Kristine Harjes: Is this the best business model in the banking industry?
This is Industry Focus.
Welcome to Industry Focus, financials edition. I’m Kristine Harjes and I’ve got John
Maxfield on the line; The Motley Fool’s senior banking specialist. We’ve got a great
show for you today. Diving into this really unique business model of one particularly
efficient bank. I first want to open the show with a quote from Warren Buffett.
It goes like this: “The insurance industry is cursed with a set of dismal economic characteristics
that make for a poor long-term outlook. Hundreds of competitors, ease of entry, and a product
that cannot be differentiated in any meaningful way. In such a commodity-like business, only
a very low cost operator, or someone operating in a protected and usually small niche can
sustain high profitability levels.”
I bring this quote up because the banking industry is also an industry with these dismal
economic characteristics that Buffett talks about. He says “They make for a poor long-term
outlook.” What he means by this description is that companies that are in the business
of commoditized products often don’t have the economics to really easily be able to
get strong pricing power and be super profitable.
It’s easy to see why the insurance industry fits into this category because the only thing
that differentiates your offerings there is price, but if you think about banks are kind
of the same way. Money is just about the most commoditized product out there, but that leaves
banks unable to compete on anything other than price with this undifferentiated product.
If you’re an investor and you’re looking for a competitive moat you have a bit of a
conundrum. John, I’ve talked to you earlier about this dilemma. I would love to have you
weigh in here and expand more on this insight of Buffett’s in these commodity-like businesses
such as insurance and banks. How can one find durable, competitive advantage?
John Maxfield: If you think about businesses in general, particularly from the perspective
of an investor, what’s the objective? The objective is to identify opportunities in
businesses and business models that will produce outstanding returns. That is returns that
not only beat other competitors in that particular industry, but is also able to outperform the
market at large. That’s how you become a really good investor; by identifying those.
When you’re looking at industries there are all these different things that factor
into what’s going to allow a company to outperform other companies in its industry
as well as the market at large. When you’re talking about industries in particular that
are commoditized then the only time - - Warren Buffett’s letters have so much wisdom and
context in terms of how to think about business.
One of the greatest analyses I’ve come across of his is when you are dealing in a commoditized
market -- where it’s extremely difficult for the average company to generate above
average profit margins -- is if you’re in a niche market so you have some type of monopoly
pricing expanding your margin more than others, or if you’re a low cost producer. Your margins
are the difference between what you’re bringing in for revenue, and what you’re paying out
in expenses.
Since money isn’t the only commoditized product -- a dollar is a dollar regardless
of whether it’s a new dollar or an old dollar --
if your expenses are low compared to your revenue, compared to your competitors those
are essentially the only two situations in a commoditized market that you can generate
outsized returns. When you’re an investor in banking that’s really the starting point
that you should bring to the table when trying to identify a good stock.
Harjes: That leads me right into the heart of what I wanted to talk about today, which
is a bank that we think has found a way to exemplify both of these criteria for long-term
competitive advantage in a commodity-like industry. That is New York Community Bancorp.
We have talked about this bank before on the show, usually in reference to its ultra-low
efficiency ratio which makes it the most efficient bank out there by a long stretch. John, how
have they managed this?
Maxfield: New York Community Bancorp is such an unusual business model. Even though it
is a small bank relative to your Bank of America, J.P. Morgan Chase, Wells Fargo, and Citigroup;
it provides a textbook example, or illustration of Warren Buffett’s point that we started
out the episode with. If you want to generate outsized returns you’ve got to either be
in a niche market, or be a low-cost provider.
Then you look at New York Community Bancorp. You go back to the mid-1990s when it went
public and it has outperformed. When you take into consideration the dividends, stock buy
backs, and share price appreciation; it has outperformed every big bank in the country
by a large margin. I think they say their total return over the past 20 years has been
roughly 4200%, as stated on their website.
The data I came across was around 3800% or 3900%. Either way, it’s even outperforming
U.S. Bancorp. U.S. Bancorp is probably the best run, large bank in the country. So the
question is: how has Community Bancorp been able to generate these outsized returns, even
against the best in the business like U.S. Bancorp? The reason is that it focuses on
a very specific niche in the lending market.
It lends money primarily to owners of large, multi-family, rent controlled buildings in
the New York Metropolitan area. There are two reasons why this works so well. The first
is, as opposed to Wells Fargo that has to have thousands and thousands of branches spread
across the United States which are really expensive to run in order to serve its consumer
deposit base and consumer lending base; by focusing on many, fewer potential customers
but larger customers, New York Community Bancorp is able to produce the same amount of revenue
on a size adjusted basis as a large consumer bank at considerably lower expense.
Even more important, if not equally important to that, is the fact that because they’re
lending money on buildings that are rent controlled in the New York Metropolitan area, when the
economy turns down and other apartment owners and other real estate owners see their vacancy
rates shoot up and make it difficult for those building owners to service their loans, leading
to higher default rates; there’s always a demand for rent controlled buildings in
New York because it costs so much to live there.
The cash flow on these things basically stay the same regardless of whether the economy
is down or up. That means those owners can service their loans through all stages of
the credit cycle, meaning New York Community Bancorp has zero loan losses, even in the
worst of scenarios.
Harjes: We’ve seen that throughout history. Their record of loan losses is insanely good.
Maxfield: That’s exactly right. Let’s use a comparison point. If you’re looking
at national lenders Wells Fargo and U.S. Bancorp are the absolute best. If you look at Wells
Fargo, the CFO, or the CEO said “Through all stages of the business cycle we generally
try not to lose any more on loan portfolio than 0.33% of our total loans” when things
turn really bad.
If you look at New York Community Bancorp through all stages of the credit cycle, it’s
lost only 4 basis points, which is 0.04% of its loans to credit losses. Its business model
allows it to dramatically outperform even the best in the business in this regard.
Harjes: It seems like, with such a specific business, they would be pretty small. From
what I understand, that’s not the case. How large is this bank?
Maxfield: You’ve hit on a really, really important point about New York Community Bancorp
right now.
Harjes: Good.
Maxfield: You’re very smart. I’m sure you knew that way ahead. If you look at its
assets on its balance sheet it has about $48 billion worth of assets. That is a big bank,
but it’s nothing like your $2.2 trillion Bank of America, or $2.5 or $2.6 trillion
J.P. Morgan Chase. It’s relatively small compared to those, but to most other banks
in the U.S. it’s pretty large.
That $48 billion is so important because it’s $2 billion underneath the $50 billion threshold.
After a bank crosses that threshold they are considered a systematically important financial
institution; a SIFI. A laymen’s term for that is that they are then “too big to fail”.
Once a bank is classified as “too big to fail” under the Dodd Frank scenario that
means they are subject to higher capital requirements and higher regulatory and compliance costs.
That makes a bank much less efficient.
New York Community Bancorp has been struggling, thinking “Here we are under this threshold.
We don’t want to pass it.” Normally, a bank would just organically grow a few percent
a year and that would put it past that $50 billion threshold. New York Community Bancorp
doesn’t’ want to just slightly pass it because then they’ll have all those additional
expenses with only a small amount of additional revenue. What it wants to do is a transformative
merger.
They want to do a large merger, or acquisition that will ‘transform’ the business in
such a way that it will be much larger and it will have the economies of scale that are
necessary to then absorb those additional costs while still staying as profitable. That
is the whole conversation. If you listen to a New York Community Bancorp conference call
after the quarterly earnings, or if you read the transcript, that takes up a large chunk
of the conversation right now among the executives.
Harjes: I’m sure it must. What’s the speculation out there? Has the bank said anything? Have
you heard any inklings of a rumor about where thy might head for this sort of merger?
Maxfield: The bank has been pretty quiet about that, and you can understand why. They wouldn’t
want to ignite a bidding war for a potential acquisition target. It has said that it’s
first going to be a transformative merger, and secondly it could be a non-traditional
lender.
The question is “What does a non-traditional lender look like?” Particularly, what is
most attractive to New York Community Bancorp? If you look at its business model one of the
small downsides compared to the upside is, because it doesn’t have a large consumer
deposit base it has to get its money from the money market. It has to borrow it from
corporations that are buying commercial paper, or celling C.D.s and all these other things
that are much more expensive than consumer deposits.
You can see this by looking at its cost to funds; how much it pays to borrow all the
money it has to borrow in order to support its asset portfolio. Its cost of funds in
the most recent quarter was something like 1.37%, whereas Wells Fargo’s cost of funds
is around 0.34%. It’s much larger than that.
I would think the goal would be -- and I could be wrong -- to pick up some type of bank or
company that has a large amount of consumer deposits because that will decrease its cost
of funds and make it more profitable even after you take into consideration the higher
regulatory and compliance costs associated with being a SIFI.
Harjes: At that point they wouldn’t have that advantage anymore of not having to maintain
all these bank branches. Why do you think they would abandon that just to get that cost
of funds a bit lower?
Maxfield: That’s a great question. There is another niche business model in the banking
industry that has a lot of low-cost deposits, or a lot of consumer deposits that are low-cost
relative to the money market, nut they don’t have an extensive branch base. That is your
online banks. The Bank of the Internet is probably your textbook example of that.
I would think -- again, I could be completely wrong on this -- but I would think a bank
like New York Community Bancorp would be looking at something along those lines where you get
the good from the deposits, but you don’t have the bad from that extensive branch network.
Harjes: That would certainly be a transformative merger.
Maxfield: It would be. If you think about it -- and you listen to the conference call
-- these guys are from New York; they’re New Yorkers. You have these guys going out
and buying an online depository institution and then funneling that money in, allowing
it to fund the purchase of these multi-family rent controlled units in the New York City
Metropolitan area.
New York would owe all of us west of the Mississippi -- I know you’re on the east coast -- a
big thank you.
Harjes: When do you think that these hard core New Yorkers are going to make this move?
Maxfield: That remains to be seen. What they said on their most recent call is - - it sounds
like they’ve identified some perspective targets that they’re interested in, but
they want to make sure that they dot all their I’s and dot all their T’s on a regulatory
level before they go to the regulators and ask them to pass that threshold.
The second thing to keep in mind is that there is a bill working its way through senate right
now that would actually increase the SIFI threshold from $50 billion to $500 billion.
If that bill goes through…
Harjes: Wow! That would be a game changer.
Maxfield: It would be a total game changer. To be honest, that’s probably the appropriate
thing to do. It would only leave 6 banks that would be considered “too big to fail”.
If that threshold changes then that would open it up for New York Community Bancorp
to do a merger or acquisition at any point in time. If that doesn’t’ go through they’ll
work more slowly and methodically and make sure regulators are okay with the decisions
that they’re making.
Harjes: Lots to keep an eye out for coming up, it looks like.
Maxfield: That’s exactly right. As we wrap up, to make sure everyone understands exactly
the significance of New York Community Bancorp; it proves again that Warren Buffett is right.
If you want to generate outsized returns in the bank industry you’ve got to invest in
a bank that either has a niche market -- some type of niche market that allows it to earn
large margins on its revenue -- or it’s got to be a low-cost producer.
You identify those, you will find a bank that will generate much larger returns over the
long run than its competitors.
Harjes: Fortunately, New York Community Bancorp exemplifies both of these things which is
pretty awesome. If you listeners, in your research, find any others that you think are
just as good and follow what Buffett is saying for the best way to generate these outsized
returns; let us know. I have said this before and I’ll say it again: we love hearing from
you. Our email address is IndustryFocus@Fool.com. Shoot us an email.
John, thank you so much for being here and for all of your insight as always. Looking
forward to talking to you next week. As always people on the program may have interests in
the stocks they talk about, and The Motley Fool may have formal recommendations for or
against. So, don’t buy or sell stocks based solely on what you hear.