TOM BROWN’S BANKING WEEKLY: 4/7/17 Financial ......2017/04/07 · Tom Brown’s Banking Weekly April 7, 2017 5 This is hardly a bombshell, of course. But given that student lending

Vol. II, No. 14

TOM BROWN’S BANKING WEEKLY: 4/7/17 Financial Services Insights and Intelligence FIRST WORD: I gave a presentation this week to the top 100 executives of a $25 billion-plus bank who were gathered to begin the bank’s annual strategic planning process. To start off, I touched on four banking-related topics that seem to be on a lot of people’s minds lately: 1. Slowing C&I loan growth. Apparently this is an issue that has everyone worried but me. Yes, loan

growth slowed in the first two months, but consumer and business confidence remains high and the economy is growing steadily. And from what I can tell, loan demand picked up a bit in March. Some analysts might use slowing loan growth as an excuse to cut their estimates following first-quarter earnings reports. That will likely be a mistake.

2. Auto loan credit quality. Delinquencies are rising, particularly in subprime. The problem has been

exacerbated by delayed tax refund payments and declining used-car prices. This is certainly an issue to watch, but I’m relatively unconcerned, and continue to believe that auto credit is simply going through normal, cyclical deterioration.

3. Customer cross-selling by banks. This issue has gotten a lot more attention than it’s deserved lately, since most banks don’t attempt much cross-selling in the first place. Thankfully, it seems to be going away.

4. Bank stock valuations. The average bank stock is probably a bit ahead of where it ought to be

strictly based on valuation. But interest rates seem set to rise, tax rates set to fall, and banks’ regulatory burden set to ease, which would all help bank earnings. The market seems to understand that, and has taken it into account.

Then I talked about some longer-term, not-just-banking-related issues that are worth keeping an eye on: 1. The rise of populism. The political and economic establishments have managed to cope pretty well

so far with recent populist flareups in the developed West. But if the flareups keep happening—particularly if Marine Le Pen gets elected president of France—certain core Western economic and political arrangements could be suddenly in doubt. A near-term tail risk, but one I think most people recognize.

2. The federal debt and state pension obligations. What’s that old Herb Stein quote? “If something can’t go on forever, it won’t.” This is especially applicable to the fiscal outlooks for the federal government and certain states and localities. It’s an issue that’s not getting the attention it should.

3. Federal student debt. Another disaster waiting to happen. My own view is that, for better or worse, some sort of debt relief will occur, which will only exacerbate item 2, above.

4. A changing economy. Technology is changing the way consumers behave, and the way work gets done, in a fundamental way. One obvious example: the growth of online commerce has led to reduced demand for retail space. Another example that may strike closer to home: soon A.I. robots will replace humans in underwriting loans, and risk generally. Technology always drives change, of course, but the pace and severity of that change seems to be accelerating.

Happily, I’m not the one who’s supposed to come up with actual solutions to these challenges. I like my job as an investor better: all I need to do is figure which companies are best-positioned for the future. Trust me, that’s challenging enough.

Tom Brown’s Banking Weekly April 7, 2017

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STILL ON TOP: What scandal? Wells Fargo still has the highest brand value of all U.S. financial services companies, according to consultant Brand Finance. The firm determines a given brand’s value by calculating what another company would be willing to pay to license it. As a more general matter, considering the PR shellacking the U.S.’s Big Four banks have endured over the past decade or so, it’s a little surprising (to me, anyway) that the value of their brands all rank in the top 50 globally. AS THE FED TURNS: Farewell, Dan Tarullo. Boy, that sounds nice. NAME A PRICE. ANY PRICE: Great moments in investment banking: Elevate, the on-line lender mentioned here last week that ludicrously suggested to would-be investors last fall in a (since-withdrawn) prospectus that it should be valued on the basis of its EBITDA, filed a new prospectus this week. Price thinking is, ahem, somewhat different now. Old price talk: $12 to $14. New: $6.50. Number of shares to be offered is now 12.4 million, up from 7.7 million. I’ve been at this awhile and can’t recall such a dramatic revision of planned terms. Given how the fundamentals of the fintech space have lately been crumbling, it’s hard not to get a sense that the selling investors will take whatever price they can get. MORE WORRIED ABOUT THE BASICS THAN EVER: Here we are seven years into economic expansion, and 67% of individuals earning less than $30,000 tell Gallup they worry “a great deal” about hunger and homelessness, the highest such percentage since Gallup started asking the question in 2001. A sign, maybe, that maybe everything’s not quite right. P.S. Declining life expectancies among middle-aged whites is another sign that something is profoundly out of whack.

ONCE-LEGENDARY PRICING POWER VANISHES: I need to get into the habit of no longer being surprised whenever a one-time Corporate Indomitable finds itself on the defensive against new, web-based industry entrants. Gillette, whose share of the men’s razor market has fallen to 54% from 70% in 2010, mainly as a result of gains by online vendors such as Dollar Shave Club, plans to cut prices by 20%. What the heck ever happened to moats? A SURPRISE COMEBACK: Alternatively, at least one industry that was seriously disrupted by the internet has managed to figure out a way to profitably adapt, and via a revised business model that involves doing something other than merely giving its product away for free: recorded music. Industrywide


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revenues are actually set to start growing again, if you can believe it. There’s got to be a business school case study in there somewhere.

BOOMING EQUITY: A happy milestone: residential homeowners’ tappable equity is now as high as it was back in 2006, says consultant Black Knight. A potential economic tailwind, yes? At the peak of the cash-out refi mania in the mid-2000s—Ah! Those were the days!—homeowners cashed in $100 billion of their homes’ equity in a single quarter, the third quarter of 2005. By contrast, in the final quarter of 2016, that number was just $31 billion. But as home equity continues to swell, homeowners will have a bigger and bigger source of potential liquidity to spend on who knows what. I approve.


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MORE BREXIT FALLOUT: It turns out that, in England, the proverbial “Polish plumber” really is a thing:

HOME OWNERSHIP, DELAYED BY DEBT: Surprise! A New York Fed study out this week shows that recent college graduates who carry student debt are less likely to own a home than are recent graduates who don’t. There’s even a chart:


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This is hardly a bombshell, of course. But given that student lending has surged over the past decade or so (to $1.4 trillion outstanding, from $250 billion in 2003) all that debt now effectively constitutes a serious headwind for the housing market, and, by extension, the economy generally, no? MERE MORTALS AFTER ALL: It’s kind of reassuring, in a weird way, to know that a swarm of really smart Ph.Ds, with access to mountains of data not available to anyone else, can be as terrible at predicting the future as the rest of us:

POP ICON: Big-time Coca-Cola investor Warren Buffett is apparently so popular in China—and I admit this took me somewhat by surprise—that Coca Cola is putting his likeness on cans of Cherry Coke as part of the promotion of its product launch there.

RETAILERS’ BANKRUPTCIES ON RISE: The brick-and-mortar retailing industry’s slow-motion train wreck continues. Nine retail chains filed for Chapter 11 bankruptcy protection in the first quarter, CNBC reports, the same number of chains that filed in all of 2016 and, annualized, the most since 2009 when a considerable amount of economic havoc was still underway.


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Many struggling merchants’ main problem is of course growing competition from on-line retailers. But others are dealing with an additional issue: servicing the heavy debt loads imposed on them in the course of their acquisition by private equity firms. (Nice timing!) Anyway, over half of retailer BK filings this year were by chains that were bought by PE firms, up from an average of 31% over the past five years. FASTER: Bonus negative factlet regarding the retailers: the pace of store closings industrywide appears to be accelerating:

A LATE AND UNLIKELY CHANGE OF HEART: Now he tells us. Back in 2009 as Congress was considering the Volcker rule, a lot of us warned that the rule would be more complex to implement than it seemed, and could have the unhappy effect of, say, inhibiting liquidity in certain parts of the capital markets. In the fullness of time, outgoing Fed governor Dan Tarullo seems to think we had a point. “Several years of experience have convinced me that there is merit in the contention of many firms that, as it has been drafted and implemented, the Volcker rule is too complicated,” he said in farewell comments delivered at Princeton on Tuesday, apparently with a straight face. “Although the evidence is


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still more anecdotal than systematic, it may be having a deleterious effect on market making, particularly for some less liquid issues.” Duh. In fact, the Volcker rule has likely made the financial system less able to cope with the next crisis, by reducing the amount of liquidity large institutions will be able to provide. As if to illustrate, a chart Jamie Dimon included in his shareholder letter this week shows just how far dealer positions are now versus where they were pre-Dodd-Frank. When the next panic comes, this sure won’t help. Once more, the perils of unintended consequences.

MONEY MANAGEMENT COLOSSUS UPDATE: The wages of success: at Vanguard, which has traditionally taken the quality of the service it provides at its call centers so seriously that, during times of high volume, executives and portfolio managers are pressed into service to help pick up the slack, phone wait times are lately running a once-unthinkable half an hour or more. You surely know the reason why: the company is lately in the midst of a tsunami of inflows of new money. Vanguard took in more than $300 billion in 2016, an additional $44 billion and $30 billion in January and February of this year, and now has $4.2 trillion under management. Now that I think of it, I’d feel overwhelmed, too. TIME WELL SPENT: If you’ve never been to the Consumer Bankers Association’s annual “CBA Live” conference, you really should go. This year’s was in Dallas this past week, and it was, as CBA Live is every year, as entertaining as it was informative. Country singer Derek Anthony opened things with a terrific rendition of the national anthem, and Roger Staubach gave a talk that was just outstanding. But to me, the highlight was a panel discussion among two bankers and two fintech types over the state of competitive play in the consumer lending space. The fintechs are certainly less cocky than they used to be, but one banker on the panel, Larry Franco of BBVA, acknowledged the banks’ vulnerability, too. “We bankers,” he commented, “are getting the disruption we deserve.” Anyway, kudos to CBA president Richard Hunt for another great event. REPUBLICANS PEPPY AGAIN: Whoa. Republicans sure are feeling better about the outlook for the economy than they were at this time last yerar, according to Pew.


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A REAL BARGAIN: Wait. I thought Brexit was going to cause havoc with London real estate values. In Chiswick in west London, $1,000 per month gets you a studio with a shower in the kitchen:

SHALE CHEAPER TO DEVELOP: The economics of shale energy production seems to be getting better and better. A survey conducted by the Dallas Fed this month finds that the price of oil that shale operators need to break even on their operating expenses ranges from $24 to $38 per barrel, while the breakeven required to profitably drill a new well is in the range of $46 to $55. For the full sample, the breakeven price on new development is $50 per barrel, down from $54 when the same question was asked at this time last year. Only a few years ago, by telling comparison, most analysts put shale’s breakeven price at around $75. All this is of course great news for domestic energy lenders. But forget about lending; these efficiency gains will presumably continue and, as they do the implications for places ranging from Saudi Arabia to Iran to Russia figure to be mind-boggling.


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A TAX DODGE FOR THE UPPER-MIDDLE CLASS: President Trump has for some reason not called me for my views on tax reform yet, but if he did—and I know I’m about to speak against my own interest here—I’d tell him he should start by getting rid of every cussed subsidy for home ownership embedded in the tax code, starting with the mortgage interest deduction. Seriously. If anyone ever labored under the illusion that broad homeownership (which is what the deduction is said to promote) is essential to prosperity and social comity, the unpleasantness of 2009 should have blown his or her blinders off. For most of the country’s history, the homeownership rate has been below 50%--often way below--and things seem to have gone mostly swimmingly. The government has enough other important things to do (and you’ll have your priorities on the question, while I’ll have mine) that spending money to get people to own houses can’t be anywhere near the top of the list. THE UPSIDE: I somewhat understand the reservations harbored by President Trump and others about the purported benefits of free trade and globalization generally, but it’s hard to deny that those policies, just in our own lifetimes, have been profoundly positive for billions of people:


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UNWARRANTED OPTIMISM BY BUILDERS?: A striking divergence: homebuilders, who presumably know what’s going in their business better than anybody else, are more optimistic about it now than they were even before the housing blowup, at the same time that equity investors seems to believe the outlook for builders is strictly ho-hum:


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Who’s right? I have my guess. AMERICAN SCOURGE: It’s easy to forget that opioid abuse, which killed 40% more people in 2015 than did car crashes, and which, for whatever reason, still doesn’t seem to be getting the national attention one would think it would merit, is a uniquely American problem:


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NO TAKERS: I understand used-car prices are under some pressure, but this seems a bit much: “Donald Trump’s Ferrari Disappoints at Florida Auction”. NEXT WEEK, TODAY: Three items next week will bear paying special attention to. On Tuesday, the Labor Department’s February JOLTS job-openings report will provide an indication of the strength of labor demand. Also on Tuesday, the National Federation of Independent Business will release its Small-Business Optimism Index for March. Small-business optimism has been on a tear in recent months; Tuesday’s report will show whether that’s continued. The consensus looks for 104.5 vs 105.3 in February. Then on Friday, March Retail Sales will provide an indication of both the strength of both the consumer as well as the increasingly embattled retail industry. The consensus expectation is for sales to be unchanged from the prior month, vs +0.1% in February. Also, don’t forget that Friday is Good Friday. Banks will be open, and the financial markets closed. THE LAST WORD: Not long ago I had an internist based in Greenwich, Conn. About every three years I succumbed to Amy’s pressure and would see the good doctor on my own. Then I’d return home and tell Amy just what he said, “Stop smoking cigars, cut back on the alcohol, but otherwise you are fit as a fiddle and strong as a bull!” For whatever reason, Amy didn’t like these reports, so she found an internist for me to see at Penn Medical near our home in Villanova. And she insisted on accompanying me to the exam. He has since made me (and Amy, as my tag-along) see several specialists. If these new doctors are to be believed, I’ve gone from fit-as-fiddle-strong-as-bull to a basket case of problems. Now Amy is happy. As a result, I now take two prescription drugs, an aspirin, and a vitamin


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each morning. It’s crazy. I have been having problems sleeping so Amy started giving me Aleve P.M. at night. I think it helped. But a couple days ago she decided to check with my doctor to see if adding Aleve to my drug mix made sense. His e-mailed response said, “Current evidence indicates important adverse cardiovascular effects that include increased risk of a stroke, heart failure, and hypertension.” First the rancid pork chop now the dangerous drug cocktail. Hmmm!

Questions, comments, or observations? Pass them along! If you’d like to try a special trial subscription to this newsletter, contact Stephen Krug at [email protected] or call him at 646-563-7610. Edited by Matt Stichnoth [email protected] Copyright © 2017, Second Curve Capital LLC

Tom Brown CEO Second Curve Advisory Services Empire State Building 350 5th Ave, Suite 4730 New York, NY 10118 [email protected] (646) 563-7676 office (347) 234-8963 mobile/text

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TOM BROWN’S BANKING WEEKLY: 4/7/17 Financial ......2017/04/07 · Tom Brown’s Banking Weekly April 7, 2017 5 This is hardly a bombshell, of course. But given that student lending