Chris Whalen, Managing Director, Institutional Risk Analytics

(This is not a legal transcript. Bloomberg LP cannot guarantee its accuracy.)

CHRIS WHALEN, MANAGING DIRECTOR, INSTITUTIONAL RISK ANALYTICS, TALKS ABOUT BANKS AT MIDDAY SURVEILLANCE

MAY 16, 2011

SPEAKERS: TOM KEENE, MIDDAY SURVEILLANCE HOST

CHRIS WHALEN, MANAGING DIRECTOR, INSTITUTIONAL RISK ANALYTICS

12:01

TOM KEENE, MIDDAY SURVEILLANCE HOST: Let's bring in Chris Whalen. Very suspect. Walk in now, Chris, that's it. Did I hear a rumor that your book is in second printing?

CHRIS WHALEN, MANAGING DIRECTOR, INSTITUTIONAL RISK ANALYTICS: Yes.

KEENE: Is this public knowledge?

WHALEN: Yes.

KEENE: Congratulations.

WHALEN: Thank you.

KEENE: Why are people buying your book? Is it they're afraid of the American financial system?

WHALEN: I think they would like an explanation of how we got here, which, as you know, is why I wrote the book.

KEENE: It's a history...

WHALEN: A little context, not just the last 20 years.

KEENE: No, it's just...

WHALEN: And I think more than anything else, the positive feedback I get is, "Thank you for giving me at least a frame of reference." Some people take issue with my opinion...

KEENE: Interpretation, I say (ph)...

WHALEN: But I think overall, it's been well-received.

KEENE: OK. Here's a research note. We're going to do dreaded chart in a minute because we just got this late. I love this.

ING bank plus Ally Bank, the happy Dutchman driving ING off a cliff back home had decided they wanted a big U.S. bank out, I'll (ph) editorialize, to solve problems on NGP (ph) for funding over the internet and wrote Alt A (ph) loans.

WHALEN: Exactly.

KEENE: I was fun (ph) struck with the human comedy of GMAC renamed, touchy- feely adds...

WHALEN: Right.

KEENE: ...buying what seems to be a successful retail experiment. Your thoughts?

WHALEN: Well, internet banking has yet to prove itself to me, Tom, for the simple reason that you have to pay up to get the customer and keep them. There's no stickiness.

There's no brand...

KEENE: Right.

WHALEN: ...relationship, nothing. So these two banks at one time were actually shoveling money into the furnace, when they were really focused on internet. Even GMAC had their experiment in internet banking.

But Ally did it out of necessity. Once the government saved them, they've essentially had to go somewhere else other than the commercial papermarket to fund their auto...

KEENE: They made (ph) use (ph) of the internet.

WHALEN: Well, they use deposits now to fund auto receivables. At first, I was horrified by this. The returns weren't obvious. But you know, auto paper is short-term,

KEENE: Right.

WHALEN: Compared to a 30-year mortgage, it looks pretty good. Ally has gotten the bank cleaned up so that we give them an A, which is good.

But they still have issues upstairs of risk cap, all of these mortgage exposures that were making the bank look very bad...

KEENE: Right.

WHALEN: ...two years ago, they moved when the Treasury did the restructuring.

KEENE: And ING bank - I mean, it's just sort of like there.

WHALEN: Well, as I said, they grew for the sake of size. I know a lot of the people in that platform several years back. They were basically the high bid for the deposits.

KEENE: Right.

WHALEN: And they're either buying agency paper or making low payment loans. And again...

KEENE: Yes.

WHALEN: ...no branch network. They were buying market share. The guys in Holland wanted at least a hundred billion dollar bank. That was their instruction.

KEENE: Did they get it?

WHALEN: Yes, they did.

KEENE: OK.

WHALEN: But it was one of the worst performing trips (ph) in the country...

KEENE: Exactly, exactly.

WHALEN: ...it only turned down the gas and the marketing spend. And now, it's OK. But the real issue is what is the core deposit, quote-on- quote, "over the internet worth?"

That's what it comes down to.

KEENE: And the answer is not that much. Dreaded first chart here. Let's look at the banking industry in general. I don't get that merger. Someone will have to explain it to me.

Way (ph) in search of revenue, here's the key free-up (ph) index. I mean, as you look at the operating story, you're so negative from (ph).

WHALEN: Right.

KEENE: And I've got an email today from a sell-side analyst that really took off after you. He just doesn't agree that it's that bad out there. What kind of revenue growth do you expect from banks?

WHALEN: Flat to down depending on the institution.

KEENE: Down - really down.

WHALEN: Well, volumes going into the end of the year were OK. We had refinancing. The banks went out to every consumer that was refinanceable and at least asked a question.

And so today, when you look at the opportunity facing your average branch manager, it is the lesser credits.

You figure 40 percent, maybe half of all housing stock today's not release financeable, given the criteria you see at Fannie and Freddie. So your opportunity is reduced, is the basic thesis.

KEENE: Yes. We're going to have headlines, too, here for the entire hour on the soap opera playing downtown, of course, very serious matters with the former or the president of the IMF, Strauss-Kahn.

Just a headliner here - Strauss-Kahn should be held in custody, that, according to the prosecutors as that gets under way. No cameras in the courtroom.

Chris, when you look at the banking business and you look at the challenging revenues, anectode, I went into my bank, which I do, like three times a year. It was like Walmart on steroids. I got tackled. I got so many...

WHALEN: But being very nice.

KEENE: Yes. They were very nice about it.

WHALEN: Look, I think of banking as an extension of retailing, Tom. Every vendor you deal with in the retail channel today is greeting you at the door, asking you how your experience is, even before you have it.

And they want you 0to fill out a survey before you leave.

KEENE: Let's look up chart two here, Rex. Bring up chart two. This is important. This is something Chris Whalen and I would know about.

And boy, the late Mark Pittman (ph) would be all over us. The reverse split delusion or illusion, pick your word...

WHALEN: Well, we see it didn't go down that much.

KEENE: It's a $44 stock rocking, but nobody ever shows the chart that when you do a 10 to 1 split, it's gone now from $500 down to $44. I feel better at $44 than I do at $4. What do you think of reverse splits?

WHALEN: Yes. As a banker, I can't think of one that's ever worked as advertised.

KEENE: Thank you.

WHALEN: So I always recommend against them if a client ever asks me. It's better to buy the stock. They're going to reward you better.

But you know, let's face it. Citi was the biggest stock on the big board. They had reasons to try and get the handle on the double digits. They succeeded.

But it comes at a cost, obviously. If you were a shareholder the day before the effective date, you're not very happy because obviously, the thing is paid (ph) well (ph)...

KEENE: It's a delusion.

WHALEN: But I think Citi would have traded off anyway. You've got to realize, they have the same problem as the rest of the street. They've sold assets. They had $18 billion in revenues first quarter which was OK.

I'd rather see it two-handle. But the question is what do we have going forward?

KEENE: OK, let's come back. Chris Whalen with us.

12:07

(BREAK)

12:11

KEENE: Chris Whalen with us. OK, too much information. Bring it up here.

Loan demand - I can't figure this out, Chris. I'm getting a lot of different opinions right now. OK, stronger loan demand for CI banks, but it's, by no means, anywhere near normal. Is it? Is that right?

WHALEN: Well, you have the survey the Fed conducts, loan officers' house loan demand. When I talk to these same people, they shake their head and say no.

What I hang my hat on is the actual financial disclosure from the banks because it shows a downward trend, at least weakness. And let me give you an example. One of my positive recommendations has been PNC for years.

KEENE: Right.

WHALEN: They've managed that institution magnificently. After they bought Net City (ph), they're actually slightly bigger than U.S. Bank. But for the past two years, Tom, they've been shedding assets and managing that institution very defensively.

They had to pull provisions out of income or add reserves so they'd get in income, to hit their number. They did a few other things that some of their larger peers did to hit their number.

What do we do next quarter? What do we do the quarter after that? There's not much low-hanging fruit left.

KEENE: How much are they leveraged now? I mean, is it general rule, the European banks just 30 to one. The U.S. banks are 25 to one or 22 to one.

WHALEN: Right.

KEENE: What's that ratio in that?

WHALEN: Well, on bank balance sheets, leverage hasn't come down that much. But you don't have the non-banks sector anymore.

KEENE: The shareholders - go on...

WHALEN: You don't have the shadow banks.

KEENE: Right.

WHALEN: So the assembly line is broken. If we don't fix that, Tom, then we can't turn this economy around because housing will continue to deflate.

KEENE: Yes. Earlier this morning on "Bloomberg Surveillance, I spoke with Glenn Shore (ph) of Nomura and I asked him about mortgage lending and if it's still hard to qualify.

(BEGIN VIDEO CLIP)

SCHORR: It's amazingly difficult to qualify. I hear the anecdotal stories from all types of colleagues around the street, and people with really good quality credit are having a tough time refinancing without putting cash in to get their LTVs down.

I think every bank has raised the Owen Fico score and lowered the LTV.

(END VIDEO CLIP)

KEENE: So they're playing with it. Do you agree with Glenn on that?

WHALEN: Oh, totally. And when you see this, particularly, what he just described in the commercial sector, you have an income-producing property. Everything in the building is leased, Tom.

KEENE: Right.

WHALEN: But when you come for refi, they still want you to put more cash in, the lender, to give more of a credit buffer against future default. And these are properties that are not distressed.

KEENE: Yes. Let's bring up Ed Lazear (ph). This is my op-ed of the week. I want to switch gears here with you a little bit, Chris Whalen. The economy - it's behind that banking business.

This is Lazear of Stanford, one of the nation's great labor economist - why the job market feels so dismal. First of all, that number - $14 million, rounded up, the combination, low hiring and large unemployed, 13.7 million means a competition for jobs is fierce.

A worker is 1/3 as likely to find a job today as a zillion years ago.

WHALEN: That's right.

KEENE: I mean, the banks have got to compete in this. Isn't the history in your book, "Inflation," isn't the history consolidation?

WHALEN: Well, it is. And that's the natural tendency of human beings. No matter what you say about Keynesian economics or neo-Keynesian...

KEENE: Right.

WHALEN: ...people retrench when they see that demand is falling. This is just a natural human tendency. They pull back. And my fear is that we're going to see more of that this second half of 2011.

It's deflation. Go back to Irving Fisher in 1933, which is the playbook for Ben Bernanke. You have reflation driven by the central bank, but you also have that restructuring.

You have to rebuild the financial system so you can create credit again.

KEENE: This is critical question, folks. Didn't Ben Bernanke do that? He's going to restructure (ph)?

WHALEN: Well, he's doing (ph) his part. No, no, they haven't restructured at all. That's the problem. We haven't fixed the gray (ph) market securitization.

The private sector, if you will, for all sorts of financing, and the banking system's been shrinking for the past couple of years.

KEENE: Should Mr. Dimon and Mr. Pandit do their own restructuring? Should they take the responsibility on? Or do they need an institution to assist them?

WHALEN: No, I think they are doing - Citi has done more than the other three. That's why I still have them on a neutral by far. But the other three are doing it quarter-by-quarter, week-by-week.

And that means that we suffer in terms of growth. If you restructure quickly...

KEENE: Yes.

WHALEN: ...then you can restart things quickly. That's the trade-off very clearly.

KEENE: Where are the mergers? I mean, we were talking mergers at the end of the year last year. And you know, they're there. There's Skype and these technology stuff, National Semiconductor.

WHALEN: Right. But you don't see in the banks yet...

KEENE: Where is the big bank merger?

WHALEN: Well, the accounting still is your biggest obstacle. If you have two organizations that if you really do fair value have no equity left, then almost by definition, you're doing a recap.

You're not just doing a merger. And the problem is when a healthy bank looks to a bank that is not dying but they still have some problems...

KEENE: Right.

WHALEN: ...the accounting is very difficult in terms of getting all the auditors, both buyer and seller, to say, yes, this is fair value.

KEENE: Here's a sobering or rather chart of the day. This is jobless claims. I had a tough time at Dartmouth College. Thanks to Danny Blanchflower and great hospitality up there.

And you can see this nice trend we've seen, and I would say this directly relates to that animal spirit - you need in your financial system. You can see that little curly Q (ph) over there on the right side. That's not a good trend, is it?

WHALEN: No. And it goes to the point about demand. Right now, consumers are trying to delever. You know, we went through a period where you had too much leverage but the job market was artificially stimulated by very low rates - zero rates.

Now, here we are. We have basically the same interest rates, but you very little demand. And it's because of the change in perception, the change in the animal spirits, if you will, that they're not willing to take on their debt.

They're not willing to hire workers. Everyone I talked to, every vendor I call on when I have my other hat on, representing IRA (ph)...

KEENE: Right.

WHALEN: ...is trying to cut costs and stay away from anything having to do compensation. They'll do partnerships to do whatever but they don't want to bring on more comp costs right now.

KEENE: How linked the travails of small regional and big banks to the housing market now? Have they de-linked?

WHALEN: Well, to an extent. There's three kinds of banks in this country right now, Tom. There's the smaller stronger banks who never had a problem dealing with their losses.

They had enough income to just deal with it and keep going. U.S. bank comes to mind. No games there as far as earnings and loss reserves. You have a group in the middle that were badly hurt.

And there are still eight, 900 of them on the FDIC problem list. Some of those are going to get bought. Some of them are going to end up curing themselves.

But then, you still have a large number of institutions, especially the big ones, that have these outsized legacy costs that they're going to try and deal with over time.

And that means they're not going to participate in supporting a recovery.

KEENE: OK. Thank you. Wonderful summary. Chris Whalen, thank you so much.

WHALEN: Thank you, Tom.

12:17

***END OF TRANSCRIPT***

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