How Banks Can Roll the Dice and Lose It All

Recently, fellow Fool David Hanson posted a video of former Countrywide CEO Angelo Mozilo being interviewed on CNBC way back in 2007. Mozilo's words are both prescient and oblivious, and it got me thinking about risk. Or, perhaps more accurately, how many banks have failed to understand risk and reward.

Countrywide, the remnants of which are now owned by Bank of America , epitomized the false thinking in banking, the skeletons of which can be seen across the country from Wells Fargo to JPMorgan Chase to American International Group .

Two scenarios, same math, dramatically different outcomes
Bear with me for a moment, because the math is the backbone of understanding how banks got it all wrong.

Mark Buchanan of explains it in terms of two scenarios. First, suppose that you roll a die. If you roll a 6, you win $10. Roll anything else and you lose $1. If you roll 1 million times, you will on average win $0.83 per roll -- not bad.

Scenario 2 ups the ante. Instead of winning $10, you now will win 10 times your net worth if you roll a 6. However, if you don't roll a 6, you lose everything. Not quite as tempting; however, the math works out the same. If you did this roll 1 million times, on average you would still win $0.83 per roll.

The difference is that Scenario 2 makes it obvious that you may not get 1 million rolls. You may just get one and then be bankrupt. And that brings us back to Countrywide.

The Mozilo interview occurred just after Bank of America provided financing to Countrywide and just before the bank bought Countrywide outright. Mozilo talked up the company's capitalization, value, and bright future prospects, yet in the same breath, he predicted that housing will lead the U.S. into recession.

He was a salesman putting a positive spin on an otherwise unsavory situation. But he was probably also confusing his math, a la the two scenarios I mentioned. He understood that housing would eventually rebound (and he was right; low interest rates have led to a genuine boom in mortgage refinances), but he failed to understand that Countrywide may not survive to profit from that return to normality.

On average, Countrywide was positioned to profit over a million rolls, but the reality of the times was that the company didn't have financial wherewithal to survive the losing roll.

Trying to find a common theme
Countrywide isn't alone in this failure. Wachovia (now part of Wells Fargo), Bear Stearns (now part of JPMorgan), Lehman Brothers, IndyMac, and all the others were probably positioned to reap exponential profits in the long term, over a million rolls. But none did. None waas able to survive the series of bad rolls that hit during the crisis.

What can we take away from this? Has the industry learned from these mistakes? Can we rest easy at night knowing that our financial futures, our savings, our investments, are safe and in capable institutions?

If you read the news or have listened to politicians and pundits of late, you'll think capital is the solution to all bank problems. The FDIC defines "well capitalized" as having Tier 1 Risk Based Capital greater than 6%. JPMorgan reported a capitalization ratio in 2007 of 8.4%. Wells Fargo reported 7.59%, and Countrywide reported 7.2%.

Despite all being "well capitalized" by FDIC standards, Wells Fargo and JPMorgan survived the crisis as pillars of balance-sheet strength while Countrywide was bailed out by Bank of America. AIG had $1.8 trillion in derivative exposure at Dec. 31, 2008, via more than 35,000 different contracts. The scale of that exposure is staggering alone, but even more so when you consider that this represented 34 times shareholder equity on the balance sheet.

The lesson is that capital levels in a vacuum are not enough. Credit quality, off-balance-sheet risk, and risk management should all be considered relative to capital. This is as true today as it was in 2007.

Through this lens, it's clear that while Countrywide and Wells Fargo had seemingly comparable capital levels in 2007, the tsunami of credit problems at Countrywide was more than enough to flood capital and sink the company. Because of its more conservative underwriting, Wells Fargo was orders of magnitude more capitalized than Countrywide, despite the mere 40-basis-point difference on paper.

"Built to Last" versus "Built for Big Quarters"
Baseball, much like investing, is a game steeped in averages and data. Some teams play for the "big inning." They swing for the fences, hoping to hit home runs and put up a large number of runs in a short amount of time.

Other teams play "small ball." They focus on getting on base, playing as a team to chip away at the defense, scoring runs slowly and consistently every inning. JPMorgan and Wells Fargo never took a quarterly loss throughout the crisis, scraping for earnings as they protected the balance sheets and fought hard to further the brands.

When times are good, hitting home runs makes you look like your the best team in the big leagues, as Angelo Mozilo and Countrywide looked in 2005.

But when times get tough, it's risk management, culture, and fundamentals that allow companies such as JPMorgan and Wells Fargo to continue to produce profits every single quarter without fail.

Banks need to play small ball. They need to make good loans, add value to customer's businesses and finances, and put up consistent, low-risk returns from quarter to quarter. Countrywide, AIG, Bear Stearns, and the rest proved that in finance, you aren't guaranteed to even finish the game if you're playing big-inning baseball.

There is one bank today that stands out as a "small ball" institution. This bank is committed to the fundamentals, to safety and soundness, and to consistently winning over the long term. On a playing field of mismanaged and dangerous peers, it rises above as "The Only Big Bank Built to Last." You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.

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To follow the Fool's coverage of financial stocks, click here!Fool contributor Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends AIG, Bank of America, and Wells Fargo; owns shares of AIG, Bank of America, JPMorgan Chase, and Wells Fargo; and has options on AIG. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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