Decision Quality Blog

The foundation to behavioral economics is the idea that investors are not rational actors: That they overreact to uncertainty, are influenced by immaterial information, and act for all manner of reasons not consistent with their best interests (utility). I found a paper the other day published by The Paul Woolley Centre for the Study of Capital Market Dysfunctionality called How Do Investors React Under Uncertainty? that reinforces this point.  Here’s a clip from the conclusion:

It is proposed that uncertainty, rather than risk, provides a much more realistic representation of the setting that we face when we come to pricing asset, and particularly corporate equities. We have gone a long way down the path of developing pricing models that incorporate risk (e.g. CAPM, APT, Fama and French empirical three-factor model) but comparatively little work has been done on the role (if any) that uncertainty plays in asset pricing. In order for uncertainly to affect pricing, it must have some influence on how investors incorporate information into pricing. Our contribution is to evaluate whether uncertainty influences the way by which investors respond to earnings announcements which will provide us with valuable insights as to the role that uncertainty plays in asset pricing.

In particular, we evaluate the proposition that investors will follow maxmin expected utility and so will progressively overweight bad news and underweight good news as they become more uncertain. Using VIX as a proxy for market uncertainty and earnings announcements as our information signal, we find that there is an asymmetric response to good and bad earnings news at high levels of uncertainty which is consistent with uncertainty breeding pessimism in the minds of investors. However, we do find evidence to suggest investors might have a more optimistic bent than is allowed under maxmin expected utility as indicated by how they react to earnings announcements when uncertainty is at the lower end of the scale.

A decision table is the “best practice” tool for doing the following:

• Breaking a complex decision into component parts.
• Generating a wide range of interesting choices in each of those sub categories.
• Creating multiple possible scenarios for answering the larger exam question.

Here is a brief tutorial on how to build one.

Goal of the Activity

Building a decision table is an activity that can be done with the internal team or the client.  It can be done in small or large groups. The goal of this activity is to explore the key drivers of a complex decision-like thinking through a complex deal or developing a new strategy–to generate multiple possible scenarios. These scenarios can be further refined using a variety of tools and techniques until the team finally arrives at single, fully integrated strategy. The work is based on the principles of Decision Quality.

Typically this work is driven by a standard Decision Playbook: Either one we already have, or one we pre-build as part of the customization process.  In some cases, the team will build a Decision Table from scratch.

Categories of Choices

The team starts by identifying all the relevant categories of choices. These collectively comprise the framework you’ll use to develop and test strategic scenarios. There are many ways to do this, but success looks like topic headings in some sort of logical order.  For example, if we wanted to develop a ”’human resources strategy”’, the topic headings might look like these:

• Talent model
• Sourcing
• Recruiting
• Hiring
• Onboarding
• Training
• Coaching and Mentoring
• Career Path
• Rewards and Recognition

Note: This isn’t meant to be a complete list, just an illustration. The implication here is that we want to make choices in each of those areas. The sum of the choices, one or more from each category, becomes a possible strategy.
These topics become individual column headings. MS Excel is an excellent tool to organize the work.
In an even more complex setting, we might want to identify headings in multiple areas. For example, in a large outsourcing deal, there might be a section or table for each of these areas:

• Desktop
• Servers
• Infrastructure
• Service Desk
• Human Resources
• Financial

Note: You can imagine that under each of these super headings, there would be multiple topics or columns we would want to explore.

Ranges of Choices

Once you have laid out the story line, or the topics you want to explore (we use the idea of story line because you should be able to imagine describing your preferred strategy by simply narrating across the tops of each of the columns), the next step is to think through the full range of choices in each of those columns or categories. This is an activity best done in groups, and should be a creative, brainstorming, lateral thinking exercise.

Values are what we want, choices are ‘what we can do.  A choice is something tangible, something you can buy with time or money. So while we might want customer satisfaction, that’s a value, not a choice–only the customer can choose to be satisfied. But we can choose to invest in training our people (for example).

• Choices should be mutually exclusive and collectively exhaustive.
• Choices should range from least to most, easiest to hardest, cheapest to most expensive, etc.

It is too often true that we gravitate immediately to choices that are familiar and safe. There are few better ways to kill innovative thinking. So the key thought here is to explore the full limits of each category of choice. For example, if we have a category called PRICE, here are some of the choices we could identify:

• More than anyone else
• Top of our peer group
• Par with our peer group
• Below peer group
• Lead the market
• Free
• Pay the customer

Note: Whether you would build a range of choices using those thoughts isn’t the point. All you need to notice here is that the range explores a FULL span of ideas. Why is this important? When we start to develop possible scenarios, exploring some extreme thoughts is often the key that unlocks the second and third idea that lead to a keen insight or sparkling strategy.

Strategic Lenses

The whole point of building a decision table is to build strategic scenarios. Think of a strategic scenario as a potential story line, competitive response, or strategy for cracking the problem you’re trying to solve. Common problems we’re trying to solve are the tendency to favor solutions we’ve seen work in the past, solutions that are favored by politically powerful people, or strategies that seem easy to do. Along the way, we often start down a particular path without fully considering all the interdependencies and follow on effects. So to do these things, we build strategic scenarios, using a decision table:

• Consider a wide range of alternative strategies before we land on one.
• Ensure that we’re thinking about all the dependencies (that’s why we built the table).
• Ensure that we’re getting multiple and different points of view early in the process (that’s why we do this in teams).

The process generally works like this: Once the decision table is built, we identify three to five strategic lenses, each of which highlights a different but interesting thought. In a competitive sales situation, those scenarios might have names that sound like these:

• What Will a Competitor Likely Do?
• The Solution We Think Our Customer Wants
• Win on Price
• Change the Game Using Services
• Compliant Solution
• If the problem you’re working is internal, the strategic lenses might sound like these:
• Quick and Dirty: Just Get it Done
• Maximize Customer Experience
• Minimize Roll Out Risk
• Aggressive Cost Reduction
• Compete for Talent

Scenario Development

A team is assigned to each strategic lens. The teams can be of any manageable size. The teams create strategic scenarios using their lens and the common decision table, making choices in each column that best support their lens. For example, you can easily imagine that the team most focused on how Competitor A will bid will be making different choices that the team looking through the lens of “Changing the Game.”

This activity is done simultaneously, so the teams are all working in parallel, using the same tool set, at the same time. When they’re done, the teams present their strategic scenarios using the decision table to guide the process. Teams use some sort of code or color to mark their choices on the decision table. The different strategic scenarios are overlaid, often using dots on MS Excel documents, to show the individual choices, as well as how they cluster and compare across strategies.

In case you missed this or don’t care, tech blogger gizmodo recently came into possession of a prototype of the latest blockbuster to be next gen iphone setting off a first class 21st century brouhaha.  So why bring it up here? As an exercise in decision-making, three thoughts . . .

Thought 1: John Stewart just devoted nearly nine minutes to poking Apple and its iconic CEO in the eye on this.  Possible second order implication: Steve, you jumped the shark.  Does it really matter or is it possible this is all a cleverly thought out publicity stunt?

The Daily Show With Jon Stewart	Mon – Thurs 11p / 10c
Appholes
www.thedailyshow.com
Daily Show Full Episodes Political Humor Tea Party

Thought 2: Given that the phone in question was “disguised” in the shell of the current generation phone, tell me again how this happened?  I mean really, how many iphones get left in a bar on a daily basis?

Thought 3: Hey Gizmodo, how you feeling about the decision to take this thing public? The short term spurt in readership has to be a rush. My guess is whatever inside line you had to Apple isn’t looking so good right now.

For more on the fun, here are some links . . .

• Did Apple call the cops on Gizmodo
• Police raid Gizmodo editor’s home
• Lost iPhone: The cops are on the case
• Apple wants its secret iPhone back
• Letterman’s Top 10: Excuses for the guy who lost Apple’s top secret iPhone

These are my notes on comment by Tom Brown at the BAI Mavericks in Banking Conference.

Five interesting aspects to this debt crisis. Why we believe a new financial stocks boom has begun that will be powerful and long lasting. To understand this, you have to realize that the future of the stocks is different than the business.

I don’t use the word crisis lightly. This is a crisis.

The problem is a fundamental asset value deterioration that led to a liquidity crisis because of a loss of confidence. The root cause is that subprime delinquencies became a big problem. The base case with subprime loans is that over the life of the loans, you would lose 5% of the principal. In 2003 they were 3%. You also prepare to be wrong and they might be 10%. The real stress case is 15% and some people are really hurting. We’re way beyond that. For loans originated in 2007, we may see cumulative loses of 20% of or higher.

The good news is that there were $600 bn originated in 2006. There were only $200bn in 2007. So it’s the 2006 vintage you need to focus on.

It was poor underwriting, borrower fraud, declining home value, and rising rates in 2005 and 2006 that lead to a credit problem. What turned us into a crisis was when the Bear Stearns hedge funds failed. People became worried about the counter party. Not just sub prime loads, Any kind of loan. That lead to tighter credit conditions. That let to de-leveraging. And round and round.

The second part is the role of speculators. We know if there was poor underwriting and fraud, you’re going to get some real repercussion. The originators have reps and warranties and the paper is going to move back through the pipeline. The fact is that borrowers misrepresented income and residency.

In 2004 6% of borrowers indicated the loan was for an investor property. In 2006 it was 13%. We think it’s double that. We own Ocwen Financial that does servicing only. In 2006 when a notice of foreclosure went out, they could rescue the borrower 79% of the time. In 2007, that went down to 77%. How much came from owner occupied vs. investor owned? 16% of loans accounting for 50% of foreclosures in 2007 were for non-owner occupied. This isn’t what they said on their applications; this is what they found out afterwards. The government is trying to help these people, but you can’t help the people who lied. They don’t even want you to work with them.

This part of the problem went through the system last year. This is why I think we’ll see a big fall in concern about loses in sub prime.

The third thing about this is that it created a lot of fear. In August when we locked up the credit markets, asset backed commercial paper went up at the point that the T-Bill went through the floor. It was a huge gap and reflected the panic in the markets.

Let’s look at credit default swaps. Take IBM. Let’s say I own their debt. I want to make sure they don’t default, so I by a swap and I buy a premium. It only pays off if they fall from Triple A and don’t pay. So total default. Last year, you were paying 40 bp annually. Today you’re paying 150 bp. There just isn’t that kind of risk here.

GE is a AAA credit. You would have paid 12.1 bp on 12/31/06 to insure that they wouldn’t go from AAA to default. In April 2008 it’s now 104 bp, a 760% increase. The 2006 numbers might have been too low, but there’s no way there is that kind of risk here. The credit default swaps peaked in August.

Underwriting will ultimately matter for investors. Right now there is no distinction between who underwrote loans. Moodys has taken a look at credit performance. They split the underwriters of sub prime into three categories. Almost none of the Tier 3 are still around. The order of magnitude of the difference is this: If you look at the loans that were originated 9 months ago, what’s 60 days delinquent. 4.5% tier 1, 11% tier 3.

Last problem, the one we see growing every month. We have a problem with home equity lending (all types) that are increasingly isolated in areas that are depressed and where there was a lot of speculation. The biggest change in foreclosures is CA, FL, TX OH, MI, GA, and IL. One of the stores you’ll see played out in 2008 is that home price depreciation has slowed in 42 states. It’s still going south in the others.

Why am I optimistic? Unprecedented action by Fed and Congress. The Fed knows it’s bad and they have more arrows to shoot if they have to.

The second reason is they’re doing all this and the fear has driven down company valuations to the point that it looks like companies won’t survive. If they show normal levels of earnings, the valuations will return to rational levels.

When you see headlines on Business Week like “Meltdown” and “Credit on the Edge” in Feb of 2008, you know you’re near the bottom.

When you’re in a bull market you can’t say enough bull things. The same is true in a bear market. You’re always trying to out bull and bear your competitors.

The other thing to be careful with is to think that with your company the worst is not behind us and I’m not going to buy my own stock. In 1990 the last bull market began months before the estimates turned up.

Looking at credit crisis in other markets around the world: The lag between financial market stabilization and the real estate price bottom. In the US S&L crisis, it was 8 quarters of lag.

The maverick in me says that you shouldn’t wait until estimates or home values bottom. Fears over sub prime loses is too high.

When you make a mortgage loan, it’s not like any other kind of loan we make. If there is problem, you have to go 30 days delinquent, then 60, then 90, then you have to go into foreclosure, then take the asset, then sell it. So it’s 15 months before you’re done. There are early signs that the beginning part that’s entering the python is being reduced. It will take a lot of time, but you have to start by slowing the inflow. It’s slowing because of speculation being flushed out.

What percentage of 2006 originations have resulted in loses? Well, 2% in actual loses. We know another 20% has defaulted. We can make estimates in how those things roll down through the buckets (30, 60, 90). There are varying forecasts we can do. We think the bad stuff moved through in 2007, we think this stuff will perform like the 2002 vintage and the curve will be at a lower angle than what others are projecting.

60 + 90 + foreclosure + REO. The delinquency rate is still growing. But the dollars in delinquent loans in 30 day is down 30%. 60 day is coming down. 90 day has flattened. Next comes foreclosure etc. Same is true with second half 2006, first half 2007, and second half of 2007.

Part of that is seasonal. Consumer credit is better in Jan and Feb. But 33% is more than seasonal. It wouldn’t surprise me if the dollars don’t bump up again, but the big pig is moving through the pipe.

There is an index called ABX. They take 20 loan pools of about 1.5 billion. Every month we go through and estimate loan loses. A true analysis of what’s going on is that people got scared and the loss estimates are way too high.

Upside volatility could be similar to downside. On January 23, 2008 BKX rose 8% vs. 2.1% rise in the S&P 500. That has hardly ever happened. When it does, the bull runs.

The average bank was down 44% prior to the last bull run. 1 year after the bull, the worst was still down 6%, the average was up over 83%.

In 2008. Most financial companies will under earn. Stabilization of some financial institutions and narrower spreads. Panic and uncertainty rose so high in 08 that a number of companies are trading below their liquidation value. My conclusion is that we’re in the nasty part of the credit cycle. The markets take all that into account. Next year it will be all better.

Tags: TomBrown, Second Curve Capital, BankStocks, bull market, Ocwen Financial

These are my notes on a conversation between Tom Brown and Chris Larsen of Prosper.com. It occurred at the BAI Mavericks in Banking Conference.

Tom

Talk about starting E-loan

Chris

It started with taking out my first mortgage. It pissed me off how I was treated personally. It was motivated by anger. Anger and being poor. It helps blind you to following all that good advice you get. Ignoring the advice of the people you respect. You get an idea, an epiphany, and you only get that once in a venture. Then you spend the next years hacking through it. Any advice you get, you have to say, “no.” Take the financing advice, but not on the core idea.

Tom

Talk about what you did right and wrong?

Chris

First, ignoring advice.

I always partner with a cofounder, so you can help each other ignore all the good advice you’re getting.

We recognized early that finance and tax are different than entertainment. You have to bring together three domains: technology, risk, and regulatory. Then marketing. The good thing is that the tech heads in the valley can’t compete just on technology like they can do in music. This is what makes finance work more slowly on the Internet. But it gives you an advantage if you get it right. The barriers are so high.

Get domain experts, not great “athletes.” You need people that know what they’re doing and get them to work together.

Get the money in as early as you can and as much as you can. So many companies die of starvation. There are all these booms and busts. We were in a boom and now we’ll go into a bust. Teams work best in a trough by the way.

Mistakes? Not firing people who were only four stars (vs. five stars).

You need to iterate very quickly. Stay in that brutal Bataan death march of 4 to 6 week release cycles so you can innovate against your competitors and wear them out. Stay in that for years, and years, and years.

Companies will have a good idea and then they’ll outsource some part of what they do and then they really pay the piper because they can’t keep innovating.

Tom

You came public at the peak of the Internet craziness. How hard was it to run your business when the valuation cratered?

Chris

After the crash, we were worth less than our cap price. It was frustrating and depressing. We lost all the mercenaries, the people who just chase the money. We tried to focus on positives. We were about core values. We were radically pro consumer. If the financial values weren’t there, we went with the missionary values.

You try to focus on the long term.

Tom

As the company makes progress, there were some wild swings. How did you decide to sell?

Chris

It was the right thing to do. Personally, my value occurs early on. I think an entrepreneur gets in the way after a while. We had a great team. You check on the core values. Will they take care of the employees? I was already on to my next thing, Prosper. The time was right. This was 2004. We couldn’t do Prosper before that. ACH was there. Credit scores were transparent. Social networking. Timing was good.

Tom

Tell us about Prosper.

Chris

My wife was telling me about a concept in China called Lun-hui. . . we liked the idea at e-loan about creating an eBay for money. They thought about it. It was all these things coming together. We couldn’t do this at e-loan. We needed a new company to do it. Make it or don’t.

We wound up with a version of Wall Street meets online social networks. We couldn’t do a straight peer to peer. Then we got some really crazy ideas about social networking that probably went too far. So we scaled them back. We’re probably just finding out how it’s different in finance than entertainment.

Tom

You found that large groups turned out to be a negative.

Chris
We tried to learn the lessons about Friendster and MySpace. One the technology couldn’t keep up with the use. They also tried to get too involved with the users. They’re just a utility.

What really works is hands off. Don’t mess with the community. Let any group form. Let the market find its way. If you try to get in and mess with it, you’ll screw it up.

We wanted to build something where anyone could tap their group wherever it was. They can create their own virtual credit union. Where we screwed up was incenting people to go recruit people. Up to about 150 people groups work okay. Once you let groups get big, there are some very opportunistic people on the internet and they spot these things and milk them for whatever they can get. So they would find people who weren’t in a group and weren’t funded . . . in fact they would be prime borrowers but something wasn’t right. They’d pull them into their group but it didn’t work and the default rates were high. Adverse selection.

So we pulled it back.

Tom

How much in and out of group?

Chris

It’s now about 30% in a group. It was 60%.

In finance, unlike other social networks where accumulating a lot of friends is the thing, on Prosper, you’re not a friend unless someone bids on you. If you get friends to put money in the pot, default rates go down about 35%. We’re just now learning how all this works.

There is really cool stuff going on with combining social capital, friends, and scoring data, both for driving financial performance and customer engagement. There is a huge opportunity here for financial markets and for consumers to monetize their own financial data.

Google is working on something like this to help people monetize all their data: data as property. The young generation is much more open about things . . . much less ashamed about sharing data about personal finances.

Tom

Why are the demographics different than I expected? Borrowers are older. Lenders are younger.

Chris

Lending is scarier than borrowing on line. Both borrowers and lenders are consumers. The lending part is the most radical.

We suspect this will work through.

Tom

How are you attracting the customer bases on both sides?

Chris

On the borrower side, you can do all the classic methods. On the lender side, it’s trickier. It’s a different asset class. It’s more viral. There is social value in introducing someone to doing this. We’re still trying to figure this out. We now have something on Facebook. See how smart I am. Show your friends. Things like that.

Tom

You talked about Phase 2 and helping lenders improve their understanding of credit.

Chris

We switched over in October going to default data based on Prosper data. Before, we had to use Experian data. Finally we had $100mm lent, lots of units, 2 years of history, we could start popping up data on how loans like this have performed. That was a pretty big breakout.

We have to be careful about not guiding people too much. If we manage too much, we’re a security. There are all kinds of things we’d like to do on one side that are gated on another side. Again, the cool thing about finance because of the complexity is that all those things move like that.

Tom

Is there an optimum loan size?

Chris

We go from $1000 to $25,000. We go after unsecured business. I don’t see why we couldn’t go in other areas as the market grows. Our average is about $6,800. We’re square in the middle of replacing credit cards.

At some point we could get into a secondary market which would allow for longer terms. We think that the platform can accommodate all kinds of products.

Tom

Any meaningful changes in lenders?

Chris

Early on you had a wild west where so we had all early adopters. We were very hands off. So you saw some funky behavior. A lot of irrational exuberance. People bidding on the picture of the puppy and they hd horrible default rates.

Later, it changed. People pulled back. We can’t step in because we’re just a market. We saw a change in lender behavior. We had a reevaluation so people were looking at 75% financial return and 25% of engagement. That seems about right.

Now we’re seeing really cool stories emerging that we had nothing to do with.

Question

What are your defaults?

Chris

We run about 5 to 6%. We have more to come. We do collections for the first 120 days, and then we sell the bad debt off to bidders.

Last year we had about 30% subprime. Now it’s about 5%. A radical shift in what lenders will fund. We’re trying to get mainstream buyers, just another channel.

Question

We’re sensitized to selling non-insured products through our networks. Have you been sued yet?

Chris

We’ve been very lucky. We always want to let people know the risks are. People get that. You’re giving them the power to make the call. We looked at the insurance products, but we don’t see how we could do that in the US. They’re better off diversifying their portfolios of loans.

Question

What about other entrants into the space?

Chris

Quite the opposite. Because of the complexity and regulatory issues, we’re still the only open market place. We’re the only ones that allow you to make your own bid. We also think there’s a point, unlike e-loan, where we think this will be like eBay: one marketplace because of scale and network effects.

Question

Describe our organization vs. traditional lending institution.

Chris

Very heavy technology. Half our people. We believe in owning all our technology. We want to build everything ourselves. We build on Microsoft platform. We have a huge list of things we want to do and we want to stay on that brutal four to six week release cycle.

The other thing is that we don’t do underwriting. But we do a lot of fraud detection. We work closely with law enforcement and get people arrested. It sends a message in the blogging community.

Regulatory we look differently. We work closely with the regulators. We push the envelope. We work closely with consumer advocates. Regulators look differently at people pushing the edge for bad reasons vs. good reasons.

Question

Financial metrics?

Chris

Biggest is growth of the market and performance of the company. We have to look at both sides: borrowers and lenders. We have to be a referee . . . make sure it’s safe. Like eBay in that way. Keep on eye on things. Did we screw up here? Do we need more data? More transparency?

Question

How do you break down between business and personal?

Chris

All are personal in that they’re all on that person’s credit. For regulatory reasons, they have to be personal. About 30% are using it to fund a business. The rest is credit card replacement.

Question

Are people using Prosper to “live on?” Like an eBay power seller?

Chris

We have three roles, borrower, seller, and group leader. Like a mini-banker. You can make money as a group leader, but we don’t have the formula right yet. But we’re confident that we’ll figure it out.

Question

Are your members predominately US based? International?

Chris

We’re only US and we don’t allow lenders from overseas. We are forming a market in Japan with SoftBank. The intent would be to connect the markets. I don’t think we’ll go to Europe soon. We’ll go to Asia first. We love the idea of a global marketplace.

Tom

What are your thoughts about going public?

Chris

When you’re private, you can focus all your time on the product. I think this next wave of the internet is all about product. Google taught us all that. Heads down and don’t have all the bluster. There are so many ways to fund a company now. Now you need real numbers. It takes awhile to get there.

Question

Talk about your leadership styles.

Chris

The first go around we were a little bit more anger oriented. Very anti-bank. It was very effective. Complaining is different than doing something about it. It can work against you.

E-loan was a channel competing against the bank. Now, we focus on the products.

Early on you really have to baby the venture or it will fall away. You have to force feed it for awhile. Then you have to build the team. There comes a point wher no matter how much effort you put in, you can’t move the ball by yourself. You need to focus on team. Then the domain experts who are 5-star. Then ruthlessly get rid of the non-5 star players.

Tom

Is there a point of maximum discouragement?

Chris

You get tired after two years. Nobody knows who you are. You’re dealing with all the muck. That’s why you need a co-founder. A core team. Someone you can bounce the frustration off of. It needs to be equals.

Tags: ChrisLarsen, e-loan, Prosper, e-bay, Tom Brown, BankStocks, BAI, Mavericks in Banking

Day 2 at the BAI Conference. Here are my notes of a conversation between Tom Brown and Dick Kovacevich, former CEO and Chairman of Wells Fargo Bank.

Tom

When I sat down and thought about if I was only going to have one or two presentations, I thought nobody better than Dick. By the numbers, he’s had the best record by far of any of the large cap bank CEOs.

The first maverick decision I can remember him making was at Citi. It was the late 70s. A thing called the ATM came out and he made the decision to flood NYC with them without knowing what the response would be. He moved shared 3x when nobody was moving share.

Along the way, Wells Fargo had such a great record because he made great moves that didn’t blow up.

Dick, how did you do the pressure not to follow the herd?

Dick

I have a fairly analytical mindset. We look at what people are doing, the returns, and the risks. If it doesn’t make sense, it doesn’t make sense. So we avoid those things. However, the reason we were able to do that is that our business model, which is a broad product line and cross selling, allowed us to do well.

Our business model was developed with that in mind. The business is cyclical. It isn’t different this time. My feeling was that the only way to avoid the pressure to follow the pack is to be so diversified it would still be okay, and you could decrease an element that was too hot because you still had alternatives.

We resisted the push to be a one-product company. You just go over the cliff with everyone else.

You have to slow down. We have often slowed down way too soon. I predicted nine out of the last three recessions. We have these alternative investments. We were able to shift resources and do really okay when the markets turned. We think the market rewards consistency.

Tom

You’re in 84 businesses. You’re the smallest in investment banking.

Dick

There is a need for investment banking. Our customers have that need. Our goal is to satisfy all the needs of our customers subject to two things. Culturally compatible with our values and that we can execute it within the values and culture of our company.

The only way you can run 84 businesses is not by command and control, but by decentralized structure. Allow people to run their company with shared values and culture. We don’t avoid problems with permission to do things. We find problems using a strong audit process. Trust but verify.

We will never add a business or do a deal that is culturally incompatible with Wells Fargo. Teamwork doesn’t occur. They don’t agree to our vision and values. Partnering and cross selling won’t work. Our conclusion was that about the only business that doesn’t fit with our business is investment banking. It is a star based business and we’re team. It’s transaction and we’re relationship. Those are basic cultural elements.

Starting in the 90s when commercial banks were buying investment banks and there were lots of deals that could be done, I said these are culturally incompatible. I said six out of ten wouldn’t work. I was wrong; it was nine out of ten.

Tom

You’ve made more acquisitions than almost any other CEO. With the exception of Wells, they’ve all been small. Why was Wells the exception.

Dick

I said culturally compatible. It turns out that we have more in common with small community banks than with large money center banks. There are more of them and almost all have the cultural compatible part.

Two, for many years, other large banks did not pursue small banks. So they were in love with big deals and paid high premiums for these big deals. The strategy seemed to be pay a big premium, and in order to pay for it you had to slash the cost base. They assumed that when the cost went down and it wouldn’t’ affect the revenues. They got the costs out and it did affect the revenue. Bad decision making that started with paying too much.

With community banks, the decision makers were the founders. They care about the stock price. I can’t think of anything they hate more than paying taxes. They have no basis in the stock. What they want is a stock that they can clip the coupons. They want a good stock. What they want us to do is pay them and then never dilute.

Usually it takes five years from meeting them and saying this is what we’ll offer, a relatively low premium, before they finally gave up and said, “Okay.” I’d say 95% of the small banks we wanted to buy, we buy because they didn’t’ have a lot of other choices and they loved the stock . . . when the owner was the decision maker. When you have someone who is just a hired hand, then it was always different. Then it is always about something else.

So it was cheaper, culturally compatible . . . we bought 45 banks in Texas and became the largest bank before the Wells Fargo deal. There is Highway 35. Our acquisitions guy said I just drive down I35 and if there are two or more exits for that town, I pull off and buy a bank.

We were prepared to continue doing that. We also liked fixer-uppers. Businesses with a little trouble due to headwinds, or some management issues . . . most of our deals were done like that in Texas. If you know how to value the problems, you do the numbers and say, okay, here’s the deal.

If you believe like I do that all segments in financial services are cyclical, which is the bad news, the good news is they’re not the same cycle. If you believe that, when do you buy? Top or bottom? It’s not hard. When do most people buy? Top. It’s not hard.

Tom

So why Wells Fargo?

Dick

So we would say, we can’t pay a 40% premium. Maybe not even 10%. If we’re right about he value of the bank, why should I give you 40% premium and only get 10% of the value in the return. That’s not fair.

What happened was a merger of equals. In the case of Wells, I had a choice of paying a 10% premium to do something as big as 100 deals the size we were used to doing. It wasn’t large vs. small, it was paying a premium vs. sweat equity. Secondly, Wells was consistent with our strategy. We never changed our strategy, it was about execution. It was ring around the mid-west and the west.

Wells came up for two reasons or issues. One, as you know Wells Fargo had decided that a narrow strategy in a single geography wasn’t working. So they did First Interstate. What they did was to execute with First Interstate the way they were executing before. It didn’t work.

They then decided they needed help in running multi-geos. And the narrow product line doesn’t work. So, either spend 20 years to figure it out or go with someone who does it well.

So we started talking. I said Paul [Hazen], “We’re going to do the right business decision. Then we’ll talk about the social issues.” As it turns out it took me two seconds to agree that Wells Fargo should be the name. As much as people in the company liked Norwest, It sounded like a mispronounced airline with bad service.

The good thing about the Norwest name was that we could register it because nobody wanted it. Wells Fargo had huge unaided awareness. Not a very big concession.

Another question: Where should we headquarter the company? A state with 12 billion in assets or 40 billion?

It wasn’t easy on the Norwest side. It appeared that we made social concessions, but we never made a deal on social issues that didn’t make rational business sense. So we were able to get through by being rational. I believe this wasn’t about scale, it was about getting into new geographies and about skill. Never about doing deals because we were too small, but because they made sense.

You should never do an acquisition unless the revenue growth of the combined company is greater than the sum of the two if they stayed separate. The only way you know you’re adding value is if the top line is growing. You don’t have to know anything else. If your top line is growing three times the industry, you must be doing something else. Risk adjusted. The market doesn’t just give it to you.

This deal was done on the basis that the combined revenue growth would be much greater because of the skills. Wells was way ahead on Internet banking. They had the best real estate and commercial banking teams. They were in high growth markets. Norwest brought in a broad product line and how to manage geographically.

Question

When you made the decision at Citi about ATMs, how do you make a decision like that when there was no data . . .

Dick

You do testing. You just keep testing the concept. We knew ATMs would work. When I was in the toy business, I brought ten toys home and let my kids play with them. I would look at what they would pick up first. It’s all scientific. Usually you make mistakes in execution. You reduce uncertainty by simulating in test markets to the best of your ability.

We had a lab set up in New York testing language and so on. We had customers tell us the machine was more polite than the tellers. It was all done by listening to customers. Why do you think we put two machines in at a time? 97% reliability wasn’t good enough. If we told people it was available 24 hours, it better be there.

We introduced this thing in April in 1975; we had to redesign every store. It took us a year to get it done everywhere. That was part of the research, how to introduce it. It meant we needed people to show customers how it would work.

In February of 1977 we had one of the worst blizzards in the history of New York. It was awful. I couldn’t make it home. I said, “We have to do a commercial. Even in the worst blizzard in the City’s history, the Citi Never Sleeps.” That was our tag line.

We had a camera crew coming in from Brazil. We were doing an internal film about what it would be like to work in the company. So I went and got the camera crew. It was a beautiful sunny day the day after the blizzard. Customers were coming down Park Ave. on cross country skis coming in to use the ATM. We interviewed them about what it was like. We had a cameraman blowing smoke across the lens to make it look like a blizzard. We were on television within 48 hours.

When we introduced ATMS, the CEO of Manufacturers Hanover said, “I’m sure glad my head isn’t in that noose.” Later he apologized [and later his head was in the noose].

Question

Tough times look like the best time to buy.

Dick

War, pestilence, and famine, I just lick my chops. There is just tons of opportunity. Not only in deals to be done, but customers, spreads, and so on. Our assets are up 100 billion dollars in the past 12 months. We just couldn’t put more assets on. Spreads went from historical lows, none of them made sense, to the end of the year to fair value, to most asset classes are under valued. So we’re buying with both hands. You buy the assets, then the companies. We now have the best share in Colorado by a factor of two by buying the best bank in the worst of times.

Tom

Let’s talk about courage. When you bought Wells, you bought a commercial loan portfolio with huge individual exposures. You don’t like that. How did you get comfortable with that?

Dick

The reason we didn’t take large exposures is we didn’t have experience with that. They had issues because of geographic and product line concentration. I would never have let it get that concentrated. But now it’s much more spread out.

Question

Comment on the future of the retail banking franchise. It looks like we’re still doing brick and mortar.

Dick

You get back to our strategy of a broad product line. 35% of our stores aren’t traditional banks. We have mortgage, financial consultants, insurance, and finance. 40% of all the checking accounts are for near prime or sub prime customers. But we only do prime lending in the bank. We’re going to convert most of Wells Fargo Finance offices into banks. We’re testing it to figure out how to do it most effectively.

The way to preserve the store as an important element is to have more things to do in that store than was traditionally there.

This is just one person talking, but I think that narrow product providers are doomed. Monolines are gone. Next it will be three or four product companies that will be dead [interesting in light of Bill Taylor’s comments on focus and simplicity].

You have to decide. Which kind of company do you want, an easy company to manage with a small number of products that analysts understand with a worse business model, or a superior business model that’s harder to do? Pick your poison.

A broad line company is harder to do, but you’ll always have products in the sunshine. For example, when rates are low, it’s great for mortgages. In a recession when commercial loans aren’t being made, asset-based loans are great.

Money never goes away. It only moves. It move for two reasons: economic cycles or customer life cycles. If you can keep the customer’s money as they decide to move it for either reasons, you’re going to make money.

Second, the cost to sell an additional product to an existing customer is about 10% of selling the same product to a new customer. You have to advertise. Five come in and two buy. You have to set them up on the system.

So who has the margins? It’s not about the product, it’s how you distribute. Why can WalMart beat everyone on cost? It’s not their buying, it’s their low cost of distribution: The logistics of the interaction.

Question

Wells was an early proponent of putting banks in super markets.

Dick

When we merged, they had 900 in-stores, now we have 550. Wells said you could substitute in-store for traditional. I didn’t ever believe that. I think of it as a hub and spoke. They took some stores in the Pacific Northwest. They took a $100 million branch and put it in a Safeway.

Think as an engineer. Ask yourself, what is the percentage of bank customers that shop at Safeway? The easiest answer is their market share. Next, ask which they’re most loyal to? Where they buy food, or where they bank? As much as I like banking, do I think we can compete where they buy food? It didn’t work. So I like hub and spoke. It’s a service proposition. Even that’s questionable.

Question

Talk about your interaction with your senior team.

Dick

If and when I get comfortable with someone to run company, my attitude is I am there to help them run their company. There are things I know, I’ve been around awhile. They come to see me because they have an issue. If I come to see you, that’s not going to be fun. I’m not talking about doing visits; I do that all the time.

I believe that great leaders have confidence in themselves and create confidence in others. My job is to build the leaders such that once you give them a thought or idea, they never have to come back to you. We’re trying to teach and learn so they know what to do so they can do it.

Tags: DickKovacevich, Tom Brown, BankStocks, Second Curve Capital, Wells Fargo, Norwest, BAI, First Interstate, In-Store, Citi, The Citi Never Sleeps