The Greatest Bank Business Model Out There

As the banking industry remains unpredictable, New York Community Bancorp (NYCB -3.77%) has a business model that has brought them success in an otherwise shaky market.

Tailoring their services to an area of New York that is constantly in high demand has pushed them closer to the SIFI threshold with each passing quarter. With increases in regulatory and commercial fees that go hand in hand with the SIFI threshold, they've hesitated to launch a full-force agenda to reach that magic number. But with a bill awaiting the go-ahead for an increase to that threshold, their worries might be inconsequential. 

A full transcript follows the video.

Kristine Harjes: Is this the best business model in the banking industry? This is Industry Focus.

Welcome to Industry Focus, financials edition. I'm Kristine Harjes and I've got John Maxfield on the line; The Motley Fool's senior banking specialist. We've got a great show for you today. Diving into this really unique business model of one particularly efficient bank. I first want to open the show with a quote from Warren Buffett.

It goes like this: "The insurance industry is cursed with a set of dismal economic characteristics that make for a poor long-term outlook. Hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way. In such a commodity-like business, only a very low cost operator, or someone operating in a protected and usually small niche can sustain high profitability levels."

I bring this quote up because the banking industry is also an industry with these dismal economic characteristics that Buffett talks about. He says "They make for a poor long-term outlook." What he means by this description is that companies that are in the business of commoditized products often don't have the economics to really easily be able to get strong pricing power and be super profitable.

It's easy to see why the insurance industry fits into this category because the only thing that differentiates your offerings there is price, but if you think about banks are kind of the same way. Money is just about the most commoditized product out there, but that leaves banks unable to compete on anything other than price with this undifferentiated product.

If you're an investor and you're looking for a competitive moat you have a bit of a conundrum. John, I've talked to you earlier about this dilemma. I would love to have you weigh in here and expand more on this insight of Buffett's in these commodity-like businesses such as insurance and banks. How can one find durable, competitive advantage?

John Maxfield: If you think about businesses in general, particularly from the perspective of an investor, what's the objective? The objective is to identify opportunities in businesses and business models that will produce outstanding returns. That is returns that not only beat other competitors in that particular industry, but is also able to outperform the market at large. That's how you become a really good investor; by identifying those.

When you're looking at industries there are all these different things that factor into what's going to allow a company to outperform other companies in its industry as well as the market at large. When you're talking about industries in particular that are commoditized then the only time -- Warren Buffett's letters have so much wisdom and context in terms of how to think about business.

One of the greatest analyses I've come across of his is when you are dealing in a commoditized market -- where it's extremely difficult for the average company to generate above average profit margins -- is if you're in a niche market so you have some type of monopoly pricing expanding your margin more than others, or if you're a low cost producer. Your margins are the difference between what you're bringing in for revenue, and what you're paying out in expenses.

Since money isn't the only commoditized product -- a dollar is a dollar regardless of whether it's a new dollar or an old dollar -- if your expenses are low compared to your revenue, compared to your competitors those are essentially the only two situations in a commoditized market that you can generate outsized returns. When you're an investor in banking that's really the starting point that you should bring to the table when trying to identify a good stock.

Harjes: That leads me right into the heart of what I wanted to talk about today, which is a bank that we think has found a way to exemplify both of these criteria for long-term competitive advantage in a commodity-like industry. That is New York Community Bancorp.

We have talked about this bank before on the show, usually in reference to its ultra-low efficiency ratio which makes it the most efficient bank out there by a long stretch. John, how have they managed this?

Maxfield: New York Community Bancorp is such an unusual business model. Even though it is a small bank relative to your Bank of America, J.P. Morgan Chase, Wells Fargo, and Citigroup, it provides a textbook example, or illustration of Warren Buffett's point that we started out the episode with. If you want to generate outsized returns you've got to either be in a niche market, or be a low-cost provider.

Then you look at New York Community Bancorp. You go back to the mid-1990s when it went public and it has outperformed. When you take into consideration the dividends, stock buy backs, and share price appreciation; it has outperformed every big bank in the country by a large margin. I think they say their total return over the past 20 years has been roughly 4200%, as stated on their website.

The data I came across was around 3800% or 3900%. Either way, it's even outperforming US Bancorp. US Bancorp is probably the best run, large bank in the country. So the question is: how has Community Bancorp been able to generate these outsized returns, even against the best in the business like US Bancorp? The reason is that it focuses on a very specific niche in the lending market.

It lends money primarily to owners of large, multi-family, rent controlled buildings in the New York Metropolitan area. There are two reasons why this works so well. The first is, as opposed to Wells Fargo that has to have thousands and thousands of branches spread across the United States which are really expensive to run in order to serve its consumer deposit base and consumer lending base; by focusing on many, fewer potential customers but larger customers, New York Community Bancorp is able to produce the same amount of revenue on a size adjusted basis as a large consumer bank at considerably lower expense.

Even more important, if not equally important to that, is the fact that because they're lending money on buildings that are rent controlled in the New York Metropolitan area, when the economy turns down and other apartment owners and other real estate owners see their vacancy rates shoot up and make it difficult for those building owners to service their loans, leading to higher default rates; there's always a demand for rent controlled buildings in New York because it costs so much to live there.

The cash flow on these things basically stay the same regardless of whether the economy is down or up. That means those owners can service their loans through all stages of the credit cycle, meaning New York Community Bancorp has zero loan losses, even in the worst of scenarios.

Harjes: We've seen that throughout history. Their record of loan losses is insanely good.

Maxfield: That's exactly right. Let's use a comparison point. If you're looking at national lenders Wells Fargo and US Bancorp are the absolute best. If you look at Wells Fargo, the CFO, or the CEO said "Through all stages of the business cycle we generally try not to lose any more on loan portfolio than 0.33% of our total loans" when things turn really bad.

If you look at New York Community Bancorp through all stages of the credit cycle, it's lost only 4 basis points, which is 0.04% of its loans to credit losses. Its business model allows it to dramatically outperform even the best in the business in this regard.

Harjes: It seems like, with such a specific business, they would be pretty small. From what I understand, that's not the case. How large is this bank?

Maxfield: You've hit on a really, really important point about New York Community Bancorp right now.

Harjes: Good.

Maxfield: You're very smart. I'm sure you knew that way ahead. If you look at its assets on its balance sheet it has about $48 billion worth of assets. That is a big bank, but it's nothing like your $2.2 trillion Bank of America, or $2.5 or $2.6 trillion J.P. Morgan Chase. It's relatively small compared to those, but to most other banks in the U.S. it's pretty large.

That $48 billion is so important because it's $2 billion underneath the $50 billion threshold. After a bank crosses that threshold they are considered a systematically important financial institution; a SIFI. A laymen's term for that is that they are then "too big to fail". Once a bank is classified as "too big to fail" under the Dodd Frank scenario that means they are subject to higher capital requirements and higher regulatory and compliance costs. That makes a bank much less efficient.

New York Community Bancorp has been struggling, thinking "Here we are under this threshold. We don't want to pass it." Normally, a bank would just organically grow a few percent a year and that would put it past that $50 billion threshold. New York Community Bancorp doesn't' want to just slightly pass it because then they'll have all those additional expenses with only a small amount of additional revenue. What it wants to do is a transformative merger.

They want to do a large merger, or acquisition that will 'transform' the business in such a way that it will be much larger and it will have the economies of scale that are necessary to then absorb those additional costs while still staying as profitable. That is the whole conversation. If you listen to a New York Community Bancorp conference call after the quarterly earnings, or if you read the transcript, that takes up a large chunk of the conversation right now among the executives.

Harjes: I'm sure it must. What's the speculation out there? Has the bank said anything? Have you heard any inklings of a rumor about where thy might head for this sort of merger?

Maxfield: The bank has been pretty quiet about that, and you can understand why. They wouldn't want to ignite a bidding war for a potential acquisition target. It has said that it's first going to be a transformative merger, and secondly it could be a non-traditional lender.

The question is "What does a non-traditional lender look like?" Particularly, what is most attractive to New York Community Bancorp? If you look at its business model one of the small downsides compared to the upside is, because it doesn't have a large consumer deposit base it has to get its money from the money market. It has to borrow it from corporations that are buying commercial paper, or selling C.D.s and all these other things that are much more expensive than consumer deposits.

You can see this by looking at its cost to funds; how much it pays to borrow all the money it has to borrow in order to support its asset portfolio. Its cost of funds in the most recent quarter was something like 1.37%, whereas Wells Fargo's cost of funds is around 0.34%. It's much larger than that.

I would think the goal would be -- and I could be wrong -- to pick up some type of bank or company that has a large amount of consumer deposits because that will decrease its cost of funds and make it more profitable even after you take into consideration the higher regulatory and compliance costs associated with being a SIFI.

Harjes: At that point they wouldn't have that advantage anymore of not having to maintain all these bank branches. Why do you think they would abandon that just to get that cost of funds a bit lower?

Maxfield: That's a great question. There is another niche business model in the banking industry that has a lot of low-cost deposits, or a lot of consumer deposits that are low-cost relative to the money market, nut they don't have an extensive branch base. That is your online banks. The Bank of the Internet is probably your textbook example of that.

I would think -- again, I could be completely wrong on this -- but I would think a bank like New York Community Bancorp would be looking at something along those lines where you get the good from the deposits, but you don't have the bad from that extensive branch network.

Harjes: That would certainly be a transformative merger.

Maxfield: It would be. If you think about it -- and you listen to the conference call -- these guys are from New York; they're New Yorkers. You have these guys going out and buying an online depository institution and then funneling that money in, allowing it to fund the purchase of these multi-family rent controlled units in the New York City Metropolitan area.

New York would owe all of us west of the Mississippi -- I know you're on the east coast -- a big thank you.

Harjes: When do you think that these hard core New Yorkers are going to make this move?

Maxfield: That remains to be seen. What they said on their most recent call is -- it sounds like they've identified some perspective targets that they're interested in, but they want to make sure that they dot all their I's and dot all their T's on a regulatory level before they go to the regulators and ask them to pass that threshold.

The second thing to keep in mind is that there is a bill working its way through senate right now that would actually increase the SIFI threshold from $50 billion to $500 billion. If that bill goes through...

Harjes: Wow! That would be a game changer.

Maxfield: It would be a total game changer. To be honest, that's probably the appropriate thing to do. It would only leave 6 banks that would be considered "too big to fail". If that threshold changes then that would open it up for New York Community Bancorp to do a merger or acquisition at any point in time. If that doesn't' go through they'll work more slowly and methodically and make sure regulators are OK with the decisions that they're making.

Harjes: Lots to keep an eye out for coming up, it looks like.

Maxfield: That's exactly right. As we wrap up, to make sure everyone understands exactly the significance of New York Community Bancorp; it proves again that Warren Buffett is right. If you want to generate outsized returns in the bank industry you've got to invest in a bank that either has a niche market -- some type of niche market that allows it to earn large margins on its revenue -- or it's got to be a low-cost producer.

You identify those, you will find a bank that will generate much larger returns over the long run than its competitors.

Harjes: Fortunately, New York Community Bancorp exemplifies both of these things which is pretty awesome. If you listeners, in your research, find any others that you think are just as good and follow what Buffett is saying for the best way to generate these outsized returns; let us know. I have said this before and I'll say it again: we love hearing from you. Our email address is [email protected]. Shoot us an email.

John, thank you so much for being here and for all of your insight as always. Looking forward to talking to you next week. As always people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against. So, don't buy or sell stocks based solely on what you hear.