Anyone studying modern portfolio analysis knows it is good to diversify an investment portfolio because the risk associated with the portfolio decreases. Anytime you can get the coefficient of correlation or beta below one there will be some benefit from diversification. However, diversifying corporate operations may not be as simple as it seems. Perhaps my experience at a savings bank could provide a good example of this principle. .
During the late 1980s and early 1990s I was corporate controller of a large (for the time) New Jersey savings bank. A savings bank or savings and loan association must maintain a significant portion of its assets in the real estate market (principally home mortgages) as a matter of law. In return, it gets a very generous tax deduction for loan losses, well in excess of what residential mortgages had historically incurred.
Diversification of operations is therefore a problem for savings banks. If you must keep a substantial portion of your assets in real estate, then how can you effectively diversify? It was an issue the bank struggled with for a long time. Executive management tried as best it could to diversify but mainly for the wrong reasons. It sought to increase return and risk because it believed the real estate market to be completely safe. The bank recently became a public entity and was under pressure to show earnings. Some of the product diversifications were really disguised attempts to increase return on investment rather than reduce risk. Management assumed a global collapse in real estate values was not possible. Sure, there could be pockets of weakness here and there, but a major downward revision in all real estate values simply wasn’t thought possible. This was a bad assumption, as we will see.
The bank began with some sensible diversification moves. It acquired a successful mortgage banking subsidiary. This was right in management’s wheelhouse as it had plenty of experience in dealing with residential mortgages. A mortgage banker originates mortgages and then sells them to a final investor, retaining the origination fee and receiving a servicing fee for managing the mortgage. The acquisition resulted in a nice return on investment and management did not push to use the abusive mortgage servicing accounting that was so prevalent at the time. Some of the competitors used this horrible accounting and had to write off massive amounts of mortgage servicing rights when the market went sour. To its credit, management conservatively recorded only enough income as the independent auditors required for the bank to conform to generally accepted accounting principles (GAAP).
Another sensible, but much less successful attempt to diversify was the acquisition of a life insurance agency. Savings banks had long been able to provide life insurance for its members, so this seemed like a natural expansion. Again, the idea was to generate recurring fee income. Sadly, the experiment failed to reach its potential solely because of the personalities involved. Yet, the insurance agency did return a steady stream of income, and had to be counted as a successful diversification.
Other attempts to diversify turned south quickly, as the saying goes. They actually increased the bank’s exposure to the real estate market rather than reducing risk. The next place management looked was the commercial real estate market. At the time competition in this market was so fierce no down payment was required for a loan and loans were made on an exculpated basis. In short developers didn’t need to have any skin in the game. They could simply walk away from the loans if the collateral value turned against them. Management chose to compete in a superheated marketplace where irrational exuberance had already taken hold. To make matters worse, the bank began to make commercial loans well outside of its area of expertise. Borrowers from many states away found their way to our doorstep for a loan. That should have been a sign of problems to come. In retrospect, the bank did not have sufficient expertise and did not invest enough money in trained personnel to effectively operate in this arena. Management illogically believed the commercial mortgage and residential mortgage markets were so different there was some diversification value but somehow were close enough that the current staff could handle this new area. What was even worse is management convinced itself commercial lending outside of New Jersey, its home base, was another form of diversification. As we will see, this was not the case.
The next diversification decision was even more horrendous. The bank acquired the second largest relocation company in the United States. Management decided to take on the United States Navy as a client. So, as Navy officers were being reassigned from base to base the new wholly-owned relocation subsidiary would BUY their homes and then try to resell them. In essence, the bank became a dealer rather than a broker of real estate. The concentration caused by the ownership of the houses only increased the bank’s exposure to the “safe” real estate market. This was compounded even more by actions of the accountants and regulators.
The regulators took a very strict view of the subsidiary. When computing the capital requirements of the bank, regulators insisted the houses be included in the 100% risk adjusted bucket, rather than in the 50% bucket where home mortgages were. Management was limiting the size of the bank because of capital restrictions and the houses were non-interest bearing assets with soon to be plummeting prices.
The houses were accounted for as inventory by the bank, requiring lower of cost or market accounting under GAAP. As the real estate market crashed, the bank was recording large unrealized losses as the value of real estate fell. These writedowns were not generating tax deductions. Generally, losses must be realized before they can generate tax deductions. In short, the subsidiary was losing money on a “book” basis, but was taxable for both federal and state income purposes. Since the real estate company could not be consolidated with the bank for most state tax returns, the subsidiary was paying taxes in many states. This was a small but constant drain on cash flow for the bank during a difficult period as many other of the bank’s assets became delinquent as well.
What was the final nail in the coffin of the bank? The Tax Reform Act of 1986 removed many abusive tax deductions in the real estate industry, causing a universal reduction in real estate market prices. In just a few short months, the real estate market collapsed. The changes in tax law removed or limited many deductions and credits, globally reducing the value of real estate as an investment. This “black swan event” was one of the major causes of the savings and loan crisis in the 1980s. Every commercial mortgage the bank made in the two year period prior to the crash become nonperforming. The houses kept in inventory by the relocation company took a 35% lower of cost or market write-down. This was sufficient to erode the capital of the bank until the regulators forced it to merge with another bank. It was a sad ending to a financial institution with a 150 year history.
What are some of the lessons you can glean from here?
- Diversification can in fact work if you are diversifying into an area where you have sufficient expertise. The mortgage banking and life insurance subsidiaries did well. They did a good job in providing fee income for the bank. In both cases though, there was already some familiarity by bank management with the product before it was introduced.
- If you are going to attempt to diversify into an area you have no expertise in, make sure you take the time to acquire or train the human capital necessary for success in that industry. This is even more critical if the new product is risky.
- Make sure the diversification is really that: an attempt to reduce risk in the product portfolio. Reaching for return disguised as diversification will often end up increasing risk.
- Remember black swan events do happen. Can there be a plausible scenario putting all of the product lines at risk? Before management pushes the acquisition button, it should consider this very vexing question.
- Management has to remind itself most acquisitions fail. Management needs to ask itself what will make this one acquisition any different. Will there be processes in place to ensure the diversification/acquisition succeeds?