Shareholders of Bank of America have spoken: CEO Brian Moynihan can keep his position as chairman of the board. As John Maxfield and Gaby Lapera discussed on Monday's episode of Industry Focus: Financials, while the results of the vote may seem obvious in hindsight, many analysts and commentators had previously predicted that the outcome would go the other way.
Listen in as we discuss this, as well as the Federal Reserve's decision to stand pat on interest rates following the latest meeting of its monetary policy committee.
A full transcript follows the video.
Gaby Lapera: This is The Motley Fool's financials edition, where we make banking news interesting or at least less boring.
Hello, everyone. Gaby Lapera here with John Maxfield on the phone. Today, we're going to be talking about Bank of America and the Fed doing, well, nothing. Let's start with Bank of America because something's actually going on there. We talked about this a few weeks ago. Back in September of 2014, Bank of America quietly merged the position of CEO and chairman of the board.
This caused an outcry among investors who had voted to split the positions during the financial crisis in 2009. Back then, Ken Lewis was in charge and Brian Moynihan took over for him as CEO in 2010. What's Moynihan's track record like, Maxfield?
John Maxfield: People look at this differently than I do. When I read the news, I get the impression that Moynihan has done an excellent job as CEO of Bank of America. What's important to understand is that even though they're struggling and have struggled over the past five or six years, none of that was Brian Moynihan's making.
Brian Moynihan stepped into the CEO position in the beginning of 2010 after the disaster of Countrywide Financial and all these losses had occurred. He has really been the cleanup guy, which has been his role at both Bank of America and Fleet Boston Financial, which is the company he was at before Bank of America. Fleet Boston was actually purchased by Bank of America.
I personally think, if this is a referendum on anything, it's not been a referendum on Brian Moynihan's performance; it's a referendum on the board of directors who made the decision to elect him chairman of the board in addition to being CEO without asking for shareholder approval.
Lapera: Right. So it's not because Moynihan is terrible. It's because the board is sneaky. Granted, there are pros and cons to having a split CEO and chairman of the board just from a purely functional perspective. It makes it harder for the company to deal with others when you have a split position like that.
Just like the United States has one president to deal with foreign powers, it makes it a lot easier for companies -- which the vast majority of companies do have this CEO/chairman of the board combination -- but there are other reasons to have a split position. They can be especially beneficial for navigating the peaks and troughs of the economic cycle, right?
Maxfield: That's right. Just to be clear -- and I know you said this at the beginning but this is a really important point -- the problem with Bank of America isn't just that the CEO and the chair are combined, which would theoretically reduce shareholder oversight. The board is supposed to provide that oversight of the executive.
The problem is more that, in 2009 a majority of shareholders voted to split the positions and then a mere five years later the board of directors unilaterally reversed that decision. When you look at that, you think the shareholders are the owners of the company and then the board of directors and a substantial share of the board of directors are relatively new to the board over the last few years you think, "Why would Bank of America's board do that?"
It's difficult to figure out why they felt compelled to go around shareholders in this regard. They didn't see problems ahead as a result of doing that. I was talking to an academic the other day who calls this the El Dorado of corporate governance; the question of whether or not a company's chairman and CEO should be combined because even though there have been over 100 studies on this issue, not a single one of them has been able to find a statistically significant correlation between a company's performance and whether or not the CEO and chair are held by the same person.
Lapera: Right. I believe you're referring to this 2013 article by Krause Semadeni that looked at the performance of companies depending on whether or not the two positions were split. Their analysis found strong support. I didn't' see anywhere that it found statistically significant support, but strong support...
Maxfield: What that study found is that -- they looked at S&P 500 companies that split that position and then broke it down into these different categories. And the only thing they found was, at the small handful of companies that split the position somewhat punitively after a company had performed poorly, they found there's an improvement in the results subsequent to that.
Alternatively, they found that if you split the role after a really good performance then you'd see the performance go down. The sample set where the number of S&P 500 companies actually split those roles within their sample was a really small share, but what they weren't able to find was, for the vast majority of companies on the S&P 500 that actually kept them together or separated them without a change during the years between 2003 and 2005; they weren't able to tease out any sort of correlation between the two.
This would lead you to believe that, at best, their studies show if you're going through a hard time and you think it's the CEO's fault who's also the chairman, then of course he should be demoted from being the chairman. Alternatively, if things are going well, why in the world would you split them? That's what their study found.
Lapera: Right. To remind listeners, the vote on whether or not to split the position -- because the board has backtracked and said they respect the investors and they're going to let them vote on this -- that vote is tomorrow, September 22, 2015. There's no real way to know exactly how the vote is going to go, but I will say that a lot of large institutional investors have said that they are going to vote against having the position enlarged.
We'll definitely talk about that last week, right?
Maxfield: Yeah. Let me bring up one more point about that. A lot of institutional investors are lining up against Bank of America on this. This is particularly the big pension funds of the different states and government entities. However, one important thing to keep in mind is that Bank of America's biggest shareholders are actually institutional investors that operate mutual funds or index funds.
These are like BlackRock, J.P. Morgan Chase, Fidelity; and the majority of those companies' CEOs are also their chairmen. If you look at the top five shareholders of Bank of America, four of them have CEOs that are also the chairs, which would lead one to believe that at least a month the very biggest shareholders of Bank of America that they're more inclined to vote against splitting the roles, as opposed to voting for it.
Again, if a large enough share of those smaller, but still large enough institutional investors are able to get together and vote against it then Moynihan very well could be facing that possibility.
Lapera: Awesome. That's interesting stuff. Let's move on to some other wild speculation. I'm talking about the Fed interest rates. Just last week the Fed voted to keep interest rates the same; near 0%. There's definitely a few different reasons this could have happened. One of the primary reasons that seem to be bandied around is that there are overseas economic weaknesses, especially in China and Europe.
This could be one of the motivating factors in keeping the interest rate low. When foreign markets are weak it drive sour foreign exports down because our dollar is much stronger, so people aren't going to want to buy our products. Additionally, even though we've hit our unemployment target, the inflation is still crazy low. It's only at 0.2%.
Maxfield: Yeah. Let's break this down. We have two different things that are going on here. You have China who's having a lot of problems right now in their markets and potentially in their economy and one of the things their central banks did was devalued the yuan relative to the U.S. dollar. That makes the U.S. dollar much stronger.
Also, if you look at what's going on in Europe, because of the economic turmoil surrounding Greece and the other troubled countries, the euro is also trading at a decade low. If you're looking to travel to Europe, now would be a pretty good time to do so. The problem with that is because the dollar is stronger, it costs more for our trading partners to buy things from us, which then drives down your exports. Exports are a part of GDP so that impacts your economic growth.
If the Federal Reserve were to come in and raise interest rates, what would happen in that situation is foreign money would flood into the United States, take advantage of those higher interest rates, and when foreign money floods into the United States what happens is foreign investors are exchanging their currency for U.S. dollars. They're buying U.S. dollars and the demand for U.S. dollars goes up.
When the demand for U.S. dollars goes up, the price of U.S. dollars goes up relative to their own currencies, which further drives down your exports. I think that's one of the two primary reasons why the Federal Reserve is so reluctant right now to pull the trigger on higher interest rates.
That second point is, with the Federal Reserve we have a dual mandate. Its responsibility is to maintain full employment at the same time that they're balancing price stability. You don't want runaway inflation out of the interest to drive unemployment down to 1%. When they define full unemployment, right now they're defining it as between 5% and 5.2% unemployment rate.
I think our most recent reading was 5.1%, so they've hit that target. The problem is, their target on the inflation side is 2%. A lot of people think that inflation is bad. A lot of inflation is bad, but a little bit of inflation is actually a sign of a very healthy economy. What the Federal Reserve has found is, they think that for the United States economy, a 2% inflation mark is a sign of a healthy economy. Inflation right now is 1/10th of that.
That's the second reason it appears that the Federal Reserve seems to be holding back on driving up those rates, even though countless analysts and commentators have been speculating that they'll do so at some point this year.
Lapera: I do want to point out... sometimes people worry because when the Fed doesn't raise interest rates, maybe it means our economy is weak. It's actually possibly the opposite; our economy is fairly strong right now. It might be a little too strong in comparison to everyone else's. I wouldn't worry about the market just crashing all of a sudden.
Of course, with the added stipulation that you never know what's going to happen, right?
Maxfield: That's exactly right. Unemployment is really good right now in the United States, and because our economy -- on a relative basis, relative to the other economies of the world -- seems to be doing the best among the major economies; that is the reason that the U.S. dollar is already strong, and the reason that the Federal Reserve wouldn't want to make it even stronger. At least, not right now.
Lapera: Right. Then there's also the possibility that Janet Yellen is just being conservative with interest rates because the last time there was something in an economic crisis this large was the Great Depression.
Maxfield: That's exactly right.
Lapera: What happened then was a lot of people think that right at the beginning, when the economy was recovering, they cut programs and cut initiatives that had been helping the economy too soon, which drove the country back into depression. We really only recovered from that when we entered the world war.
Maxfield: Right. That's exactly right. Let me just clarify a couple things in there. When we think of the great depression we just think of one big, bad thing. The great depression was actually two steep recessions that were in close proximity to each other. One was in 1930, and the other was in 1937.
The economic historians that have looked back, the most credible one that carries the most weight nowadays look back on that second recession in 1937 and say that the reason it happened was because the Federal Reserve started increasing interest rates too early, before the economy was stable enough, and that kicked us back into another deep recession.
When you couple that with the first one, that's what makes up the great depression. You can be assured that Ben Bernanke was a specialist on the great depression, and Janet Yellen who worked with him for many years at the Federal Reserve; you can be sure that 1937 in particular is one of the things that is on their head right now, as they're trying to determine when to start reducing their support for the economy.
Lapera: Right. Of course, people are already asking if the Fed will raise interest rates the next time they meet. I definitely want to put out there: trying to predict what the Federal Reserve will do is impossible. Everyone always wants to try. There are always articles coming out that "They're going to raise it", or "They're going to lower it".
I saw an article this morning saying they're going to have negative interest rates, which is just absurd and inflammatory.
Maxfield: That's very possible to have negative interest rates. We're not far from there right now. We're only 20 basis points, but to your point; nobody knows. It's extremely difficult to predict what the Federal Reserve is going to do because they're looking at so many variables and a lot of their variables other people don't have access to because they have such good data.
It really is a fool's errand to base any type of investment decision around what you may or may not predict the Federal Reserve is going to do. I can guarantee, you may guess right, but it's all just a guess.
Lapera: That's very true. We're obviously going to report on this next time they meet. They might do nothing again. They might do something because I believe the next time they meet is in December, which is right in the midst of one of the stronger upticks in our economy due to the holiday spending.
Who knows? Maybe they'll keep it the same. The other thing to keep in mind is; besides them having a lot more data than we do, we also don't know what's going to happen in the rest of the world, economically speaking. There's just no way to no. Everyone; sit tight and react to what happens, as opposed to trying to anticipate.
Our time is almost up here, but next week we're going to be doing an earnings preview for the banking sector's third quarter. We've already heard that banks think their revenue will be down and the volatility is high.
Maxfield: We've heard that. Banks haven't said that their revenues will be down, but what they've said is revenues from trading are going to be down. Revenues from trading depends on what bank you're looking at, but they account for something like 5% or 10% of some of these big, universal banks' total revenues.
It's not a majority of the revenue; it's a small share, but even a small share makes a big difference. Look at Bank of America in particular. In the six months into June 30th this year it earned just south of $4 billion in trading revenue. They're saying that their trading revenue is going to be down by 5% in the upcoming quarter.
That translates into something along the lines of $100 million of quarterly pre-tax income. $100 million dollars for a company like Bank of America where, when everything is going well it should be earning around $6 to $8 billion per quarter in after tax income; $100 million may not seem like a lot, but $100 million is $100 million. Every little bit matters.
I figured the statistics before we jumped on the podcast. One thing with trading revenues you have to keep in mind with these large banks is that they are inherently volatile. Look at J.P. Morgan Chase and go back to the beginning of 2007, capturing the financial crisis, and compare the volatility of its trading revenue, to the volatility of its asset management revenue, to the volatility of its investment banking revenue.
What you see is the volatility expressed by standard deviation, for its trading revenues is 10 times greater than either the volatility for its investment banking revenue, or the volatility for its asset management revenue. That just goes to show that this goes with the territory when you're talking big, universal banks. It shouldn't be a big surprise, but it is something that's going to be weighing on their results in the upcoming quarter, which could have a downward impact on their share prices.
Again, they could have revenue in other areas that makes up for the difference. Really, to figure out and see what happens on the actual bottom line you've got to wait to see their results, which we'll talk about next week.
Lapera: Great. We'll definitely get into that next week. Just a reminder to our listeners out there: The Motley Fool and John and I may have positions in any of the stocks mentioned. Don't buy or sell based on anything you hear today. Thank you very much for listening, and have a great day!
