"These new products are in essence combinations of conventional options or futures contracts, but, in their most sophisticated versions, they incorporate all the risk-management inventions I have described, from Pascal's Triangle to Gauss' normal distribution, from Galton's regression to the mean to Markowitz's emphasis on covariance, and from Jacob Bernoulli's ideas on sampling to Arrow's search for universal insurance. The responsibility of pricing such complex arrangements goes well beyond what Black, Scholes, and Merton had so painstakingly worked out. Indeed, all three men ultimately showed up in Wall Street to help in designing and valuing these new risk-management products.... But who takes the other side of contracts that come into existence precisely because they are too specific in their coverage to trade in the public markets? Who would be in a position to play the role of speculator and assume the volatility that the corporations were to urgently trying to shed? Few of the counterparties to these tailor-made corporate deals are speculators."

Peter L. Bernstein (1919-2009)
"Degrees of Belief: Exploring Uncertainty"
Against the Gods: The Remarkable Story of Risk
John Wiley & Sons (1996)

The US Supreme Court struck a blow for citizens rights and the rule of law with the decision to "allow" the State of New York to investigate loan fraud committed by national banks within its territory. The high court, in a 5-4 opinion on an appeal on a writ of ceriorari of Cuomo v. Clearing House Association et al., written tellingly by Justice Antonin Scalia, said federal banking regulations didn't preempt the ability of states to enforce their own fair-lending laws. Hopefully this decision ends the specious fiction that the OCC and the large banks may tell the sovereign states what laws they are allowed to enforce.

It says a great deal about the leaders of the commercial banking industry generally that they would pursue a position so completely at odds with the US Constitution, namely federal preemption of consumer protection laws enacted by the states. After all, there is no federal tort law -- this despite the valiant efforts by members of the trial bar to synthesize one out of thin air. Whether regarding claims of product liability defect or financial services fraud, the Supreme Court has made clear that multiplicity of legal conflicts, discovery and decisions of state law claims, whether heard in state or federal courts, is the preferred route for resolving disputes under our federalist system.

No act of the national Congress, much less a mere regulation promulgated by a federal government agency, supersedes state law -- unless in an area specifically enumerated in the Constitution. In fact, under our Constitution, the states are paramount. Yet the proponents of "efficiency" in Washington, who by and large are also advocates of financial innovation, managed to deprive the citizens of the fifty states of their legal rights for a decade via the theory of state law preemption. Bravo to Justice Scalia and the majority.

The efficiency so prized by the Obama Administration and the nations of Europe, where individual rights are nonexistent, should be rejected by all Americans as an alien concept. Arguments regarding efficiency are often a pretext for evading well-established legal norms or internal controls within corporations, especially when the arguments are made by dictators or, in this case, bankers and their captive federal regulators.

Due process and good governance require inefficiency and discovery. Aggressive, politically ambitious state prosecutors and trial lawyers operating under state law are a necessary check on the "efficiency" of federal regulators and their conflicted sponsors in the Congress. Jamie Dimon of JPMorgan (NYSE:JPM) and the other members of the Clearing House Association will just have to spend more time in Albany.

Hopefully the defeat for the OCC and the state law preemption lobby led by the American Bankers Association will force all of the parties to come to the table. It is high time to settle the infantile dispute between the states, on the one hand, and the OCC and the Congress, representing the ABA and the larger players in the banking industry, on the other. Now that we have dismissed the notion that Washington can preempt private state law claims for redress against fraud or other bad acts by lenders doing business in these jurisdictions, maybe the banking industry can stop spending tens, perhaps hundreds of millions of dollars pursuing this issue and instead cut a deal.

The Congress does not need to create another federal financial consumer protection agency, but instead needs to organize the states to enforce a common national standard for all lenders and all products. The ABA and the banks are right; we do need a single legal standard which the states can then police and enforce. If we give the Fed, as seems inevitable, greater say over systemic risk issues, then FDIC should be the federal enforcer of consumer standards. By using the states and their attorneys general as the first line of defense, but require common federal standards for products and with federal regulators supervising the application of these standards, we might just achieve efficiency that is also accountable to consumers.

As Anne Rutledge discussed in The IRA last week, ("Back to Basis for Securitization and Structured Credit: Interview With Ann Rutledge,") simply enacting federal definitions for common mortgage industry terms like default would go a long way to help make consumer protection a practical reality. Remember that every monument built in Washington in the form of a federal agency created by a member of Congress costs the federal taxpayer forever. Monuments built at the state level tend to be smaller and less costly to maintain.

Two housekeeping notes. First, our new consumer web site, www.irabankratings.com is operational but still a work in progress. We are going to provide lots of functionality in this new bank analytics consumer portal, but as with Disneyland you must register on the IRA Bank Cart to gain admittance to the theme park. We will also be providing banks with self-serve functionality to address the needs of their customers and investors for timely information. When you pull up a Bank Stress rating summary for a bank on the IRA Bank Monitor, that bank will have the opportunity to display information about their operations, products and services.

Second, we have started to publish occasional profiles like those below as a feature in American Banker. Last week we profiled Frontier State Bank (FDIC Cert# 21978) and we will be picking banks at random to profile in future issues of American Banker. Please let us know which banks you'd like to see us profile in a future commentary.

IRA hosts a tool called Benchmark My Bank on www.americanbanker.com that lets you look up financial analytics and benchmarks for specific banking institutions using the same tools that power The IRA Bank Monitor. If your organization would like to have IRA's Web Services functionality driving traffic to your web site or for internal use, including hosted analytics solutions for bank regulatory data as well as market data, financial statement information and documents from the SEC's EDGAR portal, please contact us at info@institutionalriskanalytics.com.

Bank Stress Profiles: USB and CFR

Switching to the main topic of this issue of The IRA, as Q2 2009 comes to a close, we want to showcase a couple of superlative banks to give our readers an example of how we analyze financials for clients of the IRA professional Advisory Service. As with Q1 2009, we'll be harvesting the Q2 2009 call reports from the FDIC web site in real time as they are released by supervisory review personnel. The profiles of US Bancorp (NYSE:USB) and Cullen/Frost Bankers (NYSE:CFR) below are based upon the QuickSheet displays in The IRA Bank Monitor as of Q1 2009.

The Stress Index in The IRA Bank Monitor is a CAMELS type ratings analysis that asks a simple question: How did my bank do this quarter? We look at Return on Equity, Defaults, Lending Exposure, Capital and Efficiency and then array the results of this quarterly stress test census of the entire US banking industry using an an index to score each bank. The index has a baseline of 1 = 1995 and a maximum stress score of 100 or two orders of magnitude above the 1995 baseline of 1. We picked 1995 as the baseline for the Bank Stress Index because it was an unremarkable year, neither good nor bad in terms of bank operations stress.

At the end of the first quarter, USB had a Stress Index score of 1.4 vs. the 2.4 for the industry as a whole. It is accurate to say that the Stress Index score for the whole industry is almost twice that of USB. A summary of the Bank Stress Index sub-indices for USB is shown below:

IRA Surveillance Benchmarks - US Bancorp - Q1 2009

Source: FDIC/The IRA Bank Monitor

With an ROA of 1% and ROE of 11%, USB is one of the best performing banks in the US of any size and leads the large bank peer group in terms of nominal performance measures by a full standard deviation and also in terms of measures such as Economic Capital and Risk-Adjusted Return on Capital or "RAROC." The bank also has one of the most stable financial statements in its peer group, with little variation observed in key relationships from quarter-to-quarter. The 44.4% efficiency ratio for Q1 2009, for example, goes back for years and illustrates the consistency we see as a positive regarding USB. As we said above, it's all about operations research, from credit management to administration right down to the presentation of financials.

As you can see, USB's levels of stress are below industry levels for ROE, Defaults and Efficiency, but above average levels of stress for Capital and Lending Capacity, which measures part of the relationship expressed by the Basel II concept of Exposure at Default. For example, the peer score shown above for Lending Capacity of 1.2 reflects an exposure calculation of 128%, which meaures unused commitments as a percentage of committed loans. A rate above 100% is more than the average for smaller banks, but well below the 300-400% exposure figures for larger money center banks with big credit card books.

The above peer Stress Index score for Capital of 1.2 reflects the fact that USB with $250 billion in assets has slightly lower capital to total assets than some of the smaller banks in the peer group, but more than sufficient income to keep provisions adequate. The ratio of actual losses to provisions has been stable for years around 0.7:1 and, again, illustrates one of the benefits of a sub-50% efficiency ratio and strong equity and asset returns. USB reported 178bp of defaults in Q1 2009, just about even with the peer group and, again, reflecting well on USB to benchmark positively against smaller banks.

Whereas banks which are larger than USB tend to have a relatively even distribution between lending and capital markets activities, USB has a strong emphasis on lending and investing, and only a fraction of its business on trading activities. Looking at the business model is a key part of the analysis after you inspect the nominal financial performance measures.

We illustrate a bank's business model by calculating a second ratings perspective on the subject using classical Economic Capital or "EC" definitions to tell us in what business segment a bank operates and how it is paid for the risks that it takes via these business model choices. To do this, we estimate a stressed, maximum probable loss for three buckets within USB: lending, investing and trading. As of Q1 2009, the EC stress test calculations for USB were:

Economic Capital - USB - Q1 2009 ($000)

Lending Operations: $5,092,807
Trading Operations: $2,130,626
Investing Operations: $5,221,170

Total EC $12,444,603

EC/TCE 0.769:1
EC/T1 RBC 0.768:1
RAROC -0.62%

Source: FDIC/The IRA Bank Monitor

Now you might look at the negative RAROC for USB and turn up your nose, but in fact USB had a very stable RAROC profile in high single-digits to low double digits going back years -- until rising credit costs forced returns down. So even though USB reported a bank level ROE of 11.6% in Q1 2009, the RAROC (which is Net Income/EC, BTW) calculated by The IRA Bank Monitor is negative.

As we constantly remind subscribers to the IRA Advisory Service, rising expense is a sign of a well-managed bank dealing with a deteriorating credit environment, while a sudden, sharp drop in efficiency can reveal desperation at a fatally wounded bank. USB, however, exhibits very stable operating efficiency. When you take into consideration first the good financial performance, upon which we base our "A" Stress Index rating, and second the conservative EC profile for USB, it suggests a safe and sound institution that follows effective management practices.

Click here to log in to the IRA Bank Cart and purchase a one-year subscription to the profile for USB that was used in preparing this analysis (including four quarterly reports), including the Stress Index Rating and Economic Capital profiles.

Cullen/Frost Bankers, Inc. (NYSE:CFR) (Q1 2009 Stress Index Rating: "A+")

While USB is a great performer among the largest US banks, when you compare them to CFR the competition gets tough. CFR has been rated "A+" by The IRA Bank Monitor for years and like USB, the TX-based $15 billion asset institution evidences great stability in its financial performance.

In Q1 2009, ROA was 1.23% and ROE 9.6%, in both cases a full standard deviation above peer. With CFR's equity volatility a fraction of the large peer average and a price-to-book ratio of 1.6x, CFR is easily one of the best performers in the US banking industry.

The "A+" Stress Index rating for CFR is a reflection of an overall score of 0.9 vs. 2.4 for the entire industry as on Q1 2009. To get an "A+" rating from The IRA Bank Monitor, your Stress Index score must be below 1.0 or 1995 levels of operational stress. A summary of the Bank Stress Index sub-indices for CFR is shown below:

IRA Surveillance Benchmarks - Cullen/Frost Bankers - Q1 2009

Source: FDIC/The IRA Bank Monitor

The bank has an excellent operating profile, with a Stress Index score of just 0.9 vs. 5.2 for the entire industry. CFR has an efficiency ratio of 60%, which puts it well-below the industry average in terms of cost structure and even below 1995 levels of efficiency, but is still above the mid-40% levels of efficiency for USB and other money centers. This is not particularly surprising since CFR is one twentieth the size of USB, but as we like to remind one and all, nominal profits and efficiency does not always mean superlative RAROC.

CFR's RAROC for Q1 2009 was 26% and this measure of risk-adjusted returns has regularly been in triple digits. So while CFR reported a nominal ROE of 9.6% vs. 11% for USB in the same period, based on RAROC CFR was actually more profitable and was creating more shareholder value. When we go from the nominal, Stress Index rating perspective of "A+" for CFR and look at the EC profile for the bank, the reason for the superior RAROC performance vis-à-vis USB is very easily discerned.

Economic Capital - CFR - Q1 2009 ($000)

Lending Operations: $ 43,432
Trading Operations: $ 130,613
Investing Operations: $ 6,085

Total EC $180,130

EC/TCE 0.142:1
EC/T1 RBC 0.128:1
RAROC 26.07%

Source: FDIC/The IRA Bank Monitor

When the IRA Bank Monitor calculates EC for CFR, the bucket with the largest EC weighting is trading! The low loan default rates for CFR's bank unit and the almost non-existent investment book risk makes trading the leading risk in a bank with no trading book to speak of! And even then, the stressed EC calculation is just 10% of the bank's Tier One Risk Based Capital or TCE -- take your pick.

Of interest, CFR not only has one of the lowest loan loss rates in the large bank peer group but they also have among the best post-default credit recovery performance for large banks, with a Loss Given Default or "LGD" of 75% vs. 90% plus for USB and other large banks. During the high tide of the mortgage bubble, even large banks were reporting LGDs below 50%, meaning that the bank was making money on many foreclosed properties.

Today the opposite is the case and most banks are selling defaulted paper at pennies on the dollar as the vultures feast, meaning LGDs above 90% is the norm. So when you see a bank at 70% LGD in this environment, that metric is remarkable. At the end of the day, how a bank limits and mitigates loss is one of the key indicator of safety and soundness. Based on the LGD we calculate from its Q1 2009 financials, CFR sets a very high bar indeed for the rest of the US banking industry to follow and in all respects.

Click here to log in to the IRA Bank Cart and purchase a one-year subscription (including four quarterly reports) to the profile for CFR that was used in preparing this analysis, including the Stress Index Rating and Economic Capital profiles.

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