Thoughts From Recent Travels

OK, Be That Way

(Writing from 33,000 ft. somewhere between Houston & Philadelphia)

We spent time on the road in the past month meeting with many bank management teams. One comment captured how a CEO saw the world and was managing for the business cycle. Our visits suggested not everyone was taking the same approach, but we see nothing wrong with the intuition in his statement.

"We are making a lot of money, we have a lot of flexibility and I just think its time to put a couple of nuts away. I want to run with half a turn more capital and raise loan loss reserves. I am happy to grow more slowly. I’m not giving up on structure. Which means we will accrete a whole lot more capital and that means looking at the dividend and when to buy back stock.”

For some reason in bank lending (or for many reasons) there has long been a willingness to expose earnings and capital to credit distress in pursuit of growth or “to protect important relationships.” To be fair, bank investors themselves may be the unindicted co-conspirators, often punishing managements and company valuations for slower growth even when underwriting conditions clearly were deteriorating. We believe there are early indications aplenty (some subtle, others obvious) that underwriting discipline is again softening, as reports of “one-off” credit surprises and borrower fraud begin to repeat quarterly.

If the banks want to be that way, so be it. But it will be a shame to head down a well-worn path that is bad for industry profits, capital, and credibility. Clearly, more protective mechanisms are in place, like beefed up capital, compliance and risk management regimes, but they have not been tested. They will be. When, we cannot say.

(Exerpted from KCA Equity Advisors, LLC monthly letter. For educational purposes only. Not a solicitation to buy or sell any security. Consult your financial adviser.)