Bove: Why Washington will soon back off banks By Duff McDonald, contributor

FORTUNE -- Gadfly analyst Dick Bove rarely disappoints when he unholsters his guns. On Tuesday, the Rochdale Research VP put out a report accusing Sheila Bair, head of the FDIC, of completely misunderstanding her job. "Unlike the heads of the Federal Reserve (FRB) who have repeatedly acknowledged their failure to act before the financial crisis, the FDIC has never done so," he wrote. And he suggested that Bair, "knew what was wrong but did nothing about it." We caught up with Bove yesterday to get his dependably provocative view on Bair, Bernanke, and the state of the U.S. banks.

Is it really fair to blame the FDIC for the fact that banks went crazy during the credit bubble?

Yes, it is. You need to start with an understanding of the powers of the FDIC. They audit all the banks in the United States -- some 8,000 of them. Basically, they have the power to close a bank, to oust management or boards of directors, to change banks' lending policies, or to force them to adjust their capital ratios. They have total power.

Ms. Bair took her position in July 2006, which was more than two years before the September 2008 crisis. I had written in 2005 that the powder keg was going to blow. But the FDIC failed to live up to its requirements. Ms. Bair wrote that banks should not have put so much money into property loans but should have spent it elsewhere. Well, the FDIC has the power to force the banks to do that. It's not as if the FDIC was sitting on the outside and couldn't go into a bank and tell them to reduce exposures. So she is complaining that the banks were doing something that she had the power to stop. That's hypocritical, and it's just not right. The FDIC had a role to play in moderating the problems banks faced but did not play that role.

I gather you think she's not playing the appropriate role today either.

No, she's not. Fast-forward to the crisis, and the FDIC is called in to come up with solutions. They decided that the issue was capital, and that banks needed to increase their capital ratios. At the same time, the government passed a law that said banks could no longer use trust-referred securities [a hybrid security that paid dividends yet was considered equity for capital calculation purposes] in their capital ratios. I agree with that law -- banks were allowed to view the Trust Preferred's as equity but dividends were tax deductible as if they were bonds. Putting that issue aside, though, the net effect is that if you are a small bank in the U.S., you cannot now use Trust Preferreds but you must add capital.

In effect, the government is forcing capital down in small banks while demanding that they increase their capital ratios. So what can a bank do? It can only shrink.

If you are told that you cannot add capital with this instrument but you must increase capital ratios, then you are forced to shrink. When you force the bank to shrink, all sorts of hell breaks loose. The first thing they do is get ride of loans. In doing so, they reduce the money supply. And that's not helping anybody.

Give us a report card on Ben Bernanke at the Fed.

He's kind of in a tight spot, isn't he? The Fed has got this policy of quantitative easing. They are keeping interest rates as low as they can keep them. And yet the money supply is going down. Basically, the Fed is not controlling the money supply, the banks are. The banks are killing it because they are shrinking their balance sheets because the government wants higher capital ratios.

The American banking industry has more capital as a percentage of assets than at anytime since 1935. If you are at the second highest level in 75 years, you are way out at the end of the spectrum. You are the most overcapitalized than you have ever been in years, but the government is still demanding more capital. Citigroup (C, Fortune 500) has $180 billion in cash. $1 of every $9 in that company is cash or government-backed securities. Its Tier 1 ratio [the ratio of its core equity capital to total-risk weighted assets] is high because it has dumped loans and raised cash. If you look at the American banking system, roughly 8% or 9% of the assets are in cash versus 2% to 3% a decade ago. What we're seeing is the banks are readjusting their balance sheets to get these capital ratios higher by shrinking their balance sheets and shifting out of loans into liquid capital.

So the government is essentially acting at cross-purposes?

Exactly. What is the government doing? It is taking banking out of the picture as an element in assisting the economic recovery. That's why the leadership of the FDIC needs to be turned over. At least the Fed has Greenspan and Bernanke admitting that they didn't do their jobs in regulation leading up to the crisis. The FDIC didn't say a word. Nor did the Office of the Comptroller of the Currency. If they don't understand what they did wrong, how can they do right?

Shifting gears here, let's go to everyone's favorite topic, Goldman Sachs. The sound and fury of Abacus has died down. What's Goldman's business going to look like going forward?

I think that the mechanism and the structure will be different, but that the business will be the same. By that I mean that the proprietary traders won't be sitting on the desk anymore, they will be sitting in a hedge fund in the asset management division. Private equity will be another fund in the asset management division. Goldman (GS, Fortune 500) has already started shifting people over to those new venues to get away from the new Volcker rules. So the structure won't be the same. But will the company still do deals working with clients? Absolutely. What the hell does a corporate finance department do? One way or the other, someone is proposing a deal to be done. If both sides agree, they are going to do it. The functions will not change.

Where has Vikram Pandit gone and hidden? We barely hear from the guy. Can you give us a report card on his performance?

I give him an A+. I think the guy has done a phenomenal job. He walked into a company that had a decade of mismanagement behind it. Actually, it goes back even further than that -- to Walter Wriston [See Fortune's 1999 story "Don't Say Retired: Walter Wriston Is Wired"]. Wriston believed in survival of the fittest in the business world, so he created a culture where beating the guy down the hall was better than beating the guy across the street. It was dysfunctional. And then you had constant shifts in direction depending on who the leader was. Wriston liked international lending. John Reed liked technology and consumer lending. Sandy Weill liked cost control and acquisitions. Chuck Prince liked the capital markets.

When you keep changing the direction of the company, you keep changing what is important and who is important in that company. And you create confusion. And they ultimately drove that company into bankruptcy. There is no question that Citigroup was bankrupt in September 2008. Pandit had to change the whole culture, change the structure, and find businesses that can grow.

And he has done all of those things.

And how do you think James Gorman is doing at Morgan Stanley.

I don't have a report card on him for running Morgan Stanley (MS, Fortune 500) yet. But certain people are absolutely superior as managers -- Jamie Dimon, James Gorman, Dick Kovacevich. What makes Gorman one of that group is all these guys are detail-oriented. They have spent an enormous amount of time learning the functions of their business and how it operates. They have the ability to create a vision and execute on that vision. Gorman is particularly good at that.

One of the first things he did at Morgan Stanley was to review 500 executive positions. How they can be "executive positions" when there are 500 of them is beyond me, but he did it. And he brought in people whose skill set made them capable of the job. This is quite different from his predecessor John Mack, whose approach was more along the lines of if you were his buddy, then you got the job. Whether you knew what you were doing was irrelevant.

Then Gorman did town hall meetings all over the world. He is like Kovacevich in that he understands that motivating his people is the most important thing he can do to turn the company around. He put in a retail-oriented strategy based upon a humungous sales force selling consumer finance or small business finance products. He reduced risk on the trading desk. He is doing everything in the right direction. It won't show up in their third quarter earnings, but it will show up soon.

Bank stocks have been all over the place this year. What's with bank stock investors. Why can't they make up their mind?

The typical bank stock investor is a guy who recognizes that the company he is investing in his highly cyclical. Therefore he is always seeking out some piece of information that tells him where he stands in the cycle. The most important factor in that analysis is the quality of the loan portfolio. He doesn't look at the quality of management, the size of the franchise, or the power of the company. He is only looking to see if loans are good or bad. The fact that Jamie Dimon is a superb manager, nobody really cares. They should realize that Dimon's team will generate higher returns over time. All they do is say that commercial real estate looks bad, so sell the stocks. Or, wait a minute, the economy is looking better, buy the stocks! It gets farcical.

You don't have long-term investors in bank stocks. The core reason is that bank managements have failed to prove that they know how to deal with the cycle. If you look at their business results, they look like roller coasters at Coney Island. Banks never seem to be able to get out of the way of the economy. There is something wrong in the way these companies operate. They can't seem to avoid a down cycle. Wells Fargo (WFC, Fortune 500) has shown they could do that, which is why that stock traded at a premium.

I understand that banks don't control interest rates. I understand that they don't control the strength of the economy. And that their earnings are tied closely to both interest rates and the strength of the economy. But banks have the ability to do what [longserving Fed Chairman] William McChesney Martin said, which is to expand in bad times and contract in good times. They have the ability, but they do the opposite, and that's not the way to maintain earnings. They expand at the wrong times and contract at wrong times, and in the process they exacerbate the tendency of the cycle. Government regulations don't help.

What's the next surprise waiting to happen? Will it be a positive or a negative one?

The next surprise will be a big positive. The government will back off all of these laws they just passed on banking. They have taken the banks out of the economy with the rules they put in. But they need the banks. They will repeal parts of the Dodd-Frank abortion and recognize that they need banks to grow the economy. We're going to see a rollback of a bunch of these new requirements. To top of page