Banking on Trouble

Commercial bankers typically have a pretty good feel for
the pulse of the local business scene. Collectively,
lenders have access to the financial statements of hundreds
of local business, allowing them to stitch together a
rather accurate composite sketch on such items of interest
as sales growth, profits and the health of corporate
balance sheets.

Moreover, they can develop a sense for the mood of business
owners, since they are in frequent contact with them: are
the owners optimistic and expanding or are they cautious
and holding back? Local lenders can answer these questions
intelligently; at least the good ones can.

Unfortunately, this financial "sixth sense" does not
necessarily improve their ability to forecast the future or
even to competently manage their own affairs. Bankers still
make mistakes – lots of them – and are subject to episodes
of bad judgment. I should know, since I was a member of
their tribe for more than a decade.

Often, when I get together with my old banker friends and
former colleagues, I ask them about what they are seeing.
Sometimes, what happens locally is a microcosm of what is
happening nationally.

We met where bankers often seem to meet, in the elite
confines of a local country club (the name of which I will
withhold to protect the innocent party). Over toasted club
sandwiches and lobster bisque, washed down with the club
lager (brewed on the premises), I expected to get the
skinny on the local scene.

This time, however, the conversation was less about the
business scene than it was about the business of banking
itself. And my banker friend’s mood was darkened by what he
saw as gathering storms on the horizon.

"Fee income is drying up," he said, "especially the
punitive ones."

Ah yes, those delightful overdraft fees and late fees.
Consumers may not realize this, but bankers love it when
consumers do dumb things with their money. Writing a $28
check only to be whacked with a $34 overdraft fee is the
foundation of many a bankers’ fortune.

We once lent money to a fraternity house that was late
every month, and every month we would whack them with a
huge late fee. At the end of the first year, our return on
that loan was over 30%. Zimbabwe could have borrowed money
more cheaply.

"It’s not just us," my friend continued, "it’s across the
industry. We’re all facing the same problems." There were a
few theories as to why this might be, but none of them
seemed convincing to me. From a banker’s perspective, fee
income is the most desirous sort of income. It is not
interest-rate sensitive; the banker gets his fee whether
rates are 2% or 6%.

Lacking fee income, bankers must rely more on their
traditional interest rate spreads…and that’s much harder
work.

"Now that the yield curve is flattening [i.e. the
difference between short-term and long-term interest rates
is shrinking]," I observed, "profit margins must be feeling
the pinch."

He winced, as if I had just doused an open wound with salt
water.

Tighter margins and less fee income mean pressure on bank
earnings, and more pressure to grow through acquisitions or
by building new branches. Acquisitions are tricky by
nature, and create new headaches of their own. Branch-
building is expensive and the payoff does not usually occur
until well into year two or three.

Plus, banking is a competitive business. Branch expansion
is no cinch for new profits, because your competitors don’t
stand still.

"I’ve heard some banks have incredibly aggressive goals for
opening new branches," I began, "in fact, I heard one
bank…"

"Commerce," my banker friend answered before I completed my
sentence. "Commerce Bank is coming in here [meaning the
Washington-area market] with over 100 new branches."

I let out a skeptical laugh. "Where the heck are you going
to find 100 suitable locations to open new branches in the
already over-banked Washington area market?" I asked. "When
I was in banking, we were lucky if we found a handful in
any given year."

"That’s what we thought," he continued, "but then we found
out that they already have the locations secured." His eyes
were alight with fear it seemed to me. Every bank in the
area can count a dozen competitors without blinking and
they are surely not eager to have to grapple with an eager
newcomer apparently willing to spend lots of money.

We had an old saying in banking that the market was only as
good as your stupidest competitor. In other words, it only
takes one bank to start giving away money and then you have
two choices, each of them ultimately painful. You can
either match their deals, preserving your market share, but
putting off the pain ’til later (when your profits are
depressed) or you can take a hard-line stance, in which
case the pain is immediate and you lose a bunch of
customers. Pick your poison.

Wow, I thought. This Commerce really is a machine. I’ve
read about them before. In fact, Grant’s Interest Rate
Observe ran a bearish piece on Commerce in January. Since
Grant’s commentary, Commerce’s shares have only become more
expensive.

So let’s end this note with some of the bearish points on
Commerce, an idea you can short, buy puts on, or just watch
with a sense of schadenfreude, as your speculative
temperament permits.

Despite all the pressures weighing on bankers’ earnings and
the fierce competition that will inevitably result,
Commerce Bancorp (CBH:nyse) trades for about 18 times
earnings and almost 3 times book value. Analysts expect
earnings growth of 17% next year. Remember, this is a bank
we’re talking about here.

Commerce’s management team, led by the autocratic founder
Vernon Hill, has laid out some big goals – he intends to
grow from 319 branches to about 700 by 2009. These branches
are not cheap; Commerce spends an average of $3.24 million
on a new branch office. A more normal number would be
closer to $2 million, sometimes much less, especially with
so-called in-store branches nestled in grocery stores.

"I heard they hire greeters," my banking friend said in
amazement, "you know, people to shake your hand as you walk
in the door." Safe to say, Commerce’s operations spare no
expense.

Commerce’s formula for success has been, in the words of
its founder, "low cost of money, high cost to operate, high
growth." The "high cost to operate" part of the formula is
the only constant. "Low cost of money" is already vanishing
and "high growth" will be more difficult going forward.

Here’s betting that Commerce’s shareholders will be
disappointed and that the shares will be marked down
accordingly. Commerce, though it has delivered remarkable
results so far, is still a bank at the end of the day and
it will not be immune to the forces that are already
buffeting its peers.

The long bull market in banking stocks is showing signs of
wear.

Crisis Point Trader

Did You Notice…?
By Eric J. Fry

"The dollar’s crash is now over," Steve Sjuggerud
confidently declared last Tuesday. "The cover story off
this week’s Newsweek magazine – ‘The Incredible Shrinking
Dollar’ – virtually seals the deal…Everyone believes the
dollar is doomed but me…"

Steve, as the editor of True Wealth, has been made a number
timely contrarian calls. So we have learned to respect his
instincts. While we remain dubious that the dollar will
muster a sustained rally against either the euro or gold,
we have no trouble imagining a counter-trend rally that
lasts for a few weeks.

But if we are to trust Steve’s contrarian instincts, we
should not hesitate to up our exposure to the greenback,
while trimming back on our gold holdings.

Or maybe there’s a middle road…

As the chart below illustrates, ASA, the closed-end fund on
the NYSE that holds South African gold stocks, has been
trailing well behind the XAU Index of North American gold
stocks. Since the end of 2004, ASA has managed a return of
less than zero, while the XAU Index has advanced about 25%.

The strong South African rand is to blame for this
disparity. Because the rand has been rising sharply against
the dollar, the gold price in rand terms has actually been
FALLING, even though gold has been appreciating in terms of
the U.S. dollar. If, however, the dollar has turned the
corner against world currencies, as Steve boldly predicts,
the gold price in rand terms might also begin to
appreciate.

As a result, South African gold shares should begin to
perform better than the North American variety. Buyer
beware, however. A gold stock that performs better than a
North American gold stock might still be a stock that
falls.

When all else fails, the far-sighted, dollar-bearish
investors might simply stash some ingots in the backyard
and forget about them for a while.

And the Markets…