Photo by: Sue Clark.
Warren Buffett likes to ask executives a single question: If you could put a "silver bullet" through one of your competitors, which one would it be?
When multiple executives agree, Buffett knows he's found a very tough business -- one its competitors don't like to, or can't, compete with. That's the kind of business a buy-and-hold investor wants to own forever.
Two silver bullet banks
I've spent the last two weeks looking through countless traditional bank stocks. The two that stand out to me are BofI Holding (BOFI +3.40%), and New York Community Bancorp (NYCB +2.81%). It's an odd pairing -- one is a fast-growing Internet-only bank, whereas the other is a slow-growing, serial acquirer that pays out most of its earnings as dividends.
But they're remarkable at what they do. And what they do best is cost-cutting and risk management.
BofI Holding has an efficiency ratio of 38%; New York Community Bancorp's is 42%. Thus, each dollar in revenue is met with non-interest costs of $0.38 at BofI, and $0.42 at NYCB. Most other traditional, branch-heavy banks spend upwards of $0.60 to $0.70 per dollar in revenue.
How they do it
BofI Holding operates purely over the Internet, so it's easy for BofI Holding to minimize its operating costs. New York Community Bancorp has a network of branches spanning Ohio to Florida, and of course, New York. But it manages to keep costs down by underwriting bigger loans.
Actually, both banks make big loans a priority to their business model. BofI Holding "specializes" in jumbo loans. New York Community Bancorp lends primarily to multi-unit residential real estate investors. These fit the bill as "lower risk" loans because they are typically financed at lower loan-to-value ratios than typical residential lending. Multi-family and jumbo loans are often written for credit borrowers at a loan-to-value ratio of 70% or lower.
All else equal, writing bigger loans is more profitable. Anyone would prefer to make one $500,000 loan than 100 $5,000 loans. And there are additional efficiencies and synergies with writing bigger loans to real estate investors. A homebuyer might have five mortgages in his or her lifetime. An investor may have hundreds. Marketing costs are minimized by repeat business.
New regulatory changes also prohibit banks from charging prepayment fees on smaller, conforming, residential loans. That rule isn't in effect for larger multi-family loans.
Why other banks aren't as efficient
Few banks are lucky to have low operating costs. To lower operating costs, you usually have to cut out customer service and marketing spending.
Neither BofI Holding nor New York Community Bancorp are big marketers. Relative to peers like Capital One Financial (COF +2.87%) -- which has an online bank, Capital One 360 -- and PNC Financial (PNC +2.13%) -- which offers online and branch banking services -- BofI Holding and New York Community Bancorp are downright cheapskates.
I mention PNC and Capital One because they spend heavily on customer acquisition. Right now, PNC will pay you $150 just to open an account. Capital One will toss you a $50 bill. Going forward, I think aggressive marketing by Capital One and PNC Financial will make banking more and more competitive.
How these silver bullet banks will compete
When competitors are willing to throw money at customers to grab deposits, growing your bank's deposits isn't easy. Compared to other banks, BofI Holding and New York Community Bancorp rely heavily on brokered certificates of deposit and long-dated bonds, both of which cost more than deposits.
Of course, what I'm most interested in is the long game. Can BofI Holding and New York Community Bancorp compete against rivals like PNC Financial and Capital One? I think so. BofI's high interest rates attract big depositors. New York Community Bancorp attracts customers who want the traditional branch experience.
BofI Holding is chasing corporate banking accounts and deals with payroll card providers to get low-cost deposits. New York Community Bancorp will likely acquire a well-capitalized, deposit-heavy bank to lower its total cost of funds.
When they do, BofI Holding and New York Community Bancorp will have the best of both worlds -- low cost funding and low-cost operations. That's the perfect duo in the banking industry, and its why, of any banks, these are my two silver bullet banks.
