What Do The Bones Tell Us?

Last January, Bank Director held its 17th annual Acquire or Be Acquired conference in Arizona, where for two and a half days we read the bones of the bank M&A market and tried to predict its future. The buying and selling of banks is more than just an important commercial franchise for us. Bank Director has devoted more time and energy to chronicling the U.S. banking industry’s historic consolidation than any other magazine during the 20 years that we’ve been in existence. Consolidation has been one of the great financial stories of the past two decades, and it’s one I think we understand as well, or better, than anyone.

Like any economic trend, bank consolidation is inherently cyclical. When the economy is strong and bank stocks are trading at high multiples, there tends to be a lot of deals. And when they’re not, there aren’t. The market notched a modest recovery to 172 deals in 2010 after posting just 120 deals in 2009, according to SNL Financial, and most advisers at the conference were predicting considerably more activity this year. You might expect them to say that out of self-interest, of course, but I think that bankers sense it too, which is one reason why we drew a record crowd of 588 attendees to Arizona.

If the consolidation trend line has indeed turned upward, I think this cycle will differ from previous ones in a couple of important ways. First, deal pricing might never return to the halcyon days of 1998 when there were 475 deals with an average price-to-book ratio of 255.8 percent. Buyers have shown considerable discipline in the early going, in part because of lingering concern about asset quality throughout the industry. Potential sellers who hold stubbornly to the notion that someone will offer two and a half times book value for their bank if they just wait long enough should consider this: Of the 27 deals announced through March 17, buyers paid an average of just 100.7 percent over the seller’s book value. If that average were to hold through December 31, it would be the lowest average in 15 years, according to SNL. Like it or not, it looks as though sellers will have to lower their expectations.

Another defining characteristic of this market is the powerful behind-the-scenes role played by the regulators. The pressure comes in the form of tougher examinations and official sanctions like memorandums of understanding.

Undercapitalized banks with slim prospects of raising additional funds from investors are also being toldu2013sotto voceu2013to strongly consider a sale, according to several advisers at the conference. William F. “Bill” Hickey, who runs the M&A shop at Sandler O’Neill + Partners, says there is a significant number of undercapitalized banks with credit issues, “and the regulators quite frankly are really pushing the institutions towards a merger or sale.” (For a deep dive into the market, see the M&A Outlook on page 56.) There is a provocative conspiracy theory out there, voiced in the Outlook piece by Stephen Klein, a partner at the law firm Graham & Dunn, that regulators are deliberately trying to “squeeze” out banks under $1 billion in assets. I’ve heard other people make similar comments, and while I have a hard time believing that the regulators actually have an under-the-table policy of forcing small banks out of business, clearly they are not watching the action from the sidelines, as in past cycles.

A final characteristic of this market is that most of the action is likely to be in the small bank sector. Bank of America Corp., the country’s largest bank and a serial acquirer, currently exceeds the 10 percent nationwide cap on deposits and is blocked from doing more acquisitions unless there is a change in the law. JPMorgan Chase & Co. and Wells Fargo & Co. have 8.8 percent and 7.6 percent national deposit market share, respectively, and would be very challenged to fit anything more than a modest acquisition under the cap. Through the early part of the year, at least, most large banks were trading at lower valuations than smaller community banks, which has made it difficult for them to do all stock deals. This will eventually change and we’ll see more consolidation among the 50 largest U.S. banks, but the heaviest action will be in the trenches with the less-than-$1-billion institutions that need to raise capital and aren’t sure how to compete in today’s highly competitive environment.

A notion has taken hold among some M&A advisers that a bank has to have at least $1 billion in assets to survive nowadays. I’m not sure I agree with that. I could easily imagine a scenario where a $500-million bank has a secure future and a $1-billion bank should find a merger partner. But if enough bankers buy into that idea, it will become a self-fulfilling prophesy and the industry’s consolidation will be off and running again, this time from the bottom up.