Credit quality and interest rate cuts were the topics of discussion at American Banker's quarterly roundtable conducted on January 9. Analysts were uniformly cautious about the outlook for this year, expecting continued deterioration in bank loan portfolios. Credit-troubled banks like First Union Corp., Bank of America Corp., and Bank One Corp. are the stocks to avoid, analysts said, while Citigroup Inc. is the one to watch. Participants were Frank Barkocy of Keefe Managers, Michael Plodwick of UBS Warburg Securities, Andrew Collins of ING Barings, and Katrina Blecher of Sandler O'Neill & Partners.
We have just wrapped up a pretty tumultuous year, a year in which financial stocks were viewed as being out of favor. But the American Banker index of the 225 largest banks was up 35% year on year, while the Standard & Poor's 500 index and the Dow Jones industrial average were both down. Why is the perception different from the reality?
FRANK BARKOCY: 2000 was a really good year performance-wise if you invested relatively conservatively. In our judgment there were some really solid opportunities within the framework of the group, such as processing banks, selected superregionals, brokers, money centers - particularly Citigroup - and thrifts late in the year. There were obviously situations we avoided because of asset quality deterioration.
For the most part, earnings held up reasonably well, despite margin pressures, on relatively strong loan demand. Fee income was solid, and efficiency ratios improved. Moreover, with weakness in tech stocks, a number of investors returned to the safe haven of financial companies.
ANDREW COLLINS: The outperformance of the banks over the last year relative to the broader market has been due to a couple of technical phenomena: The switch out of the Nasdaq, and the switch in bias by the Fed. You saw several rate hikes through last June. Since then we've seen the bias clearly shift, and everyone is anticipating an improving rate environment for banks.
Of course, on the flip side of that you'll see credit quality concerns throughout the year.
MICHAEL PLODWICK: A lot of that outperformance actually came late in the year, two-thirds of it really came in the last month of the year. I think that was because [Fed chairman Alan] Greenspan made some comments that he was probably going to enter a neutral or easing bias, and this group is viewed as rate-sensitive.
But if you look at the components of stock price performance throughout the course of the year, the underlying theme was avoidance of credit risk, and the two types of banks that performed the best were, ironically, the thrift-like banks, and also the banks that had a high component of fee income. What do both of those things have in common? They were perceived as having less credit risk than some of the superregionals and money center banks.
KATRINA BLECHER: I actually turned positive on the group in May. What I believe is that the primary factor last year was interest rates. Clearly bank stocks tend to advance about two to three-quarters ahead of interest rate moves.
Then, of course, you had the rotation. Investors went back to the old-economy stocks. These actually had earnings, and consistent earnings is what banks are known for.
Lastly was the group's attractiveness relative to historical multiples compared to the S&P. For example, the group got to a 55% discount to the S&P, historically it's had a 35% discount. Now it's under a 20% discount, so you can see the phenomenal move in the group.
Some of the move was due to how well banks did, but I would say the lion's share was a result of how weak other aspects did, such as the Nasdaq.
Credit quality obviously continued to be an issue in the fourth quarter. Did some companies wait too long to address the credit quality issues? Should all of these issues have come out in the third quarter?
COLLINS: We downgraded Bank of America because we saw them as not providing adequately for future loan losses. Ironically, they wound up beating the Street in the third quarter. They came in at a $1.31, versus the Street at $1.29. A lot of it was due to what we perceived to be a lack of adequate provisioning.
It is going to still be a very difficult environment. We could see further weakness out of that organization throughout the year, and it's one that we're a little bit more cautious on at this point in time.
PLODWICK: I think that we're still fairly early in the credit cycle. Nonperforming assets hit their all-time low as a percentage of total loans at yearend last year. That figure was actually 0.58% for our universe. At the end of the fourth quarter, they were up, but still only 0.69%. So yes, we saw some deterioration, but just to put that in some perspective, the 20-year average is 1.89%.
In the last recession, we peaked at 3.5%. So clearly we're seeing some deterioration. But we are well below even historical norms. You can almost triple here just to get to historical norms. I think there is still a lot of room for credit quality to deteriorate.
BLECHER: It started with the larger syndicated loans. I think that was predominantly the result of the underwriting standards that loosened prior to 1999, as banks' desire to grow loans resulted in risk-based pricing that was below what we would like to have seen.
Consumers are the $64,000 question. Is the economy going to weaken enough that they're going to pull back on their borrowings? That would be a major negative. However, I have a fairly high degree of confidence that that will not happen.
BARKOCY: I think a lot will hinge on the economic scenario; whether we have a soft landing, or a rough or hard landing will determine the magnitude of these asset quality problems easing or intensifying over coming quarters.
Aggressive rate relief on the part of the Fed, however, would obviously be a major positive for financial institutions both fundamentally and price-wise, in that it would serve to moderate risk and result in expanding net interest margin for many companies in this sector.
COLLINS: I agree. With the real GDP coming in about 3.7% in 2000 and an estimated 1.9% in 2001, we don't expect there to be a complete commercial crisis. Nevertheless, we do anticipate that commercial nonperforming assets will be going up.
Now, whether that impacts EPS growth, I still think that we'll still see some fairly decent double-digit EPS growth out of a lot of the more well-run franchises.
What about another Fed rate-easing? Can everyone else talk about what they see and within what time frame?
COLLINS: We're looking about 75 to 100 for the remainder of the year. Our economist believes that the Fed in some ways missed the boat. Now they're going to have to play catch up and do it very quickly.
PLODWICK: The UBS Warburg economist is looking for an additional 100 basis points in decreases over the year.
BLECHER: I'm looking for an additional 100 basis points
BARKOCY: I believe the consensus numbers suggest about 100 basis points more, with perhaps 50 by the end of the first quarter, and maybe another 50 over the following two quarters.
Another trend in the fourth quarter was the continuous slowdown in the capital markets business. How does that affect the money centers and some of the big superregionals?
COLLINS: We witnessed a 16% decline in earnings in the multinationals for the fourth quarter, a lot of that being due to an 18% decline in total trading revenues on a linked-quarter basis, with a 4% decline in investment banking, and a big zero for private equity. It was a difficult quarter for the capital markets players in banking, and it becomes even more trying for the superregionals that have only recently made forays into capital markets over the last two or three years. They are not the bulge bracket players and they are not in the top tier.
We don't expect capital markets to be rebounding dramatically anytime soon. I think it's going to take probably the first half of the year before things look a little bit more healthy.
BARKOCY: This was indeed a consideration in the fourth quarter of 2000 and will likely impact results in 2001 as well, particularly early in the year. For the most part, the pressure on capital markets activities is already in the estimates.
PLODWICK: If you look at the stocks that did best on the day that Greenspan cut rates 50 basis points, they were the brokerage stocks. Greenspan said he wanted to ensure liquidity in the market because people were getting very concerned that certain subsegments of the capital markets were effectively getting shut down.
BLECHER: A lot of slowdown in capital market activity is already baked into the numbers.
Does that change the thinking on the J.P. Morgan/Chase combination? Looking back to the third-quarter roundtable, the markets were still lukewarm about the deal. Now that the fourth quarter has gone by and we have an earnings warning from them, what is the thinking on that combination?
COLLINS: I think there are some revenue synergies that can be gained from that transaction, but I think that now, as the market has turned down so dramatically in the fourth quarter, the opportunity really becomes cost savings. They've talked about 5,000 job cuts between the two combined organizations. I think it can be upward of 7,000-10,000 jobs that are eliminated over the next year or two years unless we see a bounce-back in the markets.
I also think that they will build out their capital markets presence. We upgraded the stock right after Greenspan made his speech on Dec. 5, at $41 a share. As it approaches $50, we're a little bit less bullish on the name, but our 12-month price target is $65.
PLODWICK: Our preference in the large-cap, money center-type bank groups has always been Citi just because of the earnings diversity, and the geographic diversity. Clearly, the new J.P. Morgan Chase is heavily skewed toward the capital markets. In our opinion the J.P. Morgan/Chase combination will never get the multiple of Citi.
BARKOCY: Citigroup would be our choice given the balance and diversity and quality of its earnings mix. At the same time, I'm willing to wait on the J.P. Morgan/Chase, recognizing that its capital markets area could indeed be weak for several quarters. As Andy suggested, there are meaningful cost benefits that will have a positive influence on Morgan's 2001 results as well as strengths in their more traditional banking business.
Will consolidation pick up in 2001? Will we see other deals in the magnitude of Chase/JP Morgan, or do you think it will go to the regional level?
PLODWICK: I think that at least the first part of 2001 will be fairly muted from an M&A perspective in the industry. First of all is the uncertainty regarding the economy. You're relatively unsure of what's in your own portfolio, and you're unlikely to go out and pay a premium for somebody else's portfolio. All the due diligence on earth can't tell for sure what's in there.
A fair amount of the banks that are likely to do acquisitions have done them already. Northern Trust is unlikely, even though they have a 32 P/E, to go out and buy AmSouth. It just isn't going to happen. Ditto for State Street, Finova, Bank of New York, Mellon. I'm just going down the list of who has currency to do acquisitions.
BARKOCY: I believe that given that the first half of the year is going to be an uncertain and unsettled period for bank stocks, management's attention will likely be focused on matters other than mergers and acquisitions. If fundamentals and pricing firm in the latter part of the year, you could see some pickup in M&A activity, perhaps some mergers of equals.
COLLINS: There really aren't a lot of catalysts for increased M&A activity in the banking space right now, other than maybe a few stumbles where P/E becomes ridiculously low and it becomes a huge opportunity for a neighbor to do an in-market deal.
BLECHER: I see increased activity based on our expectations for higher share prices because of falling interest rates. Higher stock prices produce higher currencies. Banks engage in transactions because they are interested in getting an expansion of their product universe and their footprint, but it's also a way for them to address a potential softness in earnings.
I think Mike's analysis of who the potential buyers are is very legitimate. But on the other hand, I think that we might see some acquisitions - not only mergers of equals and acquisitions among the regionals, but also regionals doing acquisitions of smaller companies for their deposit bases and loan portfolios.
November was the one-year anniversary of the passage of Gramm-Leach-Bliley, and yet the convergence that everyone anticipated and hoped for has not really come to pass. You don't see a lot of insurance companies or investment banks, for example, scrambling for bank charters.
PLODWICK: We were never expecting a big convergence and we continue to think that area will be relatively muted.
BARKOCY: I agree with Mike. We had very low expectations as well. The banks that we have talked to who could possibly be players have suggested that they would rather be on the distribution end rather than the manufacturing end of the insurance companies. I believe that will continue to be the trend. Banks can't justify paying premiums sought by insurance companies for these situations that have lower growth rates than the banks. There is just no advantage in doing so.
BLECHER: The law may have changed, but it's market forces that dictate if these deals are going to get done.
COLLINS: Financial modernization just basically rubber-stamped the Citigroup deal [for Travelers]. I would argue that Citigroup looks at insurance, particularly property/casualty, as more of a rationalization of a pricing play where they can gain market share and make it an attractive business on their own, as opposed to really insurance for growth's sake.
Some analysts say that the traditional banking businesses could become more interesting now because of the focus on gathering deposits.
COLLINS: We expect net interest margins to finally stabilize after several years of deterioration. A lot of that has to do with the funding costs becoming much more attractive or much lower over the next perhaps three to nine months. That has not only to do with money flowing into deposits and into the broader market, but also has to do with the lower wholesale funding costs. Those two things could combine to provide a lot of cushion for the traditional lines of business like lending.
BLECHER: I think an offsetting factor is really the slowdown in loan growth. On the commercial side, we're going to continue to see a pullback of availability and a widening of these margins, which will be good for the future credit quality cycle. However, it could hurt net interest income growth. We'll continue to see strong growth on the consumer side, especially given the rate environment. We should see a nice pickup in the mortgage refinancing activity and good growth in home equity lending.
PLODWICK: I think the basic banking business is a mature business, and it's inherently slow-growth. That doesn't mean it's a bad business and there can't be room for higher returns, but I don't see a huge acceleration in earnings coming from the basic banking business for the foreseeable future.
BARKOCY: While the basic banking businesses are mature, we still like some midsize situations that do basic banking well. Banks that have pristine asset quality are niche lenders to small and midsize companies, have strong deposit inflows, and would benefit from a lower rate environment.
What is your least favorite stock?
PLODWICK: We would take profits in some of the names that have run up here on the euphoria over the Fed rate cut, but still have earnings issues, like Bank One or Bank of America.
COLLINS: First Union first and foremost. They've got negative earnings growth going into 2001. They've just recently cut their dividend in half. It's yielding essentially in line with the industry. We don't really know what the reshaped organization is going to look like in 2001, and yet it's selling at 12.2 times 2001 earnings, above some of the more attractive names like FleetBoston and U.S. Bancorp.
Charles Schwab I would put on a short list as well, simply because I don't think the trend in online brokerage is going to bounce back anytime soon, particularly kind of this self-service market where you're seeing a lot of individuals going to their traditional trusted adviser.
BARKOCY: With the economy still so fragile, and with the run-up in price due to the Fed rate cute, some of the companies still have meaningful asset quality problems. It's not yet the time to aggressively invest into so-called "potential turnaround" situations. Situations that I would generally avoid at this point in time are some of the usual suspects: Bank America, Wachovia, First Union, Hibernia, Union Bank, and Union Planters, just to mention a few.