Charlie Munger and Warren Buffett on Banking
What Buffett learned was banks were profitable businesses if management issued loans responsibly and curtailed cost. In most cases, banks fail when management foolishly issued loans that a rational banker would never have considered. It is not necessary to be numbered one in the industry if you are a bank, Buffett explains. What counts is how you managed your assets, liabilities and costs. Banking is very much a commodity business. In a commodity like business, the actions of management are frequently the most distinguishing trait of that business. In this respect, Buffett picked the best management team in banking - Wells Fargo.
The banking industry has been a gold mine. I think Warren and I blew it --- we should have invested a lot of money in banks. While we did well in it, we should have been heavier in it. The amount of money made in banking has been awesome. And [this despite the fact that] the people who made the money --- how shall I say it --- have been moderately skillful. [Laughter] [I think he said something here about one being able to make a lot of money in banking even if one is “a perfect ass.”] [Bankers have been like] a duck sitting on a pond and they raised the pond. By borrowing short and lending long, one can make a lot of money. It’s so easy that people are tempted to do more and more.
Can it go on forever? A wise economist once said, “If a thing can’t go on forever, it will eventually stop.” My guess is that the extremes are over. Banking has been a marvelous business, but I wouldn’t think it would continue to get better and better and it might even get a lot worse.
Betting on a stock index is like betting on a bucket shop. The banks brought back bucket shops with the derivatives markets. With casinos you have to have parking, bars, restaurants and entertainers. But the banks have a casino with no overhead. The government then allows them to operate with leverage through the repo system. Conservative investment banks went to 30-50x leverage, making small returns on each transaction but making a lot of money in aggregate.
The bubble in America was from a combination of megalomania, insanity and evil on the part of a lot of people in banking---both mortgage and investment banking. Greenspan was a smart man but he overdosed on Ayn Rand at a young age. You can’t have total freedom to create gambling games. Much of what crept into investment banking was a gambling game in drag---it was not capital raising. Now, the banks have developed an advantage in derivatives and do not want to give it up. A casino would never give up slots to keep roulette and blackjack. Similarly, the banks don’t want to give up their best businesses to save the rest of us from risk. It makes sense that banks don’t want to give it up.
Perhaps real estate speculation did the most damage. But the new trading in derivative contracts involving corporate bonds took the prize. This system, in which completely unrelated entities bet trillions with virtually no regulation, created two things: a gambling facility that mimicked the 1920s "bucket shops" wherein bookie-customer types could bet on security prices, instead of horse races, with almost no one owning any securities, and, second, a large group of entities that had an intense desire that certain companies should fail. Croupier types pushed this system, assisted by academics who should have known better. Unfortunately, they convinced regulators that denizens of our financial system would use the new speculative opportunities without causing more harm than benefit.
Many contributors to our over-the-top boom, which led to the gross bust, are known. They include insufficient controls over morality and prudence in banks and investment banks; undesirable conduct among investment banks; greatly expanded financial leverage, aided by direct or implied use of government credit; and extreme excess, sometimes amounting to fraud, in the promotion of consumer credit. Unsound accounting was widespread.
All the passages below are taken from The Essay of Warren Buffett, 3rd Edition, pages 128 – 130 by Lawrence A Cunningham.
Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one sixth of our position was bought in 1989, the rest in 1990.
The banking business is no favorite of ours. When assets are twenty times equity---a common ratio in this industry---mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.
With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen. In many ways the combination of Carl and Paul reminds me of another-Tom Murphy and Dan Burke at Capital Cities/ABC. First, each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other. Second, both managerial teams pay able people well, but abhor having a bigger head count than is needed. Third, both attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, both stick with what they understand and let their abilities, not their egos, determine what they attempt. (Thomas J. Watson Sr. of IBM followed the same rule: "I'm no genius," he said. "I'm smart in spots-but I stay around those spots.")
Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled---often on the heels of managerial assurances that all was well---investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
Wells Fargo is big---it has $56 billion in assets---and has been earning more than 20% on equity and 1.25% on assets. Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. But were we to make such a purchase, we would have to pay about twice the $290 million we paid for Wells Fargo. Moreover, that $5 billion bank, commanding a premium price, would present us with another problem: We would not be able to find a Carl Reichardt to run it. In recent years, Wells Fargo executives have been more avidly recruited than any others in the banking business; no one however, has been able to hire the dean.
Of course, ownership of a bank---or about any other business---is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic---the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.
None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans---not just its real estate loans---were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.
A year like that---which we consider only a low-level possibility, not a likelihood---would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices, prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.
We will be buying businesses---or small parts of businesses, called stocks---year in, year out as long as I live (and longer, if Berkshire's directors attend the seances I have scheduled). Given these intentions, declining prices for businesses benefit us, and rising prices hurt us.
The most common cause of low prices is pessimism---sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.
None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do." [1990 Annual Report.]
Warren used the 1990 banking industry recession as the impetus for investing in Wells Fargo, an investment that brought him enormous rewards. Remember, in an industry-wide recession, everyone gets hurt. The strong survive while the weak are removed from the economic landscape. At that time Wells Fargo was one of the most conservative, well-run, and financially strong of the key money-center banks on the West Coast, as well as the seventh-largest bank in the nation. (For the sake of clarity we have not adjusted Wells Fargo's historical numbers for splits up to 2000. If you're a stickler for that sort of thing, you can adjust them by dividing all per share figures by six.)
In 1990 and 1991, Wells Fargo, responding to a nationwide recession in the real estate market and an increase in defaults in its real estate loan portfolio, set aside for future loan losses a little more than $1.3 billion, or approximately $25 a share of its $55 per share net worth. When a bank sets aside funds for potential losses, it is merely designating part of its net worth as a reserve for potential future losses. It doesn't mean that those losses have happened nor that they will happen. It means the losses may occur and that the bank is prepared to meet them.
This means that if Wells Fargo lost every penny it had set aside for potential losses—$25 a share— it would still have $30 a share left in net worth. Losses did eventually occur, but they weren't as bad as Wells Fargo had prepared for. In 1991, the losses wiped out most of Wells Fargo's earnings, but the bank was still very solvent and reported a small net profit of $21 million or $0.04 a share.
Wall Street reacted as though Wells Fargo were a regional savings and loan on the brink of insolvency and in four months hammered its stock price from $86 down to $41.30 a share. Wells Fargo lost 52% of its per share market price because essentially it was not going to make any money in 1991. Warren responded by buying 10% of the company— or 5 million shares— at an average price of $57.80 a share. [33% down from $86 ]
Warren saw Wells Fargo as one of the best managed and most profitable money-center banks in the country, selling for considerably less than what comparable banks were sold for in the private market. Although all banks compete with one another, money-center banks like Wells Fargo have a kind of toll-bridge monopoly on financial transactions. If you are going to function in society, be it as an individual, a mom-and-pop business, or a billion-dollar corporation, you need one or more of the following: a bank account, a business loan, a car loan, or a mortgage. And with every bank account, business loan, car loan, or mortgage comes fees charged by the bank for the myriad services it provides. California, by the way, has a large population, thousands of businesses, and a lot of small and medium-size banks. Wells Fargo is there to serve them all— for a fee.
Wells Fargo's loan losses never reached the magnitude expected, and ten years later, in 2001, if you wanted to buy a share in Wells Fargo, you would have to pay the equivalent price of approximately $270. Warren ended up with a pretax annual compounding rate of return of approximately 16.8% on his 1990 investment. To Warren, there is no business like the banking business.
In both cases, Capital Cities and Wells Fargo saw a dramatic drop in their share prices because of an industry-wide recession, which created the opportunity for Warren to make serious investments in both of these companies at bargain prices.