What follows is an edited transcript of an Oct. 29 conversation between our roundtable participants and American Banker staff members. The participants were David Ritter, director of financial services research at Argus Research Co.; David A. Hendler, head of U.S. financial services, CreditSights Inc.; and Anthony Polini, senior vice president, financial services, equity research, Raymond James.
Gentlemen, welcome to our latest edition of the American Banker Analysts Roundtable, our quarterly event here. We appreciate you coming in to discuss your outlook for 2010. Quickly, let's please have each person introduce himself, give his title and just say what your general specialties or areas of focus are right now.
RITTER: Sure. My name is David Ritter. I'm with Argus Research. I'm director of financial services research at the firm. I focus primarily on the large-cap banking sector. I also cover the large brokerages and some of the large regional banks.
HENDLER: David Hendler. I'm at CreditSights Inc. We're a global securities research firm specializing in capital structure research, so debt equity, preferreds, derivatives. I'm head of U.S. financial services and coordinate global activities with our office in London that covers European banks and insurance.
Excellent. Thank you. Tony?
POLINI: Anthony Polini. I'm a bank analyst with Raymond James. I follow 30 banks, different market caps, focus in particular on the Northeast and mid-Atlantic. I also follow the Puerto Rico banks and JPMorgan Chase, Bank of America and Wells Fargo.
Excellent. Well, I thought I'd start off with an easy question: Is the financial crisis over?
RITTER: I would say that the crisis is over but the challenges are going to last for quite some time to come. Some of what we heard this quarter and actually last quarter as well from particularly the largest banks is things are still getting worst but not as fast. You know, we saw, even in the case of Bank of America, them starting to take down some of their consumer reserves. We just feel that with unemployment still rising and our outlook for the economy still being weak that the peak in credit losses and in provision is going to be further out than widely believed. So in general, our estimates for earnings for 2010 are below the Street consensus, and largely because of our view of credit quality.
HENDLER: I would say the "systemic phase" of the crisis has been over probably since early first quarter to midyear '09. And now we're in the lagging phases of various credit categories with rising chargeoffs, nonperformers — all of which are receiving headline news and visibility. But our view is that most of your [Supervisory Capital Assessment Program] banks can get through the problems, the top 19 banks and probably a few more can get through the problems on top of that.
There are some banks like Zions and Marshall & Ilsley that are highly sensitive to regional real estate trends, and have raised and may need to raise more outside capital. So they could be resolution situations if trends do not tip their way, which in this environment can easily happen.
For the big banks, the overall trends are moving along more positively. JPMorgan is in the strongest position because it went in with the strongest balance sheet and with the least toxic exposures. But there are problem situations. We have B of A that does not have a head of the company right now. They are kind of the headless horseman of banking. So we need to know what the leadership structure will be, but we still believe that the franchise is very strong and that the company has experienced midlevel to upper-level executives.
When you look at Citigroup, there are still regulatory concerns regarding the expanse of its business activities. It seems that the FDIC still has concerns even though Citi got a good report card from an outside management appraisal company that CEO Vikram Pandit and company are a suitable management team. But there are a lot of issues there regarding a successful strategy, its return to normal profitability and whether there will be added regulatory activities.
Then among the big topics on Capitol Hill, is "too big to fail," that is focused on whether the financial system is better off if we just bust up these big banks anyhow. The politicians are running away with their versions of how to fix things, maybe as part of the political cycle of getting re-elected next fall. But, our view is that there was multiple causation of the crisis and that the politicians need to take responsibility as well.
Then you get to a Wells Fargo, who seems to be pulling rabbits out of the hat the last couple of quarters with nonrepeatable gains. This may mitigate the notion that the Wachovia deal may be more expensive than originally planned and that California is a real estate quicksand pit. It's just not a good state to be in, whether it's the economics of the state, with its budget problems.
Then there is U.S. Bancorp, which seems to play things close to the vest and doesn't want to really do the big merger trades like Wells Fargo did. So they're kind of keeping a mid-to-large-to-midsized orientation versus big-sized. So that might be good for them.
Great. Tony, you want to address the question of is the financial crisis over?
POLINI: I think the financial crisis is over. We've set the stage for a very modest and weak economic recovery in 2010. It'll probably be a period marked by high loan losses, relatively high unemployment levels and a very weak housing market. However, there are some positives. Compared to 2009, loan-loss provision levels will probably be lower and banks will establish positive earnings momentum. Some parts of the country will obviously perform better than others. In particular the Southeast will probably underperform. California will probably underperform, and I think we'll get relative strength from the mid-Atlantic and Northeast.
The key question going forward is what happens to this next recovery. I'm much more concerned about government intervention than I am about the financial crisis. We will have a period marked by low interest rates and a weak economic backdrop, but that also means less competition, higher spreads, wider margins. So for the industry's overall fundamentals, I think we'll start to establish positive momentum, but there will be relative winners and losers.
We'll come back to that. You have anticipated just about every question on the list. That's a good sign.
We tend to talk about when crises begin and end and when recoveries begin or end as sort of a yes-or-no proposition. But could we have a situation where we have things get a little better, say by early next year, but then we have a dip after that?
RITTER: Yeah, I think the real concern is where are the jobs going to come from. I know typically in a recovery jobs are a lagging indicator, but at a point where you're already at 10% and underemployment is as high as the high teens, that's what's weighing on the banks and now weighing on the commercial real estate sector as well.
To Anthony's point, there are just unprecedented government subsidies out there right now, first for the housing market. And it isn't just the tax credit and the fact that mortgage rates are probably artificially low because of quantitative easing.
All the banks are talking about, "Well our delinquency rates and our nonperforming rates have steadied in some of our consumer portfolios, therefore we're taking down reserves." I just find that curious when you're in a situation where in the next sentence you say, "Yeah, but you know what? Our delinquency would have been X% higher if we hadn't had all these foreclosure moratoriums and we hadn't skipped payments and we hadn't done this or done that or reduced interest rates to try to get people to stay in their homes."
So I think there's a lot of inventory that's still off the market and we're just beginning to see the fallout from commercial real estate. If you want to talk about what the next crisis might be, that's one that's still potentially out there. You saw big spikes in delinquency and losses at all the big banks in commercial loan portfolios, and it got offset by what some perceived as better news on the consumer front. That may not last until you start to get meaningful job growth in this economy, and I just don't see what industries that job growth is going to come from.
Would anyone else like to address that?
HENDLER: I agree with a lot of those sentiments. I still think we have a huge housing crisis, and it's really hitting more in the prime sector because of the high unemployment rate. More upper-middle-class and higher-earning households are having problems with servicing their debt loads due to lower pay packages as well as unemployment. Meanwhile, people the last three to five years had to buy into overpriced markets if they wanted to go on with their lives and expand their families. So that was the environment, and if one asks who is primarily responsible for these difficulties it is very tough to decide. Is it those individuals, or is it really the whole financial community as well as the entire community of citizens that did not really practice good home budgeting skills?
We went through a systemic shock last year and we have seen how disruptive it is to the economy. If we really would have the banks solve the problem by taking the remaining prime mortgage losses we could have another systemic shock. We estimate that the remaining losses on prime residential could be another half-a-trillion to a trillion-dollar problem. The prime residential mortgage market consists of regular people that want to work every day, and many have college degrees. But the home price depreciation environment has become catastrophic not only in the known areas of California, Florida, Arizona but also in many metro areas — and it is happening now.
And if we have the banks take all the hits, we're just going to go back to that systemic-shock problem again of counterparties not wanting to trade with counterparties and we once again lock up global system liquidity.
My view is that the prime residential mortgage crisis is probably going to require another massive government assistance program in that range of half a trillion or more. And if this program is extended it will lead to more bank regulatory restrictions with more capital and higher prudential liquidity levels. This would reduce the banks' appetite and ability to take lending risks and put pressure on profitability. So as Anthony said, the regulatory and government responses could — whether we like it or not — really change the profitability of the banking model.
I think equity, which has done well the last seven months, is going to have to readdress that. What is the total return expectation for equities and is that attractive enough to raise external capital? We may have a situation where our U.S. banks are becoming more like European banks, so our banks are more social policy lenders than capitalistic market pricing lenders.
All these regulatory restrictions and all these congressional bills — regarding credit card fees, grace periods, overdraft fees — have restricted banks' ability to execute risk-based pricing in credit cards and other businesses. That was a given capability for banks like Capital One and helped ignite its extraordinary growth over the last 15 years. And with the average American deleveraging by paying down personal debt and finally learning what their grandmother or great-grandmother said, that you've got to save for a rainy day — you can't just credit card your way into prosperity forever.
So we have more than just a banking problem; we have a societal reassessment of fundamental values and spending ways. So, these are some of the major forces that I think really put pressure on bank equities.
Now credit, which I also look at, has been rallying as much, or earlier than, equities did. It could be good for credit instrument investors if there's more government stability. Credit likes stability and sustainability as long as they're not impaired by government programs or assistance. So it could be good for credit but not so good for equities, say, going into the intermediate term.
Tony, do you want to address this?
POLINI: I'm very concerned that the U.S. economy is going to have to face up to the fact that the new normal level of unemployment may be 6 or 7 instead of 3 or 4, and that strong GDP growth may be 2% or 3%. I am very concerned about the economy. I think we'll be in a recovery mode next year but I'm not quite so sure where the job creation is going to come from. Tax reform, health-care reform, executive pay reform — these things do not bode well for job creation.
One could say the administration is taking the U.S. economy down a difficult path and we're going through a phase that most of Europe went through. Socialist reform does have its positives, but it also has its negatives. There's probably going to be a long-term damaging impact on wealth creation in this country, and I'm very concerned that my children will not have the same quality of life that I have.
Well we've established a couple of things. One that you guys are all very shy about opinions and secondly that if our theme here today is the outlook for 2010, one of the things that's reverberating through all of your comments is the impact of public policy next year and government reforms. How that'll affect the business is a very big question for 2010.
RITTER: Absolutely.
POLINI: Certainly.
Let's keep talking about regulation, about on the "too big to fail" front. The main points, can you be too large? Do they need to be this large? And how about in terms of failure, is it about dismantling these things through regulation, or should there be a better mechanism in place to handle these types of failures?
POLINI: "Too big to fail" is an interesting concept. They're also talking about making $10 billion the level that's "too big to fail." We've seen this industry go through phases where Citigroup was the original model where you had one-stop shopping for all financial services. That model has its challenges. The B of A model seems to be working. I think they have risk management under better control and they have an excellent distribution system. I think it's a positive that we have three healthy banks [Bank of America, Wells Fargo and JPMorgan Chase] controlling about one-third of the nation's deposits.
Every time something goes wrong, we like to point blame. Ironically in this crisis, I think the three biggest banks had very little to do with the problems. I think the problems had much more to do with the investment banks and mortgage companies. You literally had people getting paid to appraise properties at greater values than the cash flows could support. I mean you had intermediaries come into the marketplace, find a way to take a $100 million property, turn it into a $500 million credit, package it with credit enhancements and sell it as triple-A paper globally.
Whenever you try to overregulate, you create more problems. If AIG was going to fail, AIG should have failed. If GM was going to fail, GM should have failed. The biggest problems come into play when we try to regulate the failures or to control the process. Capitalism works just fine, but it's an evolutionary process; the strongest survive and the weakest don't. The more we intervene and the more we try to fix this problem, the more damage we're going to do longer-term.
HENDLER: Look, government's very big, so is it "too big to fail"? The regulatory apparatus is huge. Has it failed? I mean the market is always going to be greedy, but the other stakeholders have to do their jobs and I feel that over the last 25 years that the regulatory apparatus took their eyes off the ball, got distracted and overrelied on the market to self-regulate. Sure, there could have been some political pressures to lay off the industry and not restrain growth, because the economy was good, so why push back on lending, especially in commercial real estate areas. A lot of Wall Street was paying a lot of lobby money to people controlling the growth programs for housing and the GSE capabilities. The political system initially went one way and now they're talking the opposite way about the Holy Grail of preventing catastrophes again. So, there's a lot of responsibility to go round for the credit crisis.
The positive attributes of the big banks are better value-added products distributed nationally in the least-cost-method distribution, which are in the branches right now. A lot of community banks cannot compete on these products and what has happened to them is those banks have loaded up on commercial real estate. Really if you look at the numbers of banks that are going to fail, it's going to be the small banks between $100 million in assets and $1 billion. So they are very small individually in size, but collectively they are very big in numbers. They are in a lot of congressional districts and they're going to fail. And the FDIC doesn't have enough money to take care of it, and even though they say the Treasury could lob in a half a trillion, that's a political football to get that money. Maybe get the first fifth overnight, OK, but there are going to be a lot of questions.
So you have to beef up the regulatory process to get more street smart. You're starting to see that a little by hiring people from the Street who were got let go or want to do their duty and help out the government. And we have to somehow depoliticize this problem. I think the industry is starting to get its moxie back and will talk in public their position that what Capitol Hill wants to do, the Obama administration wants to do, is not generally good for economic growth in this country or globally. There's got to be some compromises. There were mistakes made all around. It's a group problem. To say that the taxpayer should not have to pay for things — look, the taxpayer was engorging on debt from home equity and credit card for 10 years. They, too, were part of the problem. And they're going to be part of the solution one way or another.
We would like to see more of a joint public-private partnership with regulation and regulators, because regulators usually are reactive. There's too much consumer debt leverage over the last 20 years. The price is going to have to be paid.
So that has to be addressed, trying to get the private sector to help the public sector regulate, by having discussions and debates about risks, the pros and the cons of risk, not just the pros of the returns until the cons set in and then woe is me, who do we blame. We've had a massive blame game, and it's not healthy for the economy in the intermediate and the long run.
Dave Ritter, is there anything you want to address on that?
RITTER: I'd certainly echo a lot of what Anthony and David said. What I'd add to that, though, is it's really shocking to me with all this talk about regulating or re-regulating the financial industry that you haven't heard the subject of Fannie Mae and Freddie Mac really come up at all. You know, these are still multitrillion-dollar obligations that are ultimately borne by the U.S. taxpayer.
Then aside from that you've had this massive explosion now of FHA loans. It's being done to prop up the housing market and the broader economy, for sure, but many of the same practices that got us into this mess in the first place are being done again now by the FHA with low-down-payment loans and relatively easy approvals.
As far as the big banks are concerned, when you look back at the whole situation now, well look, take JPMorgan Chase. It's every bit as big as Citigroup yet it sidestepped most of the big problems and ultimately didn't really need the Tarp capital to begin with, whereas Citigroup was a mess. So it really comes down to the individual risk management and management of the company. That's a very good management team at JPMorgan Chase that has been together for many, many years and as a result they were able to steer the company through the crisis. So I think it really is a case-by-case situation.
I would like to see a lot more talk about how do we ultimately get the mortgage market back in private hands. That's ultimately what's going to bring it back.
If I could, could I ask you a follow-up question to that, Dave Ritter. You talked about risk management. What do you think will be the nature of risk management and do you see any big changes in 2010 among banks?
RITTER: I mean I think it's going to be a gradual shift, but I think you're already seeing that the banks who went into this in a stronger position like JPMorgan Chase, like U.S. Bancorp, they're well capitalized now, certainly much better than they were. So they're making selective acquisitions, if not of entire banks then of different businesses so they're looking to selectively grow again. The better companies aren't still sitting on their hands, but there will — there obviously will be a big increase in the focus on it and the staffing that's devoted to it.
HENDLER: What's been really interesting to me is we went through the tech wreck and Enron/WorldCom stock market correction. One of the outcomes of the early 2000s was the Sarbanes-Oxley Act and it has not really been implemented. CEO/CFOs have been signing off on these statements for five or six years. Where is the SEC in this equation? The SEC seems to be getting another life of its own in discussions of what regulators will be part of maybe a consortium of regulators to figure out systemic risk.
If you look at the SEC, who was the primary supervisor for the investment banks for Basel II purposes, they were totally unequipped to deal with that. Nonetheless they were the primary regulatory of capital regulation. And whether it's Madoff or some other hedge fund or money management situations where they could have had early warning about problems, they were not equipped to discuss it and analyze it properly. Now they have a great tool at their disposal, and they are not even using it.
So I think that tool has to be used. I do not know if another regulatory body can use it besides them or they have to wake up and not be so cozy with the industry. Because if you make CEOs and CFOs aware that material departures of actual from expected performance will be their responsibility and they could have civil or criminal repercussions, triple damages possibly in penalties, maybe they are going to be more willing to listen to risk management.
Because if you talk to risk management — when the good times were rolling, the companies dialed down their concerns, because it's all about hitting short-term expectations for the stock, for the EPS, for the option package while that CEO and his board and administration is in place.
Well, these guys have to be held responsible for looking the other way while there was some ridiculous product manufacturing going on. There has to be more responsibility for this.
Tony, is there anything else you wanted to say on that subject, on that question?
POLINI: As for risk management, everyone sharpens risk management tools during the recession. All bankers get a nice, healthy dose of religion. The key question is how long does it last. I think the one thing we can say for sure is that the first year of economic recovery will be slow. It will be more difficult to get credit. There will be risk premiums built into loan pricing.
How long does that last? We really don't get tested until we have a period of widespread economic expansion. Usually it's product-related. This cycle happened to be home equity and pick-a-pay mortgages. The problems may differ, but they're similar at the root. Greed overcomes common sense at some point in the cycle.
Where does it start? Does it start with Washington Mutual firing their own appraisers for not appraising out their own loans? Where do we start this crazy process? I mean some loans that were made in the last year of recovery were probably bad at the get-go. On the flip side, 2009 and 2010 are probably going to be fantastic years for loans, the best vintage in decades.
Credits, that'll be relatively safe.
POLINI: Exactly, properly underwritten, low loss severity. But we'll have to see if the lessons learned this cycle last longer than previous cycles. I think a lot of that depends on what's at the heart of the math: what are the longer-term damaging impacts on the U.S. economy?
Just to switch from the big banks to the regional players, I wonder what your expectations are for the larger regionals? It just seems that there's sort of this perennial list that's out there and just years and years and years old of the ones that are going to get swallowed up or have to merge or can't survive. And yet with the exception of a very small handful like Nat City that got swallowed up by PNC, the other big regionals, Key and Fifth Third and so on, remain. Can they continue to remain independent? Is some sort of a merger or a tie-in inevitable? Can they find a niche somewhere in the middle between the community banks and the really big boys?
RITTER: I cover a relatively select group of the large ones, U.S. Bancorp and SunTrust, but I'll speak to the bigger issue. David had mentioned at the top, I think for the SCAP banks that went through the big recapitalization earlier this year, that significantly strengthened the companies. But they're less geared toward consumer and really loaded up with commercial real estate. In the case of a SunTrust, where you saw bad loans and losses accelerate from the second to the third quarter, you certainly see the impact of rising commercial loan losses and economic problems in the Southeast region.
There certainly has to be a lot more consolidation in the Midwest region. That's where you have a lot of your weaker credits and a very weak economy. I'm expecting losses and reserve-building at the big regionals to continue.
Into next year?
RITTER: Certainly. I think they're going to continue to build reserves. They actually have been slowing down some of their reserve build, in consumer portfolios for example, and I think that's going to be problematic going forward as well.
So it slowed down but you're saying that pace won't necessarily continue? They could be forced to ratchet it back up?
RITTER: I think so. I think so.
Anyone else want to address that question?
HENDLER: What was the question again, consolidation of regionals?
Well, just can these regional guys continue to stand on their own? Maybe they very well can.
HENDLER: Your sizable regionals, many of them are in the auto-supplier-chain region, have very difficult environments to deal with because just as we were saying in general regarding the economy, where are the jobs going to come from? For the autoworkers and supply-chain types, will future jobs be created be in those regions or will they be down South where there are no unions? So it's hard to figure out where the asset opportunity will be for those Ohio banks and Comerica. We know they have liquidity, so I think eventually they will be absorbed, because they do not have many asset opportunities. That is what happened in Texas for a period, in New England for a period. Whether a JPMorgan Chase or a Wells Fargo or PNC or BB&T wants to do it now or later, I think it's probably more later when there's more certainty of where CRE is going, as well as their own exposures. BB&T has a lot of CRE, although it's been performing better. How long, we'll see. PNC has a decent amount. Wells Fargo has a gargantuan amount of residential real estate, so they have got to work through that before they are going to be putting multiples on some of these banks. And they are just going to muddle along for now. They raised enough capital we think for a severe stress, even more than SCAP looked at, or maybe, 12%-type unemployment for a sustainable amount of time, which in their states is pretty much what they're experiencing.
Then you have other regionals that are scattered around like Zions, M&I, where they really went out of their region for growth and it's really led to major credit problems. They trade really cheap in the cash debt markets and they have been — some of them have been doing really well I guess in equities because they're such low priced stocks and they bounce around. But it's really a function of what does the FDIC want to do. Which banks do they want to prioritize in resolutions?
We're estimating 600 to 1,200 banks are going to be resolved in the next two years. It's like one a day starting next year. The regulators are just sort of getting to the staff levels and training them enough to do one a day. Those banks could help some larger regional banks muddle along because they'll get the liquidity, some of the good loans and the FDIC might take the bad loans in a loss-sharing agreement.
We've seen that with Zions, with U.S. Bancorp, where the regulators approve deals with smaller community banks that boost the bigger bank's liquidity. So it's really a function of FDIC recapitalizing, reloading and then deciding, OK maybe I've got to focus on the CRE problem, which is mostly in those types of banks: $100 million-to-$1 billion-asset-sized banks with CRE exposures ranging from 40% to 60% of the total loans.
Some of the vulnerable community banks can be compared to "builder banks." Some of these banks have ownership concentrations by local, well-to-do builders and this way they can get the bank to fund their projects. Does that really serve a great purpose for America? Is that any better than "too big to fail" with the big banks? Maybe not. Maybe they egged on the local growth more than it should have in their regions. These builders always spend loan proceeds while they have it, even when the markets are overbuilt or slowing. There are a lot of banks like that.
Tony, you want to address the regionals question?
POLINI: I think the government has pretty much decided who survives and who doesn't. Why didn't National City survive like Key and Fifth Third?
Do you have their list?
POLINI: The list is out there. It's out there. AIG lives, GMAC lives, Colonial dies, National City dies. Why those decisions were made and exactly how they came to those conclusions is difficult to figure out especially in the case of AIG and Citi. To a large extent, regulators were looking at global systemic risk as well. I don't see why National City was any worse off than Key and Fifth Third. It wasn't that obvious to me, but it sure helped PNC. Going forward, there should be more stability.
Stability in what sense?
POLINI: The larger regionals will survive, at least over the near term. They may not thrive, but we really won't know the full shakeout until the Tarp program is behind us. I'm somewhat concerned about B of A's inability to pay back Tarp after raising more than $40 billion and potentially bringing the "too big to fail" asset size down to the $10 billion level so that we can impose a tax on almost every large bank in the country, whether they are really "too big to fail" or not.
However, I think 2010 is going to be a relatively stable year. We think a few hundred small bank failures is normal. That would certainly be in line with what we experienced in '90-'91. This cycle, 2011, will be the critical year, assuming that most banks, especially most of these larger regionals that we're talking about, have the ability to pay back Tarp. Until we get the government out of the picture it's going to be difficult to change the playing field much from here.
Tony, just to clarify, you're thinking some of these regionals don't actually repay Tarp until 2011 or by then they'll have repaid it and we'll know how they're doing? I mean do you think that'll happen in 2010 or 2011 that they'll actually repay?
POLINI: Obviously Wells and Bank of America would like to repay Tarp by the end of the year.
I doubt Fifth Third and Key will be in a position to pay back Tarp by the end of the year. But, if the economy does improve, if provisioning levels do come down despite the fact that we have a high unemployment rate, etc., I think most companies will be in a position to pay back Tarp by the end of 2010.
And 2011 you're saying will be important because you'll see by then how they fared since they got out of it?
POLINI: And then we'll see what the bigger picture is, where the destinies lie.
One of you mentioned earlier about overdraft fees and Regulation E. We know that regulators are looking at overdraft fees. What else might they look to tighten up on and what is the impact on the banking industry? Somebody want to start? Dave Ritter?
RITTER: Sure. I think a lot of the big banks tried to get ahead of overdraft fee legislation by changing the way they go about charging those fees. You obviously have the same situation happening in the credit card business where a lot of the big credit card companies repriced accounts ahead of the changes that were going to happen there next year.
The other big issue for the big banks is going to be: How do we end up with trading of over-the-counter derivatives? Is that going to end up being traded on an exchange? I know a lot of the big banks are arguing against that. They're in favor of it going through clearing houses. That's a huge source of revenue for the top banks and investment banks, so that's an area that I've got my eye on as well.
HENDLER: You have in one of the bills the consumer advocacy agency. You're going to see more consumer rights, suggestions and interference if this gets passed, which it looks like it will, and edging towards more social policy lending. You know, banks might have to be mandated to provide a basic banking package to lower-income-to-mid-income people, which is low fees, if any, low rates. You know, basically they'll get what a 750-FICO-score person is getting but maybe not as much of a credit limit.
That might have a big impact on the traditional retail, branch bank systems. Why should banks be providing all these access points to people that they do not really make much money off of? It does get some liquidity but it may cost too much. So, possibly online deposit gathering is more profitable with select branch positioning in high-density strategic MSAs, with wealthier clientele, that do more transaction volume.
In our recent CreditSights conference, where I spoke about the future of banking, possibly banks like Citi that look down and out now, could turn around in that type of environment faster. So they'll be in a better position to rebuild a profitable model than possibly Bank of America with all its branches and similarly JPMorgan Chase and Wells Fargo. Those banks that seem better positioned with national branch deposit systems could have a good deal of obsolete physical plant that doesn't have enough same-store sales.
If someone goes into most branches, there's nothing going on except people depositing checks and asking for cash and coin, not very profitable endeavors in and of themselves. And if you superimpose the demographic trends — where the baby boomers are pretty online banking-savvy and still have a lot of spending power, and their progeny, the iPod generation, never go into a bank, never read newspapers, is all online all the time — you've got to question why do we have all these branches. Why does Fidelity have three branches in Manhattan and JPMorgan have 160-plus? Some of it's because they picked up Wamu and some legacy banks, but Fidelity Investments is doing really well, doing high-margin transactions — or higher-margin — than maybe what's going on in the branch.
So that could be the three to five-year problem challenge for some of these national branch system banks. What looks like the winning strategy now could be the Achilles' heel later. That could be the future shock.
RITTER: If I could just add a point to that. The interesting thing about that is that the whole subprime branch-oriented business, if you look at HSBC, which bought Household, which had bought Beneficial, and then Citi — there's a real credit crisis for the unbanked or subprime population because those businesses are either being completely shuttered or being sharply scaled back. There's really no credit.
I think you're right; there is a big need there and either a bank is going to step in to do it or like you said, maybe there'll be a larger government program. That's all.
HENDLER: We may have a U.S. version of the postal bank. I mean the post office doesn't do anything anymore anyhow except mail out junk mail and catalog. They need something to do. So if there's going to be social policy lending, let basic package customers line up at the post office and get their services. The government might want to outsource the actual capabilities to the private sector, and let whatever bank wants to bid on that contract.
RITTER: It's really how student lending works already and has forever really.
Do you see Citigroup being survivors in the form that they are now less the businesses that they plan to get rid of through Citi Holdings, or is the government actually getting more aggressive about breaking them up in some shape or form?
On that same topic, if Vikram Pandit came out tomorrow and said the opposite of what he said on March 9, would the reaction in the market be as dramatically down as it's been dramatically up?
When he came out on March 9 and he said, "We're actually going to make money," and the market just took off, the broad market took off. I mean he started it that day. And now let's say he came out and he said, "You know what? We're done. We're gone." Will it still have the same sweeping effect across the financial markets as it did on the way up?
RITTER: He was talking about the first-quarter earnings. Well. I think we found out that there are ways to make a net profit and when it actually came out and you had a chance to pick it apart you realized what that was worth.
As far as Citi is concerned, I think the bigger point is gradually all the big banks are getting smaller. I mean their loan portfolios are shrinking from a combination of a necessary paydown in credit — you know consumers are trying to deleverage, companies are deleveraging. They're gradually shrinking as they try to sell off assets. We still have a negative rating on the stock, a sell rating on the stock and it's really a concern about they haven't come up with a bigger strategy and a management team and a way to prove that they have a good franchise on a go-forward basis. I mean if you compare them just in terms of their credit quality, their growth, any number of variables against the other bigger banks, they're still lagging behind. You really want to see better management — better management team in there. There's too much still in runoff and just very bad credit.
Tony, would you like to address that?
POLINI: I think that its business model proved to be difficult to manage. We are talking about JPMorgan and Bank of America being kind of the one-stop financial services platforms, but actually the global risk for JPMorgan and Bank of America is much more controlled than it was for Citi.
By global you mean full-service —
POLINI: Yes.
OK, global in that sense, too.
POLINI: Also, in the sense that they're actually physically in more countries than the other U.S. banks. B of A has a limited equity interest in China and Mexico and Brazil, but Citi has deeper international roots. It may still make sense to break up Citi going forward.
Is that because it makes more strategic sense to you that way or because of some sort of systemic concerns?
POLINI: I actually think you garner more value and it would be easier to manage risk. The parts should be worth more than the whole.
What are your two or three parts?
POLINI: For starters, you could have a traditional U.S.-based bank, a global international bank and a global retail bank.
Do you think that's something that could actually happen and do you think it could happen soon?
POLINI: I assume at this point that if Citi is profitable going forward that they're probably going to keep the company intact.
So your advice won't be heeded, is that what you're saying?
POLINI: After all this government intervention, it may prove to be a moot point.
But aside from the skirmish between Sheila Bair at the FDIC and Vikram Pandit and Ned Kelly at Citi, there really hasn't been much government intervention in terms of the management of these companies. There was no corollary to Rick Wagoner getting tossed out at GM. Is that a good thing or a bad thing? What's your assessment of management in this industry, particularly at the bigger names?
HENDLER: I think there's been a soap opera going on among many banks. You know the biggest ones have been Citi and Bank of America. I think the mob mentality in the media as well as the political sphere and the regulatory sphere might be satisfied by what happened to Ken Lewis. I know Ken Lewis has his supporters and detractors in the analytical world, but to me he was overly criticized for things that were maybe wrong but minor wrongs and could have been ironed out but it got politicized by the state attorney in New York, Capitol Hill's questioning of him.
Look, B of A's branches are in almost every congressional district of America, more than any other bank. They're an easy political target. They went after him and he probably got tired of it and let the powers that be and the board decide where it's going.
So I think in a way that's brought some relief to Citi's CEO Vikram Pandit, because the political focus has been satisfied to a large extent.
Is Pandit the perfect turnaround CEO for Citi? He does know the capital markets business. That's basically how corporate lending gets done. It's been disintermediated over the last 30 years anyhow. Maybe at one time we even believed there was more value in a breakup, like $55, $65 a share, but those days are long gone.
I think now you look at what's going on with Citi, their divestment portfolio is going to pay off their TLGP debt. I'm a fixed-income guy by origins. They were one of the two to three top issuers in the world for 30 years. For them not to issue tells you a lot about where the world has changed. There's not as much debt need for the banks, because there are not as many nonbanking businesses as there were. Like Dave said, consumer and commercial finance is dead. That had been a big user of debt, so there will be less issuance in the future.
So these banks are re-equitizing quickly. As they let the runoff pay off the debt, hopefully they run the operations somewhat better.
On the consumer side, they've neglected investing in credit cards and better systems for many years. That's still a tough rubric to crack. The new managers they brought over recently such as Eugene McQuade, may be able to get it done. But it is still a tough task to turn around this huge financial entity.
Then the international side, that could still be the valuable option in the whole equation and that's what Pandit pounds the table on. In the future world we're going to have Chinese banks and Indian banks and maybe other Asians calling more of the shots in global banking, so why not have an American bank have somewhat of that complexion? Not to say that B of A may not be able to get more involved, or JPMorgan Chase. I think Morgan CEO Jamie Dimon would love to buy Citi's international consumer bank platform if it was available and priced well.
I think we've been through different phases of the Citigroup saga and I think Pandit should be given more time to execute on his plan. We think he can do it, but it's not going to be a quick return to profitability. It's more of an intermediate-term, J-curve improvement with a big dip in the J still. Maybe we're at the bottom of the J and it's slowly recovering.
While we're on the topic of management: A the financial problems start to abate, maybe if things get better next year, do you think we'll see some of the current CEOs decide to retire and move on and they'll be replaced by new people? One, I wondered if you think that's going to happen a lot next year, and two, are their replacements ready to go? Is there good bench strength at these companies?
RITTER: I think back to the "too big to fail"/"too big to succeed" issue, I think for the largest banks what the boards are discovering is it's very difficult to find someone who has the skills to even begin to manage the complex organizations that you have. I'm talking specifically about B of A. I would have expected them to have selected somebody or be close to selecting someone by now but that — it's true even of some of your larger regional banks.
But the better-run companies, again I'd go back to JPMorgan Chase, U.S. Bancorp, I just think they have a very solid stable team that's been together for a long time and so they're grooming the second-level people to take the reins, whereas you've seen unbelievable turnover obviously at Citi and B of A and others. So they're having to go outside to recruit talent, and it's hard to find the right people.
So I think a big question looking out is do you have some senior people at JPMorgan Chase like a Charlie Scharf end up as CEO of one of these other big companies, or do they elect to stay at JPMorgan? Certainly Dimon has a long way to go before he retires from all indications, so they may just decide, you know, "I like it here and I like our group and I'll stay and I'll wait." Clearly in the case of [Bill] Winters that was — he decided he couldn't wait, so I expect he'll turn up somewhere else as well.
Tony, what about even at some of the smaller companies that you follow up and down the seaboard? Do you think that management — is there a fatigue issue?
POLINI: Certainly. Once we get closer a real recovery period it bodes very well for M&A activity 12 to 15 months from now. I think bankers are tired. I don't necessarily think they're distraught or crippled by the financial crisis, but I think the regulatory environment is increasingly more burdensome. It may be difficult to actually make a decent salary at certain professional levels. A CFO at Bank of America might be able to take a much lower position at Credit Suisse and make five times as much money as opposed to being one of the top guys at B of A.
I think the industry is going to consolidate. However, the tradition with bankers is that in the bad times they don't want to sell because it's the bad times, and if it's the good times, "Why do we need to sell?" But, I actually think there's going to be a lot more consolidation than people think, once the real recovery starts.
There's a bunch of companies, even in the relatively strong Northeast/mid-Atlantic area that are above-average takeover candidates. In many cases, even if you have a young CEO, the average age of the board is usually north of 70. We are probably 12-15 months away from a healthy round of acquisitions.
HENDLER: B of A has to find a CEO soon to restart their momentum. It could be a more temporary and transitional CEO, say ex-CFO Jim Hance, who was a key strategic adviser to ex-CEO Hugh McColl. They could woo some younger-type person from a JPMorgan or a Wells Fargo, maybe even a Goldman Sachs. Goldman Sachs seems to have a high inventory of talented people.
In terms of our M&A math of pairings, SunTrust is really high up on the affordability radar. A lot of times people say it's a nice strategic fit for a JPMorgan Chase or a U.S. Bancorp, but the pricing historically rarely made sense for the buyer. According to our models the pricing makes a lot of sense now.
Capital One, I mean CEO Rich Fairbank — I think he is in his early to mid-60s, so he may be interested in moving on and doing something and having a coup de grace, very attractive deal done for his personal PA.
We have a thrivers, survivors and shrinkers table. We believe that the survivors don't have independent mandates for lengthy amounts of time. I think that's going to drive dealmaking. That's a lot of your Ohio banks, Comerica, SunTrust.
Even Morgan Stanley I would say is a survivor, but we don't know if they're going to stay independent. American Express is another survivor that may not have enough of a broad mandate.
Even State Street, although they have announced a succession plan, and we'll see how well it's received. They had a lot of problems this last couple of years with capital, as they were undercapitalized given their off-balance-sheet vehicles. That was a way to satisfy equity desires for EPS growth rate of 15-20%. Now that they can't do that, what's the next growth driver? It's going to be really hard just processing back-office payments for the mutual fund industry and others.
If each of you could just take one minute and sort of sum up, if you had to boil down your outlook for next year, why don't we close and I'll take whoever wants to start.
HENDLER: For equities, we're overweight Citi. We have a price target of $5.50.
We are still overweight, JPMorgan Chase. We are overweight B of A, but we may tend towards market weight as we see who the next CEO is — what his vision is or her vision is. We are overweight the two big brokers, Goldman Sachs and Morgan Stanley.
For credit, we're overweight big banks, regional banks for spreads, in cash and credit-default swaps. The only ones we're kind of underweight are Zions, M&I, just too much risk and uncertainty of getting intervened and debt stranded.
We're market weight Citi spreads right now. What's happened in the spread markets has been a huge rally since midsummer and then again since earnings last week, to the point where it's way ahead of the story. Part of it is the long natural investor money diving into a sector that they wouldn't buy at 600 bp over, but they're loving it through 200 over. It's typical conservative investor behavior, waiting for such a consensus move that they have to be part of the party and put the names on.
Tony?
POLINI: I'm very bullish on the sector, probably as bullish as I've been in 20 years. Even though the economic backdrop is not exciting, I think there's going to be much lower loan-loss provisions next year and by the end of 2010 we should have some reserve recapture. It'll be a healthy competitive environment marked by wider spreads, higher margins, and rational competition. Even though the economic pie might be smaller, I think we're going to be see a bigger piece of that smaller pie on the balance sheets of U.S. banks.
The top picks that we have right now include New York Community. It's probably the best midcap bank out there, a 9% yield and the lowest PE in the industry right now, still a double-digit grower.
Then we have our triple play. We think if you buy equal dollar amounts of JPMorgan, Bank of America and Wells Fargo that you'll double your money in two years. And if we're wrong it'll take three.
If you're wrong, what?
POLINI: It will take three years, not two.
Now we'll go to Dave Ritter.
RITTER: Great. I don't have anything to compete with the triple play, so I'll keep it simpler.
We actually went to an underweight on financial services last month. We had been much more bullish. You know, my "buy" ratings are very selective. I have a "buy" rating right now on Morgan Stanley. That's one I like certainly relative to Goldman. Still very bearish on the large-cap banks.
You know sell rating on Wells Fargo. That one I'm probably most concerned about, especially because of the valuation and I think continuing problems with Wachovia's portfolio and integration, among other things. Also very large commercial real estate portfolio, which really showed some signs of deteriorating. So that's probably what I'd say my top "sell"-rated idea would be, but again still very cautious going into next year.
Gentlemen, we thank you. That was great. We thank you very much. We thank you very, very much for your time in particular.
