Monday, June 23, 2008

Things that stun me: Fifth Third Bancorp

I know a very successful fund manager who is utterly stunned by the problems at AIG. He thought that the company had “more there than that”. I had been watching what they do (rather than what they did) since 2000 and was not overly enamoured. I didn’t short it – but the problems were not a surprise.

My surprise came with Fifth Third Bancorp – a bank I once held out as – indeed still do hold out as – the best managed regional bank in the world. Given the wags are now calling it “Three-Fifths Bancorp” either I was wrong or something changed.

I contend that it was change. However the extent of the change – and the resulting problems amaze me.

The bank I hold out as the best managed regional bank in the world changed radically around the year 2000 in response to problems caused by its own success. These changes created a very different bank. I still maintain that Fifth Third circa 1990 was the best managed bank I have ever seen.

I shorted the stock once – above $60. A short made despite being totally enamoured of the management. I made pennies and was never truly committed. In my eyes we shorted the bank because its success was at an end – not because we thought it had major problems.

I noticed minor issues – but Moody’s rating agency did not. Moody’s mooted upgrading Fifth Third to AAA – a ranking that they have never come close to assigning to any other mid-size regional bank.

I didn’t drink the Kool-Aid completely. As the stock fell I was always looking for an opportunity to buy – remembering past glories. But thankfully I never pulled the trigger.

The old Fifth Third

I am doing this a little from memory because I (foolishly) tossed some of the old annual reports.

The bank arose from a pre-prohibition merger of a Fifth Bank and a Third bank of Ohio. I gather they were called Fifth Third because Three Fifths referred to a particularly strong liquor – and that was considered ungodly.

There was a major management change/restructure about 1975-76 (noted now only in the incorporation of the name Fifth Third Bancorp in 1975). However that was the beginning of one of the great stock runs in history.

After the 1975 restructure the bank operated the bank in a very entrepreneurial fashion. The bank was broken into small banks with about $3-5 billion in assets. The small banks purchased back office and other services from the mother-ship – and the mother-ship also sold back office services to third parties. Everything was expected to be market-best - and market signals were used to ensure it.

When a division got too big they broke it into two divisions. The division managers competed against each other and were paid as entrepreneurs. Part of the remuneration was paid in arrears and dependent on credit quality.

The culture had its minuses. For instance if you were from one part of Fifth Third and you wanted to use a photocopier people got a little stroppy. Why? Because your photocopy would go on their cost account. (I am not exaggerating – the businesses were sufficiently small and entrepreneurial they were worried about trivial costs.) But it was pretty hard to argue with success.

The outsource back-office businesses were not too bad either. The credit card processing facility – Midwest Payment Systems – was particularly good. It was to my eyes the best in the world – and was very profitable on the out-source service it sold. It has since been renamed Fifth Third Payment Solutions – I think as much to distinguish itself from MPS – the Bank of America payment business.

Fifth Third did small fill-in acquisitions in the four Midwestern states in which it had operations. Generally the small bank was entrepreneurial and stayed entrepreneurial after acquisition. Its cost structures however improved as it wound up with Fifth Third's exceptionally good back-office services.

The stock run was extraordinary. The stock was a 600 bagger from the restructure to 2000 (and more than 1000 bagger to peak). You don’t need to hold too many of those in your life. It even came through the 1992 debacle almost unscathed. [These stock runs include hypothetical reinvestment of dividends - the general point however still holds. This was the best performed bank in the world.]

Its utterly superior economics had nasty effects on other midwest banks. The other banks competed not by being better but by accepting worse credit. The poor credit culture at National City has its origins there. (For those not following National City is one of the banks worst hit in this crisis. The same observation with less stregth applies to Keycorp.)

I never held it – which is a great pity - however one company did hold a substantial stake in Fifth Third – that was the local (high quality) insurance company – Cincinnati Financial (Nasdaq:CINF). The combination of fairly good underwriting and a super-powered stock portfolio driven by Fifth Third (and to a lesser extent fellow Cincinnati company P&G) meant that CinFin was also a great stock. At various stages I have owned CinFin for pennies of profit.

Here is the balance sheet of Fifth Third from the 10K for 1999 – which was issued two years shy of the peak of the stock run. Whilst the run continued the problems set in after this balance sheet was issud.

The are a few things to note. Firstly that the bank was very small despite the massive stock run. The loans outstanding were under $25 billion. That would place it today as a small – even one state – regional bank.

The second thing to notice is how overcapitalised it was. The shareholder equity was over 4 billion on those loans. The bank could easily have run at half the capitalisation. The bank used its excess capital to speculate in securities – but as the yield curve in 2000 was fairly flat there was not much profit there.

On that balance sheet there is simply no way that Fifth Third was getting into trouble. Moody’s later mooted the AAA rating – but it could easily have been awarded then.

The post-tax profits for 1999 were 668 million. Not a large number – but a fine return on $2 billion of capital and $2 billion of excess capital.

Profits would have gone up sharply over the next few years without the bank doing anything much. The yield curve would steepen and the $12 billion in securities which were carried at very little spread became highly profitable. The bank unfortunately felt compelled to do things.

The bank’s problem

I am going to make the strange assertion that the bank’s biggest problem at this stage was its stock price. The price was in the high 30s at year end 2000 (along with most other banks that were at low prices as tech stocks dominated). But by late 2000 the stock price was just shy of $60. The market cap was over 18 billion and the PE ratio almost 30. [Note the 3 for 2 stock split in 2000 when checking my numbers.]

Four and a half times book might not have seemed unreasonable – but it was more accurately described as seven times book plus excess capital. This was a period when banks traded at less than a third this price. This was – by far – the most expensive bank in North America.

The high stock price meant high expectations which the management sought to meet. The excess capital couldn’t be solved by buying back stock (as the stock was so pricey). Instead they went to grow by acquisition.

The home markets – the four states which they had previously conquered – were saturated with Fifth Third. Fifth Third had used its superior economics to get the superior credits. Banks that had to compete with Fifth Third wound up on the worse end of pretty well every credit. Fifth Third had pristine credit.

If Fifth Third grew in the home states they would have to take some business that they had previously rejected. Growing in the home market would have turned Fifth Third into National City.

So they went to Florida as well as neighbouring Kentucky and West Virginia.

They used their inflated stock and excess capital to purchase things – but nothing they purchased was as good at the old bank. Moreover the rate of purchase was very high, the prices often puzzlingly high.

The real problem though was that the management system that had served Fifth Third so well through the glory years became unwieldy. The bank when I started following it had 8-10 businesses all competing against each other. I stopped following when this got to 71 businesses. The internal bickering about cost allocation became thunderous.

My short – when I had one on – was not predicated on the failure of Fifth Third – but the slow demise of the business model.

Well we got the near failure of a natural AAA bank. The story is well told by Mish and others – and I am not going to repeat it here.

Lots of its businesses have blown up. The credit card processing business is not as good as it was. Midwestern credit is awful. The stuff they purchased in Florida is worse. But worst of all was that they grew hard into it.

Whereas Fifth Third was almost perfect during the 1992 banking debacle its been a total mess this time.

Count me as surprised.

There are a couple of other pristine stories in North American banking - notably WestAmerica Bancorp, and Mortgage and Trust Bank (MTB). The former is remarkably expensive (and successful) for a well run but otherwise undifferentiated regional bank in the Central Valley of California. The latter has non other than Warren Buffett vouching for the management. Berkshire is the largest shareholder.

I look at these companies and I can't fault these banks. But that wouldn't have saved a Fifth Third shareholder.

But if WABC were to blow up - then I would be feeling deja vu all over again.

1 comment:

kenhenry said...

fifth Third was formed in 1906 from the merger of the Fifth National Bank and the Third National Bank.

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