“We’ve Seen the End of Times”: Tom Michaud on Market Extremes, IPO Red Flags, and 9/11

0:00Once these companies go public, the index funds have to buy the shares. So that's built in aftermarket demand. And it's just a dynamic that wasn't there 25 years ago. But isn't that a red flag? Well, so here's what I would say. I think individual stock selection is very important. And I would be cautious. I mean, I'm a believer in diversification. I think that investors should be cautious. And not every one of them will work. I'm not speaking about SpaceX in particular, but over the long run, there is risk in these offerings. The best investment strategy I've seen in 40 years is buying the trophies when they're on sale.

0:42I love buying best in class company stocks because what you're doing when you do that is you're buying their management teams to figure it out for you. And so I was moving back to the building and I froze in my steps when the second plane hit the second building. And I think I'm right in saying KBW lost 67. We did, over a third of my colleagues who were in the office that day. I'm so sorry. And that included the co-CEO of the business? It did. And the other co-CEO lost his son who worked for us. There's no chapter in a textbook that tells you what to do when that happens. And it's really all about what you have inside, what your values are, and humanity at that moment.

1:34Welcome to the Master Investor Podcast with me, Wilfred Frost, where we celebrate and learn from the success of the greatest investors, business leaders, and politicians in the world, giving you, our listeners, the edge. The Master Investor Podcast is sponsored by LSEG, Interactive Brokers, the World Gold Council, and BNY Investments. Please do remember the views expressed in this podcast are for general information purposes only. Nothing in the podcast constitutes a financial promotion, investment advice or a personal recommendation. More on that in the show notes. My guest today, Tom Michaud, has led KBW since 2011 and worked there for 40 years, leading the firm to its IPO in 2006 and its acquisition by Stiefel in 2013.

2:25KBW is the leading financial services investment bank. It's been number one advisor on banks M &A deals since 2020. If you want to know about the banking and financial sector in the US but around the world as well, KBW is the firm to speak to and Tom, as their CEO, is the man to speak to. I'm delighted that he is here with us in London today. Tom, welcome to the Master Investor Podcast. Great to be with you, Wilf. I've been thinking about, Tom, the best way to start this. And I actually kind of, not to be negative on the outlook, I imagine you'll pivot us during the conversation and be positive.

3:04But I wanted to rewind the clock to 2008, or perhaps more importantly, to 2007, to the lead up to the global financial crisis. What were the key? Of course, banks were the epicenter of that crisis. What were the sort of warning signals that with hindsight, if we go back to a year or so before the crisis, we could have seen back then that people glossed over at the time? And what was really at the heart of that crisis that unfolded? Well, I've spent the past 40 years studying the industry, as you mentioned earlier. And I do try to look for some absolute mile markers that I think are signals for further investigation.

3:50And as you know, we had a banking crisis in the United States in 2023. And I often think about what some of the factors were that may even have been similar with that 2008 period to make sure we learn from them. So that way we see the mile markers before we get to trouble. So in that period, it's really unbridled and exceptional growth. And when you look at the financial system, the financial system and the banks, they are built to help the economy grow. They can grow faster than the economy. But if they grow exceptionally faster than the economy or if they grow exceptionally faster than other participants, there's something happening.

4:33And as you know, there's not a lot of patent protection in financial services. It's not like some company has such a unique model that it's exceptional relative to everybody else, that it can grow at such a quick pace. And if you go back to the period of the global financial crisis, what you will see is there is just so much growth in subprime mortgage. And then there were just new unique inventions with SPV vehicles and leverage. And I think leverage is the other piece to it, which is that many of the world's largest institutions were operating with tremendous leverage and growing very quickly.

5:13And fast growth usually or not always but typically can lead to credit problems. And credit problems are the scariest things that the market has when there's a financial crisis. Is that a unique warning sign for potential problems in the financial sector? Because obviously, there's unbelievably fast growth in the technology sector at the moment, but no one looks at the growth part as a warning sign. Yes, I think it's a little bit different because of the leverage. So a typical bank is levered, let's say, 12 or 13 times. So I think the leverage just creates more of an issue. And then it's also, if it's a bank that's holding customer deposits, it becomes a confidence issue.

5:58And that's what happened in 2023, which is, and it goes back, when I studied that period, I went back and actually listened to President Roosevelt's speeches when he introduced the FDIC. And bank runs, which now can happen on a phone, you don't actually have to go to a branch, but a crisis in confidence in deposits is dangerous. And so that's why it's all tied together. So for a bank, it's different, because in a technology company. Unfortunately, investors can lose a lot of money if it doesn't go well. But in the banking system, if a bank gets in trouble, well, then folks worry about their deposits and their life savings.

6:37So just sum up for us then what did then happen in 2023. Silicon Valley Bank obviously went under. First Republic might have done, but was bought by JP Morgan. Was that very different to 2008? Well, let's talk about the similarities. So the similarities, and look, these were companies that were succeeding, doing very well. I think the chain of events is, number one is we had zero interest rates, which really hadn't happened before. So money was essentially free. So there was tremendous growth in technology. In the case of Silicon Valley Bank, a lot of those proceeds found their way to Silicon Valley Bank.

7:11So Silicon Valley Bank, two years in a row, essentially just for rounding numbers purposes, doubled. Banks don't double in size in an average year unless something unusual is happening. And then in hindsight, they doubled with uninsured deposits. And at the same time, what happened was the government, then later on, the government started to change policy. And what Silicon Valley Bank did was they took these deposits and bought long-dated bonds and then went into what they thought was a safe harbor, which was holding bonds at cost and not marking them to market. And then the Fed went on a 67-year aggressive capital, I'm sorry, rate increasing campaign to have more restricted monetary policy.

7:59And those bonds went way underwater. And on a mark-to-mark basis, it wiped out the equity of the bank. And the regulators gave them a pass and said, well, you hold it to maturity. We're going to let you count those bonds at cost as capital. But the market wasn't as friendly. And so that wasn't the safe harbor that the bank thought it was. And that was exactly the same issue with First Republic. So these depositors fleed because they said, we don't want to wait and see how this mark to market on this bond portfolio happens. And so that's really how this all happened. But I think what started it all was the bank doubled in two years.

8:39And what did they do with the money? And where were they as focused on safety and soundness and liquidity as they should have been? So fast forward to today, the lessons from both 2008 and 2023. Are you relaxed about the strength of the banking sector? Well, so this is a great story, Wolf, and I'm glad you brought it up because what was the public response to 2008? Well, we got Dodd-Frank and I think we basically got nearly 20 years of a policy and regulatory enforcement that was perimeter enforcement of banks. So let me tell you what I think perimeter enforcement is. It's the government telling these banks what they can and cannot do.

9:24That's one perimeter. The other perimeter is by asset size. The bigger you are, the more structure, compliance, and capital you need to have. And so that period has changed with the current administration in the United States. But let me tell you what happened during that period. During that period, the banking industry lost a tremendous amount of market share. to unregulated banks. And that growth happened in non-banks. It happened in private credit. So the combination of not allowing the banks to innovate and grow as much as they would have otherwise with zero interest rates led us to the world we're in today with lots of private credit and non-bank lenders.

10:10And I think that there's been a pivot in Washington. And if you listen to what Secretary Besant and others say, and I know he's been a guest on your show as well, is they've moved from this perimeter enforcement period to one where they want the banks to participate in the growth economy. They'd like to allow the banks to innovate, but they want a level playing field with non-banks. And it's all going to be combined with what should be supervision and risk control, meaning nobody wants the banks to be unsafe. Safety and soundness is still number one. But the idea is the regulatory policy pivot was too extreme, and we now need to focus it more on responsible regulation and supervision.

10:59It's interesting because I always used to have this argument a lot with both Jamie Dimon and Lloyd Blankfein and James Gorman about the excessive regulation and say, well, be careful what you wish for here, because I think in the US, they kind of got it right. Does the pendulum always swing too far? Yes. But look at what happened in Europe and in the UK. I mean, yes, there's been a lot of regulation over a decade or two in the US that maybe needs to unwind a bit, but you've got comfortably the biggest banks in the world. So something went right in a way that perhaps didn't hear. Let's just dwell on the risk there, which isn't necessarily directly for the bank stocks.

11:40But is private credit a sort of flashing red worry for you in the same way that there were some flashing worries before 2008? Has it grown far too fast to use your analogy? So I think this most recent quarter was very important because the concern over private, the credit quality and private credit was extraordinarily, especially in technology. What I think this is, is not a systemic issue. I think, of course, there could be some technology technology portfolios that don't perform well. The question is, and as you related to the banks, is it a threat to the economy and is it systemic? I do not believe it is.

12:23I think what this period is going to do is going to be a resorting of the mix between banks and non-banks because the growth was so quick in private credit that now many of the investors in these funds are realizing that the liquidity is not what they thought it was and the returns may not be what they thought they were. So I think it's going to impact the growth profile of that industry, but I don't think it's gonna become a systemic problem for the global economy in these private credit. There's a very good chance many of those investors and those funds, there will be winners and losers is what I'm saying.

13:02There'll be some funds that don't do well and those investors will be very unhappy and there'll be funds that do do well. And then what will happen is I think there'll be consolidation. I think the next roll up story in financial services are the private credit managers buying other private credit managers. And you're going to see these private equity firms, I think, reconfigure themselves for the new market.

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14:14Let's just dwell on how big the banking sector is as a whole before we get on to the winners and losers and various other themes. The bank stocks have been on a tear the last couple of years. Some of them are double and tripling their size. Is it run too hot in the short term or is further to go? How big is... I think the banking industry in the United States is in fantastic shape. And I think you're right. It's a global leader. It doesn't mean that there are bad banks in other markets. It's just that their regulatory regime has not been as conducive to helping them. And I think that the policies that are being undertaken by Secretary Besson and this administration are supporting that.

14:56If you look at the capital, okay, the capital is at a two decade high for banks. So it's been more than fully restored. And if you look at Citigroup, which did struggle during the global financial crisis, their tangible common equity to asset ratio was roughly one and three quarters percent at the time of the global financial crisis. Today, it's over six. So they've fully recapitalized their balance sheets. Their liquidity is better. So I think the banks have benefited from some of this regulation. It just went too far. And I think – and as you said earlier, the pendulum went too far. And I don't – and there's an approach, Wilf.

15:36I think this is important where a lot of industry observers say, oh, we're in a deregulatory period. I don't believe that to be true. I think we're in a regulatory reset and a pivot. And the prior period was the extraordinary period where we had tremendous regulatory expansion. I think we're actually just going back to what was originally intended. And it's interesting you mentioned Citi there because I think Jane Fraser has done a fantastic job. And she's been given time because it's very hard to turn these oil tanks around. And by the way, she's probably Britain's most successful business person and she doesn't get talked about enough here.

16:15So I'll always give a shout out for Jane. We do recommend the stock and we agree. There we go. She's great, Jane. And just to finish the point, which I was trying to get at, I guess, in one of the questions, we talk a lot and we've had lots of great guests come on to talk tech and to talk hard assets, commodities and energy. And a lot refer to the size of the technology sector within the S &P 500 today at an all time high and how energy, maybe it's off its lows, but it's still very low, low single digit, historically was very big. Like, where's the financial sector as a whole at the moment in terms of both relative to history and in terms of where you think it should be going forward?

16:56So the financial services sector is currently the second largest sector in the world, and it's the second largest sector in the United States. And while technology, let's just say, is 36 percent of the index today, which is remarkable, it probably goes to 38 percent when we're done with this year's IPOs. So this is a giant sort of taking the oxygen out of the room moment, like something like I've never seen in my career before. And so just so much attention is on tech and AI at the moment and investment spending there. But financial services is number two. Let's say it's around 14 percent-ish just as a total, and that makes it number two with health care nearby, let's say, as a third player in the United States.

17:45Now, when you look at the pie of what financial services is, it's kind of exciting because it's an enormous collision. So when I started my career, banks were more than half of it. Today, banks are a quarter of it. So when you look at what's that 12%, it's the banking industry is the largest. The second largest – and then the next area, actually not the second largest, but another defined sector is insurance. And then the third is the fintech sort of everything else category. And that's where MasterCard and Visa sits. That's where Robinhood sits. That's where Coinbase sits. And these are companies, some of them, at least Coinbase and Robinhood that 20 years ago didn't exist.

18:30So when you look at these new ads into financial services, it's these non-banks, these non-bank competitors. Now, some of them, like PayPal, are trying to become banks. They filed applications. So I think that's a good thing that this administration's allowing because it means the banking regulation will now cover PayPal and Venmo. But that is the mix. So the banks are not as prominent. And it's like a Venn diagram. You've got these terrific companies in different sectors trying to get into each other's businesses. and I'll give you my most favorite press release of the last couple of weeks, was Morgan Stanley announced that they're going to undercut Robinhood and Coinbase in crypto trading.

19:13So the old sheriff wants to be the new sheriff. And then if you also think about this, in the Biden administration, you couldn't keep your crypto at J.P. Morgan because banks weren't allowed to custody it. You had to go to Fidelity. Today, banks can custody crypto, which I personally believe is a very safe thing to do. We're not saying own crypto. We're saying custody it. So they're allowing JP Morgan to compete. They're allowing Morgan Stanley to compete. And if it happens in a regulatory environment, I believe the public good and the markets will be better off. So let's talk about scale. You mentioned there two of the biggest banks, JP Morgan and Morgan Stanley.

19:57scale has been so important in in recent years because regulation has been more burdensome disproportionately for the smaller guys does the tech revolution that's been going on for a long time but ai just kicks it up a gear again benefit the bigger guys it's not cheap the investment that's going i think it will i think it will and i think there are a lot of really important forces around your question that you just asked there. So let me start with tech spend. JP Morgan spends$19.8 billion on tech this year, is going to spend$19.8 billion. They've announced that. We think that there are not 10 other American companies that spend that much money.

20:38Now, the big seven spend a lot more than that, the hyperscalers. But JP Morgan spends more money on tech than most of the number of tech companies in the world. So if they spend more money on tech than the tech companies, they probably can be a pretty good fintech company themselves. That's how I take that. Same thing with Bank America, same thing with Morgan Stanley and Goldman. So the amount of spend is incredible. Chase UK is basically a fintech company. 100%. 100%. And they're opening in Germany. I would expect if you're kind enough to have me back in five or 10 years, they will have lots of market share in those countries, in my opinion.

21:17But to get back to scale, so in the United States, there's something that I don't think everybody realizes. There are 4 ,300 or so banks. 120 of them are above 10 billion in assets. 97 % of the industry are what you could describe as community banks. They're in a class by themselves. They can't afford that type of innovation. They have to rely on providers to get them there. But there can be tremendous success being a fast follower. But what you need is you need Fiserv. You need FIS. You need Jack Henry. You need Encino. You need these companies to make sure they're moving fast enough to keep you relevant.

22:01Because the danger is that you've been disintermediated by your client base and you don't know it. That's the danger. Because then what will happen is you'll be forced into riskier asset classes and the industry will become less stable. So but just if we use deposits as a guide, there's lots of measures for size and market share. JP Morgan, Bank of America, what percentage of deposits today and where will they be in 10 years So JP Morgan is a little bit over 10 % with a public goal of being at 15 % of the nation's deposits. Are they lacking growth targets there? Should they be more optimistic?

22:41I mean, my guess is they'll get to 15 and then it'll be 20. And the way they're doing it is you could see how the execution will happen. They've got a fantastic fintech digital product. They go to a big city where the people and the deposits are. They open 25 or 30 branches that look beautiful. I've seen them. And then they compete with the local competition. And what they don't do is they don't build a branch structure in rural and suburban America where it's expensive to do it because the deposits aren't that rich there in terms of just how deep they are. But they're not the only ones. There is a theme in the United States.

23:18Fifth Third, which is a highly successful company, is opening 150 branches in the southeast. What I find interesting is some of the best banks, Fifth Third's an outstanding company. What I find happening is they're doing a mix. And I talk to these CEOs all the time about it. It's not just one delivery because you want confidence in the institution. They want to be close to their clients when they really need them at an important moment. So I would expect, but I would expect branches to be opened where the people are, not where they're not. Hi, guys. it's Wilf. I hope you're enjoying this episode.

23:51Just a quick reminder to please hit follow or subscribe on your podcast or video app so that you never miss an episode. And if you've got time, please do give us a five star rating and leave us a comment. It really helps other people find the podcast too. Now back to the episode. Let's touch on rates and where we are at the moment. I mean, you shared with me one of your kind of chart decks ahead of this conversation. And one thing really jumped out to me, which was the yield curve inversion that existed in early 2023 till September 2024 and how irregular that was for banks. Talk me through the scale of that.

24:35It was 500. You said it was 550 days. We're talking here about the 210 year. It's – I mean – and by the way, I still believe the impact of COVID and the policy action and response afterwards is still being felt today. Like this story is not being done, being told in my opinion. Banks were not built for inverted yield curves, OK? If you – and banks were not built for negative interest rates, which was the policy in Europe. I mean it sounds not intuitive. we're going to charge people to keep money in our banks and we're going to pay them to take loans. I mean, that's not how it was done. But you would think about where the forces were leading with negative interest rates.

25:17So I think the banking system with how it carried through that moment actually did a remarkably good job. And so an inverted yield curve is pretty much hostile to the operations of a bank. And the banking industry churned its way through it. And now that we're getting, well, coming into this year, it looked like we were getting a steeper curve with lower rates coming and a growing economy. It was green lights everywhere. Then the war started at the end of February. And now we have a flatter curve. We've got higher for longer. The industry will still do as well. But I think there's that the net interest margin story has probably played out.

26:01Like we would have probably gotten even more improvement than we're going to get, but it still is in a good place. But I guess my question here is even if for the net interest margin point, you know, things aren't as bad as they were when the yield curve was really inverted during 2023 and 2024. Is there a opposite risk, which is sudden increase in long term yields, which we've seen a couple of times in the last few months? You know, we got up to, you know, 4.6 % on the 10-year quite quickly. We've settled back to 4.5%. But we've had a few glimpses in the last year or two that long yields could gap up.

26:42Is that a big risk? So my view is that I don't think from an interest rate management perspective it would hurt the banks. But I would immediately worry about the bank's clients. because higher interest rates would really be a break in the economy. And really what I've said over time is the biggest torpedo in the ocean is credit. When credit shows up, those are immediate costs that impact the bank's income statement. And credit has been extraordinarily benign and better than expected than for longer it's been. We should all know a credit normalization is coming because it's just been too exceptional.

27:24But as long as it stays within the realm of historical metrics, everything will be fine. If interest rates go up so much that we start having a credit concern, whether it's commercial real estate or the underlying health of corporate America or the world, that's when – if credit comes back, that will be a headwind for the banking industry and finance in general. And like how do you judge when you see a quarter or two, which we've seen, of provisions going up when the banks report because of possibility that credit will turn bad? How do you sit here and know, don't worry, it's just ticking up. It's going to stay within the normal bands of historical averages.