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The secret to running a successful commercial bank is to lend at a good margin above the cost of obtaining those funds from depositors etc., while holding down operating costs and lowering losses inflicted by borrower default. It helps if there is plenty of non-interest income as well such as fees from investment management. If all is going well on these fronts the bank will produce a high rate of return on equity capital.
The first key observation are that Wells’ net interest margin was above 5% in every year in the 1990s, sometimes substantially above. It was 5.8% in 1995, and even in the recession year of 1992 it was 5.7%. This compares very well with the average US commercial bank only achieving 4.2% – 4.3% net interest margin.
So that’s the first key element Buffett and Munger needed to see – plenty of money coming in the form of interest from lending out deposited cash. But what about the cost of running the banking operations needed to generate that interest, i.e. noninterest expenses?
These did jump by 18% in 1991 ($1.7bn to $2bn), but that was mostly due to the previous year’s purchase of the Californian banks of Great American Bank of San Diego (92 offices $4.4bn in deposits), Citizens Holdings Bank (6 offices, $207m deposits) and a collection of four other California banks bringing in 28 offices and $1.5bn of deposits. These all had day to day expenditure to deal with. thereafter, expenses rose slowly, at about 2% per year until 1996.
To appreciate the impact of expenses on returns for shareholders we need relate them revenue, which is what you can see in Figure 1.12. Revenue consists of net interest plus noninterest income (e.g. fees & commissions, service charges, trust and investment services, advisory services).
Figure 1.12 Wells Fargo noninterest expense as a percentage of total revenue 1990 – 1995
Source: Wells Fargo Annual Reports and Accounts
Wells Fargo’s were kept below 60% of revenue and then fell, down to 54% in 1995. The rest of the banking sector suffered a peak in noninterest expenses of around 69% and it did not fall below 63% in the same period. Reichardt and Hazen’s laser-like focus on costs paid off; Wells Fargo was one of the most efficient, if not the most efficient bank in America.
A large gap between revenue and expenses is good, but it is not sufficient to ensure high profits. We also need to know if a great deal of money was lost through loan write-offs and other defaults.
Loss provisions did indeed rise in the recession years. Whereas the directors set aside a mere $310m in 1990 they had to provision for $1,340m in 1991, $1215m in 1992 and $550m in 1993. As a percentage of loans this was only 0.6% in 1990, but over 3% in 1991 and 1992.
Buffett was almost spot on with his loan provision estimate for a recession. In 1990 he had reasoned that even if one in every ten loans granted by Wells Fargo (totalling $48bn) entered a troubled period and, after some forbearance and restructuring, around one-third of these ultimately defaulted completely the bank would roughly break even – losses on defaults would amount to about $1.2bn and its income from net interest and noninterest sources (less running expenses) would amount to the much the same.
We can see how it turned out in Figure 1.13. After tax profits did indeed plunge from $712m in 1990 to $21m in 1991 as a result of the billion dollar plus losses expected on troubled loans. But note that net interest income actually rose from $2.3bn to $2.5bn and non-interest income stayed at $0.9bn. Both of these sources of income then rose steadily. through to 1995 while loan loss provisions fell to a very small amount in the mid-1990s. Hence the large rise in profits – topping $1bn – earnings per share and dividends. Six years previously, BH had bought in when Mr Market gave the bank a market capitalisation under $3bn.
Figure 1.13 Wells Fargo after tax profits, $m, 1990-1995
Source: Wells Fargo Annual Reports
Earnings per
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