"In the fall of 2007, my daughter called and asked me, 'Dad, what is a financial crisis?' I answered her by saying, without intending to be funny, 'It's something that happens every five to 10 years.' She then asked, 'So why is everyone so surprised?'"
-- Jamie Dimon, 2007 letter to shareholders of JPMorgan Chase (NYSE:JPM)
Nothing is more important than a deep appreciation for the credit cycle if your goal is to be a great banker or bank investor. And if you want a deep appreciation for the credit cycle, then you have to know a thing or two about history.
The United States has experienced 14 major bank panics in the 216 years since the turn of the 18th century. That averages out to one every decade and a half. The frequency is even greater if you include less severe crises such as the one in 1884 that led to the failure of Grant & Ward, a brokerage firm founded by former Union general and U.S. President Ulysses S. Grant.
The storyline in the lead-up to these panics is always the same. Bankers convince themselves that credit risk has been conquered, that the economy has been fundamentally altered, and that it will grow without interruption. This leads them to ratchet up the risk on their balance sheets by lowering their credit standards or outsourcing risk management altogether by purchasing brokered loans.
We saw this during the less-developed-country crisis of the 1980s and 1990s. Explaining why lending to Argentina and Mexico was a prudent strategy, former chairman and CEO of Citigroup (NYSE:C) Walter Wriston claimed that "countries don't go bust." This turned out to be wrong. Both countries defaulted soon thereafter, as they had multiple times in the past. The miscalculation not only revealed a sense of naivete, nut it also brought Citigroup, as well as Bank of America (NYSE:BAC), to their knees.
"So great was the reckless foray that a 1993 study conducted by the Federal Reserve Bank of Boston found that had the money center banks truly recognized all the losses inherent in their books in 1984, one major bank would have been insolvent and seven others dangerously close," wrote the CEO of M&T Bank (NYSE:MTB) in his 2011 shareholder letter.
We saw a replay of this in the lead-up to the financial crisis of 2008-09, when bankers proclaimed that credit risk had been conquered by a combination of securitization and diversification. The same year that JPMorgan Chase's Dimon issued an apocryphal warning in his 2006 shareholder letter, the then-CEO of Bank of America, Ken Lewis, told his shareholders:
We believe we are in a good position to weather any credit issues we currently see on the horizon. [Bank of America's] ability to distribute credit risk through the securitization of various asset classes adds further stability. And as our risk managers analyze information about our customers in ever more sophisticated ways, we can grow our portfolio without significantly increasing our risk profile. In fact, in some parts of our business we are actually saying "yes" to more customers while at the same time improving the average quality of our loans.
In short, bankers are frequently surprised by what's normal, just as Bank of America and Citigroup were when the financial crisis materialized in 2007 and 2008. They're caught off guard because they don't know, or have somehow forgotten, that banking panics and crises are the rule, not the exception in financial history. "No one has the right to not assume that the business cycle will turn," Dimon implored his subordinates in 2006. "Every five years or so, you have got to assume that something bad will happen."
The best bankers combat this by maintaining discipline. "We set our credit standards and policies in normal times, and then adhere to them religiously throughout all stages of the cycle," US Bancorp's (NYSE:USB) CEO Richard Davis told me. The CEO of M&T Bank, Robert Wilmers, has echoed a similar sentiment in his wide-ranging shareholder letters. M&T Bank's executives are especially quick to point out that M&T tends to match or underperform its competitors at the top of a cycle but then surge ahead during and after the cycle's trough.
The performance in the last crisis backs this up at JPMorgan Chase, U.S. Bancorp, M&T Bank, and Wells Fargo (NYSE:WFC). All of these banks avoided the worst excesses that brought Bank of America, Citigroup, and many others to within a hair's breadth of failure. To get a sense for this, I encourage you to read Wells Fargo's 2008 letter to shareholders in addition to JPMorgan Chase's especially prescient 2006 letter. And anything written by M&T Bank's Wilmers or U.S. Bancorp's Davis before, during, and after the crisis will invariably increase your appreciation for what prudent and profitable banking looks like as well.
All of these banks benefited handsomely from their competitors' refusal to heed history's warning. JPMorgan Chase picked up Bear Stearns and Washington Mutual for pennies on the dollar -- though the acquisitions have since cost the bank billions in legal fees and settlements. Wells Fargo more than doubled in size thanks to its acquisition of Wachovia. M&T Bank picked up a leading wealth manager and a large regional bank, both at steep discounts. And U.S. Bancorp continued its prudent strategy to fill out its existing footprint, and has since emerged from the crisis as the most profitable big bank in America.
The point here is that none of these banks were surprised by normal. All of them understood the dangers and opportunities that history makes so clear. And all of them used this understanding to temper their animal spirits in halcyon times and later surge ahead in the downturn while their less prudent peers were forced to retreat and retrench.
This same storyline will play out again in the future. And it will always be the same. Bankers who know and appreciate the lessons of history will prevail. Those who don't will see their banks flounder or perish.