, North Carolina-based BB&T Corp., Atlanta-based SunTrust Banks, and San Francisco-based Wells Fargo & Co. 

“We believe 2011 will be the year of the recovery,’’ he says. “We will finally see banks return to the norm.”

Some banks will be better off than others in the new normal, of course.  Banks such as Wells Fargo & Co., Pittsburgh-based PNC Financial Services Group and New York-based BNY Mellon have revenue potential and strong capital, he says, which means they could buy other banks or increase dividends, always a plus for the many dividend-starved investors out there. PNC Financial Services Group reported today record profits of $3.4 billion for 2010.

Jim Sinegal, associate director of equity research at Chicago-basedMorningstar, Inc. expects his top picks such as New York-based JPMorgan Chase & Co. and Wells Fargo to return 25 to 30 percent gains for investors. He hedges that a bit by saying it may happen in the next year—or two.

“We don’t see any surprises ahead that could derail something,’’ he says. “We’ll see a slow and steady improvement. Credit is slowly and steadily improving. A lot of banks already are benefiting from that. The worst loans on their balance sheets have already been charged off.” 

He even likes Charlotte, North Carolina-based Bank of America, even though other analysts are just too worried about an ongoing investigation into the bank’s foreclosure processes to recommend the stock. 

“We think the best values can be found in recovering banks,’’ he explains. “We think the stock is cheap.”

Bank of America was trading at $14.37 per share Thursday midday on the New York Stock Exchange.

jharralson.jpgJefferson Harralson, managing director in Atlanta for Keefe, Bruyette & Woods, says smaller banks might have a more difficult time seeing stock market gains this year than big banks. They could be hit hard by new regulations that limit fee income. New restrictions on debit card fees charged to merchants could limit that source of income by as much as 75 to 80 percent, he says. 

Plus, many small and even regional banks have not paid back the government for the Troubled Asset Relief Program money, which could weigh on stock prices this year as well. Investors worried the bank will be forced to raise more capital to pay back TARP won’t be eager to buy those banks.

kitzsimmons.jpgKevin Fitzsimmons, managing director at Sandler O’Neill & Partners in New York, says 36 percent of the group’s bank stocks have a buy rating, compared to 26 percent in January of last year. 

He also thinks there will be more risk in small bank stocks this year, because the heavy weight of regulation will move to smaller banks, as in rolling downhill, as regulators begin forcing those banks to recognize their problem loans.

“This is not going to be smooth going (for all banks),’’ he says. “(The market) will be selective.”

The good news is all that new regulatory pressure on small banks could lead more banks to sell out—for a premium this time.

Sinegal said recent acquisitions have netted prices at two times tangible book value for the acquiring bank, as opposed to no premium or 1.5 times book value during the last year.

“There is more optimism that the worst is behind us,’’ Fitzsimmons says. “There has been optimism that some banks will be able to go out and acquire more banks and the acquired banks can be bought at some sort of premium.”