
Hope on the Horizon
Convening this year in New York for Bank Director’s annual analysts roundtable were four of the industry’s top analysts:
Anthony R. Davis, managing director of financial institutions research, Ryan, Beck & Co.; Mark T. Fitzgibbon, principal and co-director of equity research, Sandler O’Neill & Partners; Jason M. Goldberg, vice president of equity research, Lehman Brothers; and Thomas McCandless, senior vice president of research, Keefe, Bruyette & Woods. Their mood was cautiously optimistic; all the fundamentals were in place, they agreed, for a successful banking market once the general economy edged its way out of its current slump. After a year of corporate scandals and intense scrutiny, our panel gave a nod to bankers, most of whom, they said, were faring relatively well in the current maelstrom of corporate reform.
Bank Director:
The Congress has spoken, the New York Stock Exchange has acted, and scores of investors are prodding into the corporate governance practices public companies. At a time when there has never been more scrutiny on corporate America than there is now, how do you think the banking industry has fared?
Jason Goldberg:
The banks are a regulated industry-between the FDIC, the OCC, and the SEC, and even more recently, the states, there are constant reviews of their accounting practices, so for banks, I think Sarbanes-Oxley was a non-event. The majority of banks have been following the rules. I think the bigger issue is that, clearly, some of the rules will change over time, such as how you account for off-balance-sheet vehicles. So in a lot of cases, the effect remains to be seen.
Tony Davis:
It seems to me there are different issues here. You’ve got the regulatory agencies that seem to be focused on risk control, which is a different issue from what the SEC and the stock exchanges are focusing on in terms of corporate governance. It is going to bury a lot of earnings depending on what they eventually do. Certainly as it relates to these new governance standards, it is hard to make general statements about the full effect on banks; it’s really going to be a bank-specific issue as we go forward.
Mark Fitzgibbon:
By and large, bankers are pretty honest people, and as Jason indicated, you have a variety of sets of eyes looking at their financial statements. Ultimately, these are companies that are viable business entities, and I think many of the problems that this legislation is addressing are found in industries that have business models that are fundamentally flawed. So I would suggest that it’s not a major impediment for the banking industry.
Tom McCandless:
It’s a boon to the legal industry, number one! Number two, just to add on to the point made about off-balance-sheet accounting, there’s hardly an industry in the country that doesn’t do that! In fact, most of these off-balance-sheet financing vehicles are done by the banks at the behest of the corporations. They are all somewhat guilty of it. So, yes, banks have more eyeballs looking at their financial statements than telecom companies or tech companies, for example. In fact, KBW put out a report recently indicating that because of better financial transparency, it is conceivable to us that relative P/Es for banks could increase in this period of turmoil. Interestingly enough, that has happened. So at a time when normally the relative P/Es might be under pressure, they actually have gone up, because people believe there’s safety in the banks. Of course, there are always a few renegades out there that can spoil things. But I don’t think there’s anything in the spirit of the legal changes that is going to be a materially new challenge for the banks.
Where these changes really impact banks is at the board level. There are so many corporate governance issues that are being reinforced and so many changes at the board level. Independence has become a big issue. And a lot of directors are ignorant about their degree of their liability. It may not pay to be a board director on six different boards anymore. So I think you will see board members step down from a lot of different companies. This is all designed to provide more accountability and transparency, and it’s all for the good. And yet, there are still a lot of gray areas about the interpretation of Sarbanes-Oxley as well as the New York Stock Exchange rules.
BD:
Where are the pressure points for earnings? What factors are really affecting valuations?
Goldberg:
We’re in the midst of a pretty prolonged economic slowdown. It seems every month you hear that the economy is going to pick up three months from now, and three months later it still hasn’t picked up. So the lack of corporate loan demand is an issue. At the same time, corporate chargeoffs remain at relatively high levels. That is somewhat mitigated by the strong refinance move, and consumer loan growth is clearly offsetting some of those pressures, as are the low interest rates and the low inflationary environment. The steep yield curve has also helped for much of the year, although its recent flattening is expected to hurt net interest margins in the near term.
Davis:
Just as we mentioned in the corporate governance area, different types of banks have different exposures. I agree, the number of companies that will be financially and materially impacted will be limited to just a few of the big players. But as for the point that Jason is making, we’re seeing, for example, in the June quarter, C&I loans year-to-year from our reporting banks down 13% to 14%, and yet the small- to mid-cap companies that are serving middle-market America and below are seeing double-digit growth in C&I and commercial real estate. And the chargeoff point is another issue. Since 1997, the percentage of assets owned by or controlled by the 10 largest banks in the country has gone from 62% to 67%. The percentage of nonperforming assets of publicly traded banks owned by the top 10 has gone up. Yet, we’ve done a much better job of managing the cycle this time. But beneath those numbers, typical banks-not the big guys, not the top10-have done a remarkably good job. So in terms of managing challenges, in terms of dealing with the regulatory issues and the way the world is changing, it’s going to be important to focus on individual companies and what their business models look like, as opposed to just looking at the industry-which is the way a lot of large institutional investors tend to look at things.
Fitzgibbon:
There are really four factors that drive financial stock prices. One is the economy and how that translates into the credit picture for banks. Second is interest rates. The third is M&A activity in a rapidly consolidating industry. And the fourth and final thing is the markets in general. Right now we have a lot of cross-currents among those four factors. M&A activity has been relatively slow. The economy has done a stutter step down. Interest rates have surprised people-they’ve fallen to a greater extent than I think most banks had anticipated. And the market in general is not doing well.
Our greatest concern right now for the banking industry is the credit trend. We’re not sure that we are out of the woods yet from the standpoint of the recession. And if, in fact, the economy doesn’t accelerate and turn at some point in the next few quarters, the outlook for banks may not be as good as most of us are forecasting.
McCandless:
I think it’s the economy, period. Because it drives everything else. The points made about loan growth depend on where you are in the food chain. If you are a large corporate borrower and you are refinancing your debt, you are paying down your loans. If you are in the middle market or a community bank, you are growing market share. Our observations are that at the small business level there’s decent growth. There is the appearance of the early stages of growth in the middle market area, but large corporate business is still deleveraging. However, those large corporate loan dollars swamp all the other numbers and pull down the aggregate. That process needs to cure itself, and it’s going to take a little bit more time.
Davis:
We also can’t see where we are in the wind-down of excess telecom investment and cable television investment. That whole situation is still going on.
McCandless:
Yes, and, again, it plays to the notion that there are various levers the banks use to promote earnings. The returns this cycle have been demonstrably better than history would have ever imagined, especially on an ROE basis. Part of this pertains to the evolution of capital markets, because you are now able, through a variety of risk-mitigation techniques, to parcel out risk to the capital markets and get it off of your balance sheet through such things as credit derivatives or selling loans to players who buy paper. Last cycle, the syndicated market was about 90% banks. Today it’s less than half that; there are many other players. So we’ve been able to disperse the credit risk and lessen some of the credit volatility. As a result, we’ll probably end up with higher trough ROEs.
Fitzgibbon:
For the banking industry in general, core returns on capital have been getting consistently better as the excess capacity and redundancy in the system is taken out and the banking business becomes more efficient. One of the ways that you play this kind of difficult environment is to invest in the smaller community-oriented institutions that generally have much more conservative balance sheets than the larger companies that expose themselves to some of the frailties in the U.S. economy and the foreign economy. In fact, if you were to break the banking industry into three segments and look at the chargeoff trends on those three segments being large, medium, small, the small institutions would have about half the chargeoffs, historically, than the largest institutions have, and the medium-size institutions would have about two-thirds of the chargeoffs that the largest institutions have. So given that community banks have, by and large, a very hefty capital basis and have little exposure to some of these more economically sensitive sectors of the market, and they tend to be more conservative lenders and know their customers well, we think it’s an opportune time to take a hard look at those kind of companies.
BD:
Is there still excess capacity?
Fitzgibbon:
Sure.
BD:
What will it take for M&A to heat up again?
McCandless:
I think that goes back to the first question-the economy. The economy is clearly shaping up because, as we’ve all hinted at, capital has got to go somewhere. If it’s not all needed to support loan growth, it’s got to support something.
Some of the problem is due to the lack of corporate CEO confidence. I can’t remember a time when there’s been so little of it out there because of the accounting irregularities and fraudulent activities in various industries. And it’s not totally disconnected from the economy. As companies get more confident, there are going to be more aggressive growth plans either internally or, again, by sniffing out acquisitions. So the phone calls (to discuss mergers) are going to start to go up. There’s some of that going on now, but it’s pretty spotty.
Goldberg:
One thing we’ve got going against us is that it’s the first time since 1997 that that small- to mid-cap group has a premium multiple to the largest banks, making it more difficult for the largest banks to acquire them. So you do need some sort of a mobilizing effort among the buyers. At the same time, a lot of analysts still have a bad taste in their mouth from all the acquisitions that went awry in the latter part of the 1990s. But if you look at the more recent ones, such as First Union/Wachovia, they have been priced better and have been not only better accepted by the marketplace, but appear to be doing better. So you will likely see a pick up in M&A, particularly in light of the fact that there’s more than 9,000 banks out there, even though the pricing will reflect much lower premiums.
Fitzgibbon:
I think the environment is starting to warm up; there’s been some encouraging trends out there. First, with some of the transactions that have been announced, the buyers’ stocks have traded recently right along with the market, so more institutions are inclined to go out and look at acquisitions if they think their stock will hold up after they announce the transaction. Second, I think sellers are becoming more rational about their expectations. If you look at the deals that have been done this year, the average premium in the market is a little over 20%. Historically, it’s been more than 30%. So sellers are beginning to recognize that what’s more important than the absolute dollar price or multiple that’s received is the currency that you are taking. Finally, we’re seeing a whole new breed of acquirers emerge: the “preferred buyers.” Companies like BB&T, BankNorth Group-these companies are in the position that some of the largest regionals, such as Wachovia, Fleet, and BofA, were in 10 years ago when they had strong currencies, when they did rational acquisitions that made good economic sense, and when they were able to immediately integrate these transactions and recognize the synergies. I think as these emerging acquirors become more widely known and begin to garner more credibility within the institutional investor community, the pace and the activity will return.
BD:
Who else would you include in that group of emerging acquirors?
Fitzgibbon:
BB&T, Bank North Group, Fifth Third…Wells Fargo will also continue to be a very good acquirer. I know it is a superregional bank, but it’s a community bank at heart.
McCandless:
It’s like the old Darwinian theory: those who have capital become the king.
Davis:
Let me give some additional perspective on it. This year we’re on track to do about 150 bank deals, down from almost 200 last year. Total deal value this year is going to be less than $6 billion, down from $30 billion last year. Look at the thrifts, however. Deal value has gone up: $8 billion last year to $12 billion this year. And that level of activity is continuing, which says consolidation is really shifting from banks to thrifts. There’s a lot of MHC [multibank holding company] stuff going on and there are mergers in the thrift industry. But there has been sort of a Mexican standoff, too. The acquirers that you’ve been talking about-their business model is working pretty well. There’s just been better earnings lower down the food chain than there has been at the high end.
Fitzgibbon:
There’s not likely to be a lot of big-bank transactions because the large deals that happened in the late 1990s proved to be poorly structured and poorly executed. Our sense of it is that the larger banks at some point will come back into the market buying the smaller, simpler, more traditional institutions. So that feeds into our thesis that community banks are the place to be right now.
Davis:
Another point is that there has been a fair amount of activity in insurance agencies. Some of the more astute bankers today are starting to look at the down-and-out areas such as asset management and some of the brokerage businesses, areas that have gotten the hell beat out of them. If you aren’t in that business and you want to be, this might be an opportune time to be evaluating those, as opposed to traditional bank-to-bank acquisitions.
Goldberg:
The industry continues to evolve from banking to more focused financial service companies, particularly with the advent of purchase accounting where you don’t have to buy the whole company. You can buy pieces of a company or buy a whole company and sell pieces of it. Fewer restrictions are allowing banks to expand their depth of product offering.
BD:
Is the such a thing as core banking anymore? Or should all banks really looking to become diversified financial companies?
Goldberg:
Over the last couple of years, clearly banks have shed unprofitable businesses, such as auto lending, auto leasing, aircraft leasing, even large corporate lending. A lot of banks have exited the riskier businesses or businesses where you clearly won’t gain the returns on capital required-where it doesn’t make sense to stay in them, particularly on a risk-adjusted basis. What several of these banks have is the distribution networks in place and the customers to sell additional products to. Banks have talked about that for years, but few have been successful in it. You can manufacture some of the products yourself and distribute others. But you have to have those capabilities to keep customers. It’s interesting that every bank now is focusing on “retail banking”-that’s all you hear about-growing deposits, growing home equity loans. The industry follows the herd mentality. The key is to differentiate your product offering and, more important, how you deliver it.
Fitzgibbon:
One other final thought on M&A that’s pretty important. One of the things that’s likely to drive M&A over the next several months is a company’s ability to finance these transactions very cheaply. With the advent of trust-deferred, subdebt, and other kinds of hybrid capital instruments, today you can finance the acquisition much more cheaply than you could have in the past. This essentially raises tier-one capital at a 3%, 4%, or 5% rate after tax versus funding it historically with traditional equity capital, which might end up costing 15%. My sense is that this will help consolidation over the next couple of quarters anyway, at least as long as interest rates remain low.
BD:
If I am a director today, where should my antennae be tuned right now? What do I need to be thinking about one or two quarters down the road?
Goldberg:
You’ve got to keep a close eye on the consumer. That’s what’s carried us over the last several quarters, and the longer it takes for the economy to pick back up, the longer the capital markets stay lean, the more layoffs continue to mount, the more vulnerable the consumer is. If you look at your growth over the last year or so it’s been driven by the consumer side for the most part.
McCandless:
I think related to that is growth. How are you going to get loan growth in a different yield curve environment unless there is improvement in the perception of economic growth and stability in the economy? You are going to have a lot of different deposit flows to support loan growth and so there will be funding issues that you are going to have to deal with when that happens. And you don’t need a monster pickup in the economy for that to happen. You can’t wait for two quarters, you’ve got to be vigilant now. You’ve got to be vigilant at all points of the cycle, every quarter.
Fitzgibbon:
Back to my earlier point, I would be focused on my knitting. Continue to do what you do well, avoid bad business, particularly bad lending, and try to capitalize on the opportunity that exists right now in the marketplace. With capital markets being as volatile as they are, my sense is that many companies that traditionally use capital markets to fund themselves are going to return to bank debt as their primary funding vehicle. If you are positioned to benefit from that, I think it’s a wonderful time.
Davis:
Also, directors should be insisting that managements take the interest rate risk out of the equation. We’ve had a glorious time in the last few years in terms of what’s happened to the rate structure and the cost of funds. As the economy does bounce back, it’s going to be imperative that you are able to grow the fund basis-but just don’t make any rate bets. Keep yourself balanced, because it will affect the cost of capital if you misstep and directors need to think about that as a major obligation.
BD:
One more question to wrap up. Which companies would you nominate as preeminent community banking models?
Goldberg:
I can think of three standout models: Charter One, North Fork, and TCF Financial. All three focus on delivering their customer bases what they want. TCF’s model is centered around de novo expansion and adding new checking accounts. Each quarter it will open six to 10 new branches and add 30,000 new checking accounts. That brings deposit growth and income growth. It is one of four banks in the country with earnings of 13%-plus in each of the last three years. So clearly, that model is working. North Fork also uses a de novo expansion model, but this time it is going into Manhattan looking for the small businesses. It is clearly taking market share from its large competitors. In the case of Charter One, here’s a thrift that’s totally revamped itself into a high-performing retail bank that is leading with the checking product and proven you can cross-sell your mortgage customers. All three of those companies have above-average revenue growth and the ability to grow deposits at an above-average clip, and I think deposits will stick to them better than most banks when the capital markets do come back.
Davis:
I would echo what Jason said about North Fork. I think it is clearly a good example. This company in the second quarter ranked in the top five of all the largest banks in margins, in efficiency, in charter operation, in NPAs, and they got a 26% compound growth in EPS last decade. It has been in the commercial lending business for 20 years and has never had a loss; today it has $3.6 billion in receivables. It is obviously growing in Manhattan-it’s got 19 branches there today-and it is growing deposits. It will go from $1.6 billion last year to $4.1 billion this year and these deposits are going to have a tremendous impact on its margin and profits. We call it the “Manhattan Project,” and I think it’s going to be a real boom.
The other one I would mention just quickly is Commerce Bancshares in New Jersey. It has 30% same-store deposit growth, whereas the industry is growing 5%. If it grows same-store deposits at 15% and its EPS growth is 15%, it is doing twice that. The reason is, it approaches the business by looking at the liability side as well as the asset side. Most businesses try to find loans and then figure out, after the fact, how they are going to fund them. Commerce goes out and grows deposits and then figure out what it is going to do with them. It’s got a 42% loan-to-deposit ratio; a typical bank has 80%. It is a tribute to the culture of that company. You don’t find that often in the industry- it’s very distinct franchise.
Fitzgibbon:
An additional name I would mention is BB&T, which I would argue is the largest community bank in the country at $80 billion dollars. It’s figured out how to do community banking in a superregional company. This is an institution that takes the opposite approach of virtually all of its competitors. Instead of trying to sell lots of products to its customers, it tries to figure out what the customers’ needs are, what’s important to them, and then services that need with its broad arsenal of products. It’s really pushed decision making down into the institutions. It’s retained the management teams of the companies it acquires, and it’s demonstrated an ability to outperform its superregional brethren by consistently announcing earnings growth numbers that are 30% to 40% higher than anybody else in its space. Some other names I would mention that are going to eat Citi’s and Chase’s lunch for the next 5, 10, 15 years are companies like New York Community, Independence Community, and Roslyn Bancorp. These are companies that serve the customers in their own language and provide products that they want. For example, Independence Community Bank, which is headquartered over in Brooklyn, does business in something like 15 different languages. It has personnel that speak up to 25 languages. So it can service the diverse community in which it operates and its product offerings are simple and straightforward, which is what the customers want and demand. All of these companies have generated very strong earnings growth over the last five years and, in my view, will continue to provide outsize returns for shareholders.
McCandless:
Well, there hasn’t been a company mentioned by any of you that KBW doesn’t like for all of those reasons. The banking industry, particularly at the top end, has consolidated dramatically, so that there’s tremendous opportunity throughout the whole country for smaller banks. And there are some clear winners, such as TCF, Midwest, Charter One. Some of the guys on the East Coast are benefiting from Wachovia and BofA, and BB&T is a great name in the southeast; SouthTrust is another great example in the Southeast. There are a lot of growth companies out on the West Coast. But a couple that haven’t been mentioned are in the Southwest, a region that has undergone massive consolidation particularly in Texas. Two of the leading banks are Southwest Bank of Texas and BOK Financial in Oklahoma. Southwest has a stellar long-term track record, a strong balance sheet, and continues to gain market share within the Houston market. BOK Financial is like a miniature Fifth Third-its performance numbers are phenomenal, and it executes well in acquisitions. It is funded with local people, local clients, and it has tremendous organic growth. There are two reasons for this above-average growth in the Texas banks: number one, the economies tend to be stronger, and number two, there’s over consolidation in the Southwest. And the biggest players-J.P. Morgan Chase/Texas Commerce, Wells Fargo, Bank One, BofA-own a big part of the market and every year they lose a little bit of share and those crumbs that fall off the table provide a great growth opportunity for the smaller players. Texas Regional, Sterling Bank, Summit-all are variations on the same thing. In addition to that, all those banks I mentioned in the Southwest are run by extremely seasoned bankers-people who have been through a few rigorous cycles. So, they’re all gaining share, through organic growth, which is somewhat the ultimate measure of success.

Join OUr Community
Bank Director’s annual Bank Services Membership Program combines Bank Director’s extensive online library of director training materials, conferences, our quarterly publication, and access to FinXTech Connect.
Become a Member
Our commitment to those leaders who believe a strong board makes a strong bank never wavers.