Idea Brunch with John Maxfield on Bank Investing and Bank Failures
Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview John Maxfield!
John is the former editor-in-chief of Bank Director and one of the leading experts on the American banking industry. Today, John shares his thoughts on his Substack, Maxfield on Banks, and to over 14,000 followers of @MaxfieldOnBanks on Twitter. In addition, John is the executive director of the Robert G. Wilmers Integrity Prize, named for the late M&T Bank CEO Robert Wilmers.
John, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and your passion for the banking sector?
My family has been in agriculture and banking for multiple generations — operators in agriculture, investors in banks. Yet it wasn’t until the 2008 financial crisis that I invested time into learning about it.
I had graduated from law school in 2005, clerked for a year for a federal judge, then made it halfway through an LLM program before dropping out, moving to the Washington DC area and getting a job at a bookstore. My plan was to read as many books as possible before running out of money, at which point I’d get a real job.
It was an investment in a bank, fittingly, that allowed me to do this. When I was sixteen years old, I was struck as a pedestrian late one night on the interstate by a double-trailer semi-truck that had jack-knifed on the highway after striking a patch of black ice. We went to litigation, obtained a settlement, and invested the money into two banks — an ag bank that my family had invested in for four generations and a new, commercial real estate bank that my family had helped to acquire and recapitalize. This was in 1999. By 2006, the investment in the latter bank had quintupled so I decided to sell it. I remember going to pick up my check from the CFO. She told me that it was the biggest mistake I would ever make. I told her that she was probably right, grabbed the check and left. Six months later the bank failed. I was the last investor to get money out of it. Complete luck.
When Lehman Brothers went down in September 2008, I realized that, while I had been around banks my whole life, I didn’t know much about banking. So, I decided to spend a few months immersed in the subject matter by reading every banking book I could get my hands on. The rest is history. I love to intellectually master the subjects I study, which, in the case of banking, has taken longer than I originally assumed. I’m 15 years into my studies and have only recently reached the point I was seeking.
Banking doesn’t have the best reputation due to issues ranging from widespread scandals, lackluster stock performance of the major banks, and some high-profile failures. What would you say to an investor skeptical of touching the banking sector?
I would tell them this story…
Around the time of the American Revolution, a French sailor from the region of Bordeaux got stuck on the wrong side of the Atlantic Ocean after the British Navy blockaded the thirteen colonies. Instead of returning to France, in turn, he made his way up to Philadelphia, set up shop as a merchant, and, by the early 1790s was one of the city’s prosperous merchants.
On September 12, 1793, the mayor of Philadelphia, the nation’s capital at the time, convened a meeting. A third of the city’s population had fled in recent days, including George and Martha Washington. The bonds of society had disintegrated. Residents struck down by the virus were abandoned in the streets. The mayor pleaded for volunteers to aid the sick. Only ten people stepped forward. The French sailor-turned-prosperous merchant, Stephen Girard, was one of them.
Girard took charge of Bush Hill, a hospital on the city’s outskirts that had been established to treat yellow fever patients. Removal of it was considered the seal of death. Girard was a hands-on administrator. He fed patients. Cleaned them. Encouraged them. “The act spoke the man,” wrote his first biographer. “He was made for great deeds in extreme emergencies . . . rolling up his sleeves to his elbows, he entered on his duty, prepared to discharge it at the peril of his life.”
This was just one in a series of good deeds. In 1811, Girard acquired the First Bank of the United States after Congress declined to renew its charter. The following year, he pledged his fortune to bail out the American government in the War of 1812. And upon his death in 1831, he bestowed his entire estate (he was the richest man in America at the time) to establish a boarding school in Philadelphia to provide free education to poor orphans. The school — Girard College — is still financed by his endowment today.
Girard is the rule, not the exception. The perception that bankers are greedy fat cats couldn’t be further from the truth. J. Pierpont Morgan could have amassed a fortune that rivaled the Vanderbilts or Rockefellers. Yet, upon reading Morgan’s will after the banker’s death in 1913, John D. Rockefeller is said to have remarked, “He controlled us all and he wasn’t even a rich man.” When A.P. Giannini died thirty-six years later, after building the biggest bank in the world (Bank of America), his estate was worth just $550,000. “I have worked without thinking of myself,” Giannini once said. “This is the largest factor in whatever success I have attained.” Fast forward to today, and while bankers are certainly not immune to error, if you go to any city or town in the United States and look at the people who volunteer on nonprofit boards, raise capital to build a new hospital or volunteer to help build houses for Habitat for Humanity, you’ll find that bankers dominate those roles.
You’ve interviewed dozens of publicly traded bank CEOs and have been covering the industry for a decade. What are some qualities that you look for in bank leadership? Are there any bank CEOs you view as particularly extraordinary?
This is an area I spend most of my time studying. The analysis boils down to CEOs who are committed to their fiduciary duties, particularly the duty against self-dealing. That commitment, in turn, derives from an innate or acquired tolerance to envy and avarice, which, in turn, derives from a person’s genetics and/or life experiences — the most valuable of the latter being ones that involve hardship or tragedy, which can steel executives against pressure to chase short-term growth at the expense of long-term solvency.
The bankers that I respect the most include the late Robert G. Wilmers from M&T Bank, Richard Davis formerly of U.S. Bancorp, Brent Beardall at Washington Federal, Patrick and Bob Gaughen at Hingham Institution for Savings, Scott Dueser at First Financial Bankshares, Aaron Graft at Triumph Financial, C.K. Lee at InterBank, Rene Jones at M&T Bank, Jim Reuter at FirstBank Holding Co. and Steve Miller at Fresno First Bank. This is the group of executives that, I believe will lead the industry going forward.
What are the most common sources of bank failures? Let’s say I had a friend that wanted to bet against a few banks likely to fail or chronically underperform, what red flags should they look for?
Failure is the rule, not the exception in banking. The best estimate is that upwards of 19,000 banks have failed since 1800. That’s about four times the number of banks that exist today. And if you factor in mergers completed in lieu of failure, the multiple is meaningfully higher.
Most bank failures follow a familiar three-part pattern.
First - Management enacts a new strategy.
Second - The new strategy accelerates growth by condoning concentration in an overcrowded asset class.
Third - A cataclysmic earnings decline which is often enough to wipe out a decade or more of past net income.
The primary differentiators in terms of failures are the underlying asset classes. As I’ve already noted, the first failures in the country happened in 1809 and were associated with a commercial construction project in Boston. Thirty-two years later, banks in Indiana failed en masse when the state defaulted on its debt, which had been used by banks to collateralize their notes. Twenty years after that, nearly every bank in Illinois failed when the Southern bonds they held on their balance sheets dropped by half after the start of the Civil War. Still later, banks have failed from drought, interest rate mismatch, speculation in stocks and bonds, fraud, seizure of the securities markets and from actions taken by the federal government.
By and large, however, the most common cause of failure is overconcentration in commercial real estate, particularly if the real estate isn’t located in the bank’s footprint. Two conspicuous failures in the 2008 financial crisis came better than this. Corus Bank in Chicago changed strategies and began concentrating in condominium construction in places like Florida. Eventually, more than 90 percent of its loan portfolio was associated with loans to condominium developers. ANB Financial in Northwest Arkansas followed suit by financing construction projects in Jackson Hole, Wyoming, and St. George, Utah, among other places. ANB failed in early 2008, while Corus was declared insolvent a year later.
One thing to keep in mind when analyzing a bank is the fact that their numbers are, whether intentionally or not, fabricated by management. This follows not from malfeasance, but rather from the fact that a bank doesn’t know its cost of goods sold until often years after the goods (loans) are indeed sold.
One other thing to note is that banks don’t typically fail for want of capital, but rather because of a want of liquidity that is brought about by a want of confidence. The common cliché that capital is king is thus wrong. Take Washington Mutual, the biggest bank failure in American history. At the end of the second quarter of 2008, it boasted the highest capital ratio of any big bank, yet it was the only one of them to fail. Similarly, when Continental Illinois became the first too-big-to-fail bank in 1984, it hadn’t reported a single annual loss up to that point which would have impaired its capital.
What are some interesting ideas on your radar now? Do you have any favorite ethical small banks to buy-and-hold for the long run?
Now is the time to be a bank investor.