Banks

Mike Mayo, CFA Mayo testimony to Washington,

mike.mayo@clsa.com
(1 212) 261 4000 D.C. Crisis Commission
Today, the Financial Crisis Inquiry Commission (FCIC) is holding a
hearing to investigate the causes of the financial crisis. Beginning at
9AM (EST), the first panel of financial institution representatives,
consisting of the CEOs from Goldman Sachs, Morgan Stanley, JPMorgan
Chase and Bank of America, will be testifying in front of the 10-member
commission. Calyon Securities US bank analyst Mike Mayo will be
presenting at 12:45PM (EST) as part of the three-person financial
market participant panel. The hearing can be viewed on C-SPAN2.
Attached are copies of both Mr Mayo's written testimony as well as the
13 January 2010
slides to his oral presentation, which are an effort to give insight on both
the problems that led to the crisis as well as solutions for the industry
USA going forward.
Banks

The group of companies that comprise CLSA are affiliates of Calyon Securities (USA) Inc.

Please see important disclosures on page 23.

 Testimony of Michael Mayo

Managing Director and Financial Services Analyst,

Calyon Securities (USA) Inc.

Before the Financial Crisis Inquiry Commission

January 13, 2010

Washington, DC

2 mike.mayo@clsa.com 13 January 2010

 Testimony of Michael Mayo
Managing Director and Financial Services Analyst
Calyon Securities (USA) Inc.
January 13, 2010

Chairman Angelides, Vice Chairman Thomas, and Members of the Commission, thank you
for inviting me to testify today about the financial crisis. I currently work for Calyon
Securities (USA) Inc. as a Managing Director and Financial Services Analyst. The views
and opinions expressed in this document and the oral testimony I will provide to the
Financial Crisis Inquiry Commission are solely my own and do not necessarily reflect the
views of my employer or any other institution or person I am currently affiliated with or have
been in the past. Ive submitted almost 200 pages of materials drawn from my research and
sector reports to supplement my comments today, and will also be using and submitting
slides to help illustrate my main points.1

Two decades ago I worked down the street at the Federal Reserve. We were helping banks
recover from crisis, and took great meaning from our efforts. I hope that the Commissions
efforts lead to a system that does not need to save the banks every decade or two.

This is important. To me, Ive been analyzing an industry on steroids whose prior
achievements were artificially enhanced. Benefits were front-loaded and costs were back-
ended. We are now paying the price in what will likely be the biggest taxpayer bailout of US
financial firms in history and, given government borrowing, the biggest wealth transfer to the
current generation from future generations, that is, my children.

Im shocked and amazed that more changes to banks have not taken place. There seems to
be an unwritten premise that a healthy Wall Street as it is constituted today is necessary for
the economy to work. Yet, the economy worked well before inventions of exotic instruments
such as CDOs and with risk that was more obvious and easy to see. Wall St. has done an
incredible job at pulling the wool over the eyes of government and others. Perhaps this
relates to the size of the banks. The four banks that presented this morning have annual
revenues of $300B, or close to the GDP of the 30th largest country, Argentina.

My perspective: Ive analyzed banks since the late 1980s, worked at 6 of the largest
brokerage firms, currently work in affiliation with one of the most independent research
platforms2, and wrote critical research on the banks in excess of 10,000 pages over the past
decade. The more critical issues that I focused on have been the negative implications of
slower economic activity on the growth and quality of bank loans; excessive lending related

1
Main summary is in CLSA reports, The Seven Deadly Sins, April 20, 2009 (first 40
pages). Accounting relaxation is discussed in CLSA reports Relaxing the Rules: Softer
Stance on US Bank Accounting, Nov. 2009 and Weighing in: NPAs and bank balance
sheets, Oct. 2009. Ongoing issues are discussed in the CLSA report Property Pressure
Exposure to Commercial Real Estate Makes Banks Vulnerable, June 11, 2009.
2
Asia Money, Nov. 2009; CLSA has a number one ranking in Asia, the home market.

13 January 2010 mike.mayo@clsa.com 3

 to homes and the potential backlash if and when home prices were to decline; and more lax
regulation.

I will cover two areas in my testimony:

(1) The Problem; and

(2) The Solution

I. The Problem: banks have been an industry on steroids. I have 10 examples.

One enhanced performance with excessive loan growth: Banks and the
financial industry in general grew loans twice as fast as the natural rate,
approaching 8% or about 10% or more adjusting for securitization (pre-crisis),
above nominal GDP of 5%. We consensus strongly believed that nominal
GDP would slow for the past decade, but banks still pushed for loans that
should never have been made. This difference is even greater after adjusting
for securitization of loans, or when banks packaged and sold loans, often with
little if any skin in the game with regard to the loans performance.

Two pumped up profits with higher yielding assets: Higher yields means
higher interest rates and for banks higher interest rates mean higher
profits. To pick two higher risk loan categories, for the last decade, banks
had over 20% average annual loan growth in home equity and over 15%
average annual growth in construction loans, areas with higher than typical
yields. In securities, banks reduced the percentage of low yielding treasuries
from 32% in the early 1990s to under 2% in favor of more risky securities. In
the extreme, the ability of a bank to make higher profits in the short-term is as
easy as making a phone call. The issue is that higher yields get realized
immediately but it comes with higher risk that gets paid later.

Three side effects ignored with concentration of assets: The rush in real
estate was no secret. Of the 11 loan categories listed by the FDIC, all five of
the fastest growing loan categories were real estate related. This is as simple
as the old banking adage, if it grows like a weed, maybe it is a weed or,
perhaps more generally, dont put all your eggs in one basket.

Four higher dosage with higher balance sheet leverage at banks and brokers.
By 2006 before the problems hit the industry U.S. banks had the highest
level of leverage in a quarter of a century. There are many ways to look at
this, but I took tangible capital and reserves for loan losses (source: FDIC).
This data was also not a secret since the data comes directly from bank
regulators. Similarly, leverage in the brokerage industry steadily increased
from 20x in the 1980s to 30x in the 1990s to almost 40x in the past decade
until shortly before the crisis (source: SIFMA).

4 mike.mayo@clsa.com 13 January 2010

 Five investment banks originated more exotic dosages. By this, I mean
instruments such as CDOs, CDOs-squared, etc. that amplified leverage in new
and untested forms. It is always hard for us analysts to know what type of risk
banks have on their balance sheet. These forms were so complex that not
even CEOs, directors, and auditors fully understood their risks. As a
reminder, some of these products were created by experts with Phds in
mathematics. This type of complexity is often used as a reason to pay people
massive salaries. The argument goes that if you dont pay the salaries, good
people will go elsewhere in the economy. Isnt that a good thing? The exotic
securities are a clear example of several where Wall Street needs to shrink in
importance. The protection from monoline insurers also proved much less
than met the eye. Innovation often outpaces regulation, but in this case it was
more than usual.

Six consumers went along for the ride. Consumer debt to GDP has reached
a record level of 100%, versus only 50% 25 years ago. This leveraging
created a false illusion of prosperity that allowed for the purchase of homes,
cars, and other items, many of which should have never been financed and
purchased. It is no secret that everyone from kids, pets, and dead people
received solicitations for loans.

Seven accountants assisted with performance enhancement. In 1998, the

SEC required banks to move closer to a pay-as-you-go approach when
accounting for losses on their loans. This was wrong. The result was that
banks made more risky loans with better profits but set aside even less
reserves for future problems. The banking industry saw a steady decline in
reserves for problem loans from the time of the decision in 1998. The move
by the SEC was well intentioned since it came at a time of concern about
cookie jar reserves but misguided since it failed to reflect the unique
situation related to banks when it comes to conservatism and reserving for
future loan problems. This is only one of several accounting examples.

Eight regulators facilitated performance enhancement. Banks pay insurance

premiums for the coverage that they give on deposits at banks. Banks have
paid this fee since the FDIC was established after the Great Depression. Yet,
banks paid zero deposit insurance for the decade ending 2006 because the
insurance fund was deemed fine. This was a ridiculous insurance model that
is analogous to an auto insurance company not charging premiums until
somebody has an accident or a life insurance company not charging premiums
until somebody dies.

Nine the government doled out some of these steroids. GSEs and their role
in the mortgage market helped to accelerate the growth in housing related
securities via subsidies to banks and consumers whose absence would have
meant less of a housing bubble. The government created more of a command

13 January 2010 mike.mayo@clsa.com 5

 economy model that had the effect of allocating an excessive amount of
capital to the housing sector.

Ten incentives encouraged the behavior. To still further the analogy, the
system shunted the doctors, that is, those whose job it is to report on the
financial health of companies and the industry, in lieu of those with more
positive outlooks. Compensation of banks steadily tracked revenues for all of
last decade. The problem is that compensation only tracked profits until
losses increased later in the decade, highlighting that prior compensation was
far above normal after incorporating losses that were attributable to prior year
revenues. I saw issues first hand. First, in the past decade (2000-2008), the
stocks in the bank index (BKX) declined by over 40% but industry
compensation failed to decline in a similar amount. Yet, when I wrote about
compensation issues a decade ago, the reaction about me was that these issues
were none of my business3. Second, only 7 months after I testified to
Congress in 2002 about the backlash against analysts who provide unflattering
research, I faced what I saw as backlash by a large bank against me and my
critical views when I had lack of management access similar to others. It
reached a point where I put a disclaimer about this lack of access in my
research reports. My point is that if I face a backlash even after I testify to
Congress on backlashes, how can a loan officer who is under pressure to
produce loans realistically say Maybe we should sell less loans? and keep
their job.

In summary, the banking industry has been on the equivalent of steroids. Performance was
enhanced by excessive loan growth, loan risk, securities yields, bank leverage, and consumer
leverage, and conducted by bankers, accountants, regulators, government, and consumers.
Side effects were ignored and there was little short-term financial incentive to slow down the
process despite longer-term risks.

II. The Solution:

Part of the solution is as easy as ABC A for accounting, B for bankruptcy, and C for
capital. Let me explain.

The A for accounting: The first and easiest change is to allow banks to more fully reflect
potential loan losses by taking larger reserves for their problems, that is, reverse the impact
of the 1998 decision by the SEC. In other words, let the bank regulators take charge again
and allow banks to fully reserve for their problem loans safety and soundness concerns
supersede other considerations. Thats always been clear to many of us. Also, more
transparency with reserving methodologies would be helpful as well. While all loans are not
created equal in terms of risks and rewards, perhaps some baseline level of reserves would
be helpful.

3
Fortune, 2/5/01, page 132, The Price of Being Right

6 mike.mayo@clsa.com 13 January 2010

 More generally, stop giving so much latitude to bank accounting. In one of my submissions
to the Commission, there is a report that gives 24 ways that bank accounting has been
relaxed. If it is forebearance that is desired, explicitly do so but do not muddy the financial
statements. The purpose of accounting is to capture economic reality in numbers. My job as
a financial analyst is to try to recreate this reality the best that I can from these numbers, but
the task gets tougher if the numbers are not reported on a similar basis. My analogy is with
golf. If some players can take mulligans, and others can kick their ball out of the woods, and
still more get gimmes for all putts within 5 feet, the score will not be comparable at the end
of the game. For companies, the result can be and probably should be a greater risk
premium for the higher information risk that would not exist if accounting rules were more
consistent.

The B for bankruptcy: The worst precedent was the 1998 rescue of Long-Term Capital
Management. If a hedge fund of that size was going to get bailed out, what would this mean
for other more important firms and the ability to take outsized risks? Bankruptcy is part of
our system, whether for banks, borrowers, or others. Why should the prudent subsidize the
imprudent? Having said this, some of the exceptions were necessitated by unclear rules. It is
time to make the rules clear.

So, of course, this leads to the question of whether banks are or should be too big to fail. I
agree with Jamie Dimons comments before today that bankruptcy needs to be more of a part
of the system. Yet, I also feel that it is unrealistic to think that JP Morgan would ever fail. To
the extent that there are banks with $2T balance sheets that are, in reality, too big to fail (as
opposed to many other entities), there is a question of what price and how these banks should
pay for this special status.

The C for capital. There should not be a question of whether banks have enough capital.
During the crisis, banks were considered as precious as the most important utility. Imagine
turning on the spigot and finding out that the water does not work? Similarly, the capital at
banks should help ensure that failure of banks and the system is beyond any doubt - not a
reasonable one but beyond any doubt as to whether banks will easily open for business on
any given day, even one of the worst in business history.

In other words, capitalism did not cause the problems as opposed to a lack of capitalism,
whether with regard to having good information to make decisions, allowing companies to
fail, ensuring that banks pay for external costs (even contingent ones) that they cause, and
having markets more than government allocate capital, albeit with limits and effective
oversight.

Lastly, one word that is not spoken enough when it comes to our jobs in the financial markets
is meaning. Goldman Sachs has often said that it is long-term greedy, but this too
narrowly states its larger role. This years annual reports could probably give a reminder
about the purpose of financial services to an effective economic system and society. For
evidence, I look no further than my cousin Andy who is going from Iraq and the Army to
business school in the fall.

13 January 2010 mike.mayo@clsa.com 7

 Andy wrote to me and said that he hoped that we, as the world leader in capital markets, can
make sound investments that help less fortunate people to provide for their family. In other
words, his efforts toward furthering peace and prosperity, regardless of whether they have or
will succeed, does not end because he is going into business.

This sums up the larger purpose of what we do in financial services to improve peoples lives
by moving scarce resources to where they can best get used. I hope that the Commissions
efforts lead to greater awareness of this purpose and facilitates its execution by preventing
future crisis as severe as the current one.

8 mike.mayo@clsa.com 13 January 2010

 Financial Crisis Inquiry Commission

Mike Mayo, CFA

212-261-4000
mike.mayo@clsa.com

January 2010
The views and opinions expressed in this document and the oral testimony I will provide to the Financial Crisis Inquiry
Commission are solely my own and do not necessarily reflect the views of my employer or any other institution or person I
am currently affiliated with or have been in the past.
13 January 2010 mike.mayo@clsa.com 9
Industry on Steroids
1) Excessive Loan Growth

2) Higher Yielding Assets

3) Concentration of Assets

4) High Bank Balance Sheet Leverage

5) More Exotic Securities

6) Consumers Went Along

7) Accountants Assisted

8) Regulators Aided

9) Government Facilitated

10) Incentives Encouraged Behavior

2009 Calyon Securities (USA) Inc.

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10 mike.mayo@clsa.com 13 January 2010
1) Excessive Loan Growth
Loan vs GDP growth in the 2000s

12%

10%

Securitization (Est.)
8%

6%

4% Loans

2%

0%
GDP Growth Loan Growth

Source: FDIC - All banks, Pre-Crisis

2009 Calyon Securities (USA) Inc.

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13 January 2010 mike.mayo@clsa.com 11
2) Higher Yielding Assets
Shift to higher-yielding, higher loss-rate consumer and commercial real estate loans
2008 1992 1984 1974 1942
Loan Type % of Total % of Total % of Total % of Total % of Total
Residential Mortgage 19% 17% 12% 15% 17%
Home Equity 11% 6% nil nil nil
C&I 21% 26% 37% 37% 41%
Core CRE 14% 13% 6% 9% 5%
Construction 8% 4% 5% 3% nil
Credit Card 6% 7% 4% 2% nil
Other Consumer 9% 12% 14% 18% 12%
Other 13% 15% 21% 16% 25%

Source: FDIC - All banks

Growth in securities holdings

70%
62%
US Treasuries
60%
MBS

50%
40%
40%

30%
32%
20%

10%
2%
0%
1992 19 94 1996 19 98 2000 2002 2004 2 006 2008

Source: FDIC All banks

2009 Calyon Securities (USA) Inc.

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12 mike.mayo@clsa.com 13 January 2010
 3) Concentration of Assets

Real estate was the largest area of growth

Compound Annual Growth in Loans (2000s)

Leases

Agriculture

Commercial and Industrial

All Other Consumer

Farmland

Credit Cards

Total Loans

Foreign Office Real Estate

Commercial Real Estate

HIGHEST
1-4 Family Real Estate
GROWTH
Commercial Real Estate Multifamily

Commercial Real Estate Construction and Development

Home Equity

-5% 0% 5% 10% 15% 20% 25%

2009 Calyon Securities (USA) Inc. Source: FDIC - All Banks

Page 5
13 January 2010 mike.mayo@clsa.com 13
4) Balance Sheet Leverage
Leverage increased
15 x
Banks
14 x

13 x

12 x

11 x
Tang assets/(Tang equity + reserves)

10 x
19 93 199 5 1997 1 999 20 01 200 3 2005 2 007

Source: FDIC - All Banks

Securities Industry
40x

35x
Assets/Total Equity
30x

25x

20x

15x

10x
1980s 1990s 2000s

2009 Calyon Securities (USA) Inc. Source: SIFMA Balance Sheet

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14 mike.mayo@clsa.com 13 January 2010
5) More Exotic Securities
Fees are a larger percentage of revenues

Fees as % of Revenues

45 %

40 %

35 %

30 %

25 %

20 %

15 %
1951

1956

1961

1966

1971

1976

1981

1986

1991

1996

2001

2006
Source: FDIC -All Banks

2009 Calyon Securities (USA) Inc.

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13 January 2010 mike.mayo@clsa.com 15
6) Consumer Debt - Highest in History
Household debt at record levels

Household Debt-to-GDP
120%

100%

80%

60%

40%

20%

0%
48

54

60

66

72

78

84
87
90

96
99
02
05
08
45

51

57

63

69

75

81

93
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
Source: Federal Reserve, Bureau of Economic Analysis

2009 Calyon Securities (USA) Inc.

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16 mike.mayo@clsa.com 13 January 2010
7) Accountants Aided

Reserves to Loans

2.0%

1.8%

1.6%

1.4%

1.2%

1.0%
1998 2000 2002 2004 2006
Source: FDIC All banks

2009 Calyon Securities (USA) Inc.

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13 January 2010 mike.mayo@clsa.com 17
8) Regulators Aided

Annual FDIC Insurance Fee

25 (bps)

20

15

10

0
1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995 2001 2007

Note: Per $100 of deposits

Source: FDIC

2009 Calyon Securities (USA) Inc.

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18 mike.mayo@clsa.com 13 January 2010
9) Government Facilitated
GSE debt increased over 6 times in 2 decades

$3.5
$3.1
$3.0

$2.5

$2.0
$Trillion
$1.5

$1.0

$0.5
$0.5

$0.0
1990 2009_Q3

Source: Federal Reserve, Flow of Funds

2009 Calyon Securities (USA) Inc.

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13 January 2010 mike.mayo@clsa.com 19
10) Incentives Misaligned

45%
Compensation/(Revenue less loan losses)

40%

35%

30%

25%
Compensation/Revenue

20%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Note: Loan Losses = Provision for Loan Losses

Source: FDIC All Banks

2009 Calyon Securities (USA) Inc.
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20 mike.mayo@clsa.com 13 January 2010
Industry on Steroids
Performance enhanced by excessive
Loan growth
Loan risk
Securities yields
Bank leverage
Consumer leverage

Excesses conducted by
Bankers
Accountants
Regulators
Government
Consumers

Side effects ignored

Little financial incentive to slow down
Ignored long-term risks
2009 Calyon Securities (USA) Inc.
Page 13
13 January 2010 mike.mayo@clsa.com 21
The Solution Partly a function of ABC

A for Accounting

B for Bankruptcy

C for Capital

2009 Calyon Securities (USA) Inc.

Page 14
22 mike.mayo@clsa.com 13 January 2010
 Banks

IMPORTANT DISCLOSURES
Analyst certification
I, Mike Mayo, CFA, hereby certify that the views expressed in this research report accurately reflect my own
personal views about the securities and/or the issuers and that no part of my compensation was, is, or will be
directly or indirectly related to the specific recommendation or views contained in this research report. In
addition, the analysts included herein attest that they were not in possession of any material, non-public
information regarding the subject company at the time of publication of the report.

EVA is a registered trademark of Stern, Stewart & Co. "CL" in charts and tables stands for Calyon Securities
(USA) Inc. estimates unless otherwise noted in the Source. Calyon Securities (USA) Inc. does and seeks to do
business with companies in its research reports. As a result, investors should be aware that the firm may have
a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only
a single factor in making their investment decision.RATING RECOMMENDATIONS: Buy = Expected to
outperform the local market by >10%; Outperform (O-PF) = Expected to outperform the local market by
0-10%; Underperform (U-PF) = Expected to underperform the local market by 0-10%; Sell = Expected to
underperform the local market by >10%. Performance is defined as 12-month total return (including
dividends). Overall rating distribution for Calyon Securities (USA) Inc. Equity Universe: Buy / Outperform -
82%, Underperform / Sell - 18%, Restricted - 0%. Data as of 31 December 2009. INVESTMENT BANKING
CLIENTS as a % of rating category: Buy / Outperform - 16%, Underperform / Sell - 16%, Restricted - 0%.
Data for 12-month period ending 31 December 2009. Prior to 25 November 2008, Calyon Securities (USA) Inc.
used an absolute system (based on anticipated returns over a 12-month period): Buy: above 20%; Add:
10%-20%; Neutral: +/-10%; Reduce: negative 10-20%; Sell, below 20% (including dividends). FOR A
HISTORY of the recommendations and price targets for companies mentioned in this report, please write to:
Calyon Securities (USA) Inc., Compliance Department, 1301 Avenue of the Americas, 15th Floor, New York,
New York 10019-6022. CALYON SECURITIES (USA) INC. POLICY: Calyon Securities (USA) Inc.'s policy is to
only publish research that is impartial, independent, clear, fair, and not misleading. Analysts may not receive
compensation from the companies they cover. Neither analysts nor members of their households may have a
financial interest in, or be an officer, director or advisory board member of companies covered by the analyst.
ADDITIONAL INFORMATION on the securities mentioned herein is available upon request. DISCLAIMER: The
information and statistical data herein have been obtained from sources we believe to be reliable but in no way
are warranted by us as to accuracy or completeness. We do not undertake to advise you as to any change in
our views. This is not a solicitation or any offer to buy or sell. We, our affiliates, and any officer director or
stockholder, or any member of their families may have a position in, and may from time to time purchase or
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Calyon Securities (USA) Inc. All rights reserved.

13 January 2010 mike.mayo@clsa.com 23