Deteriorating credit quality and compressed margins have caused great concern for investors in bank stocks. But the analysts at American Banker's quarterly roundtable said most banking companies will earn their way through the difficult interest rate environment. Participants were Frank Barkocy of Keefe Managers, Michael Plodwick of UBS Securities, Andrew Collins of ING Barings, and Denis LaPlante of Fox-Pitt Kelton.

Do you think that credit quality will be more of a concern in coming quarters?MICHAEL PLODWICK: Clearly we've had hiccups as far as credit quality. We've had Wachovia, Unionbancal, and Pacific Century [Honolulu] all announce additions to their loan-loss reserves. The credit quality environment has been good for a long time, and everybody has been waiting for it to turn the other way. The biggest surprise was Wachovia, which had this sterling reputation for credit quality for decades. For them to have said that they had to add to their reserves was a real black eye for the company.

The common thread throughout most of the three banks that have announced credit issues is syndicated lending. I don't think it's an across-the-board weakening in the economy; it seems to be widely centered on very few credits. And now there is this wild goose chase going on to see which banks really have pieces of these credits.

FRANK BARKOCY: I don't see asset quality getting much better than current levels. I believe that the consumer side still looks solid based on what we've seen so far. However, there is a growing concern that the Shared National Credit Exam, which will release results in the fall, might come down more severely on problem commercial loan credits than in the recent past. We're probably going to see the start of some anticipatory reserve building over the next few quarters.

As to Wachovia, perhaps this was overblown in the sense that those who cover financial institutions closely were aware that Wachovia was running behind the curve in the level of loan-loss reserves. Wachovia tends to be a bit more anticipatory than many banks in recognizing loan loss problems, and part of the reserve buildup reflects that type of conservatism. The concern was, therefore, "If this is happening to Wachovia, what about the other companies that are far less conservative than Wachovia?"

ANDREW COLLINS: We do expect some normalization of credit costs going forward. We've got about 8% growth built in to provisions this year, rising to 16% next year. We also think that the banks could earn their way right through it. We expect that we'll see 7% earnings per share growth this year among the larger banks, growing to 10% next year as we see a bounce-back in capital markets and net interest margins start to firm up a little. Also, loan growth generally was OK - nothing to write home about.

Nonperformers may pick up a little bit - maybe they'll grow 20% this year, maybe there will be a few bad leveraged credits out there. But for the most part, the problems are pretty limited to specific institutions that haven't been as careful as they should be.

DENIS LaPLANTE: The median nonperforming asset ratio for the companies that we cover - roughly 55 to 60 companies - is about 56 basis points. It bottomed out in June of 1998, and it's been gradually going up from there.

In our forecast, we're looking at 5% to 10% increases in nonperforming assets across the board in this quarter on a linked-quarter basis. Yearend changes will be something on the order of 20%, maybe a little bit more. We see the nonperforming asset ratio on a median basis going from that mid-50s range up toward 70 basis points by the end of this year. And by the end of 2001, with nothing else happening, it's probably going to be in the range of 80 basis points plus.

People always worry about banks, because they're leveraged institutions. You don't know exactly what is in the loan portfolios, and in these times that's what scares investors. But I'm not especially concerned, and I think if there is some confirmation and conviction on the part of investors that the Fed has stopped raising rates, we could see a nice rally in the stocks.

What companies do you think are faring well?BARKOCY: I like the Chase Manhattan Corp. story. Unfortunately, Chase kind of shot itself in the foot by making public part of its partners' equity portfolio. A little bit of knowledge in the hands of the investment community is a dangerous thing, as all the analysts had was a piece of their total capital markets picture to measure. It overstated or understated the importance of their core businesses, which are doing quite well, thank you.

COLLINS: Not only that, but right now it is trading at significant discounts to the brokerages. Merrill Lynch and Morgan Stanley are trading at 16 times issue returns. Chase is trading at 11.7 times. That's a significant discount, and yet I think they're going to be very competitive.

PLODWICK: It is interesting. The last time we did this roundtable, Chase was pretty much a lot of people's favorite pick. That was right before Nasdaq took its big crack. Since that time Chase has been actually one of the poorer-performing bank stocks. I'm still somewhat dubious that if we ever do get a downturn in the capital markets that people will still be willing to give them as much of the benefit of the doubt as they've been given.

We would tend to use Chase more as a trading vehicle than as a longer-term investment.

BARKOCY: We like Citigroup. We think Citi is the prototype of what the major banks will look like in the future. It already has broad diversification in place, with major positions in commercial banking, brokerage, and insurance.

What about Bank of America?BARKOCY: Conceptually I think Bank of America is a great franchise. It serves 30 million households, and if you can just tap and cross-sell to that customer base, you have a real powerhouse. I believe that the concerns regarding Bank of America tend to change from day to day. There have been margin pressure concerns. There have been asset quality concerns. As you know, they're a fairly good-size syndicated lender. Other concerns expressed are expense and integration issues.

LaPLANTE: We actually have Bank America as a buy. I think there are two issues. Frank pointed out … they're the No. 2 syndicator on the loan side behind Chase. So when you have that large a market share, you're going to get affected when people's concerns increase about syndicated credit.

I put them in the really depressed large-cap stocks, yet there is really good long-term value there. There are a couple of potential catalysts in that story. That is, they've been building for so long. Hugh McColl is probably going to be retiring sometime in the next year; you'll have a situation where the current management team is going to be more focused on rationalization. They're much more internally focused. They haven't done a deal in a while. I think that's what they need to focus on - getting a franchise working.

If you look at the franchise, not only do they have 30 million households in terms of whom they do business with, but they also have a No. 1 and No. 2 market share in eight of the 10 fastest-growing states in the country. But it's execution. People don't believe them. Even when they showed pretty good capital market numbers in the first quarter, they didn't quite offset all of that. So people questioned quality of earnings.

COLLINS: I'm not as enamored of Bank of America. I kind of use [it] more as a trading vehicle when the banks start to turn positive, whereas Chase I look at more as a long-term fine opportunity, simply because capital markets are growing much faster than the basic business of banking. That's always going to plague Bank of America. It's got some of the weakest revenue-growth outlooks among any of the banks that I follow, versus Chase, which is approaching double digits. You'd be lucky to get 3%, 4%, 5% out of Bank of America going forward. At these price levels the stock is dirt cheap. So as we do see a recovering in the broader bank group, then that stock might also fair disproportionately well, particularly as we get over the second quarter in that organization.

What are your views on banks getting into the insurance business or insurance companies getting into the banking business?PLODWICK: The next big bank-insurance deal we see in this country will be the first. We've had the legislation in place now really since last October, I believe. A lot of banks, at least some of the ones that I follow, have studied this issue fairly closely. What they can't seem to get over is this whole revenue and return profile.

Banks themselves are struggling with growth and revenue growth. The insurance industry doesn't seem to be the vehicle to sort of enhance that. Lately it's been coming mostly from the European side - and there is a simple reason for that. The return profiles of the U.S. insurance company look pretty good to most European banks because the profitability of European banks isn't at the level of many of the U.S. banks. So we don't see a big groundswell, at least domestically, of banks marrying up with insurance companies and vice versa. Frankly, it just doesn't work all that well.

COLLINS: I don't think banks are interested in property and casualty; at least the U.S. banks are not, because the returns are so low and they can't really justify it on the current rate-of-return basis.

What I would say is that it makes sense for organizations like Citigroup that can rationalize the insurance business, given their size in the marketplace.

BARKOCY: Conceptually I think it's interesting, but if you run the numbers, those combinations don't work well, because rates of returns are lower at the insurance companies relative to the banks and pricing expectations are not justified given those returns.

What about mergers and acquisitions?PLODWICK: What's interesting is most of the banks with currency really aren't banks. I'm looking at my sorting on PE here. it goes 34 times earnings for Northern Trust, 29 times earnings for State Street Corp., 24 times earnings for Bank of New York, 22 times earnings for Fifth-Third, and so on down the list. I would say with the possible exception of Fifth Third, none of those premium companies are going to blow their premium PE by buying a bank. One of the reasons they've got a premium PE is because they're viewed as decidedly nonbank. So I think if we're going to get a groundswell of consolidation later this year, it's probably going to come at the lower end of the food chain and it's going to be a very difficult M&A environment to make money from a stock-investing point of view.

Companies that are likely to merge are those that are either severely revenue-challenged or banks that will merge with the guy across the street to cut costs.

COLLINS: I don't think there is going to be any kind of groundswell of activity in M&A, that's for sure. But what I would say is a few capable acquirers have proven themselves in the last year and a half, two years - those being the Citigroups, Firstar, and Fifth Thirds of the world. Then you have to start looking at what the potential acquisition candidates are. The deals are going to be limited at best. They will be structured in a way that makes sense from a shareholder perspective, which I can't say about a lot of the deals that were done during 1997-98.

BARKOCY: Given current pricing of financial institution shares, many companies do not have the currency to become aggressive acquirers. Moreover, investors have treated acquisition announcements for the most part in a negative manner, putting pressure on the shares of the acquirer as too many acquisitions in the recent past have fallen well short of expectations.

What are your picks?PLODWICK: My favorites are Firstar, Fifth Third, and Fleet. I understand a lot of people say 24 times earning for Fifth Third is a lot. But here's a company that has had the best unbroken string of earnings increases, not only in the banking industry but most other industries as well. When you look at some of the things that are bothering investors - lack of revenue growth, lack of deposit growth - well, take a good look at the type of numbers that Fifth Third is pumping out in that regard.

Firstar has been a longstanding favorite, and there have been two issues that have kind of put a lid on that stock's performance. Number one, Can it grow revenue at this thing that they've built? And Number two, Are they going to rush out and do another deal? They are going to grow revenues at about 7% or 8% overall. The second quarter, I think, shows quite a bit of revenue progress. When you think about what they bought and where they are now, I think it's quite good.

Fleet is my chicken way of playing capital markets, because they hit on all cylinders with Robertson Stephens and Quick & Reilly. This makes them maybe a 13% grower. If they get very little contribution from those businesses, you still have a 10% grower. So you're not in a defective bank mode where you get these wild gyrations.

BARKOCY: We like Wells Fargo. It reflects high-quality depth of management, a balanced earnings stream, market dominance, and the ability to sustain above-average earnings. It has a dynamic sales culture, cost disciplines, and broad delivery channels, including a leadership position in Internet banking.

LaPLANTE: My favorite pick is Mellon Bank. Sixty percent of their earnings come from the growth sectors, just from normal growth. My guess is that that is going to turn into a 70-30 story by 2002. If they do some restructuring, that could be an 80-20 kind of split.

Bank of New York also is a favorite name. It has a processing businesses that reduces its credit risk. Firstar would be my third in terms of the higher-quality names that provide still pretty decent value.

COLLINS: My top picks are Bank of New York, Wells Fargo, and Chase Manhattan.

Bank of New York continues to gain market share in the processing businesses. They're among the top three. I think they also have some of the best ratios out there in the business: a return on equity approaching 0.7%, An efficiency ratio approaching 48%, and fee revenue over 60% and growing. Not only that, but processing as a contribution to earnings could be north of 60% going forward. It's priced at a significant discount - 20% to 30%.

Wells Fargo has some of the best revenue growth prospects in the regional banking sector. Part of that is due to the accretive acquisitions that they've been doing over the last year and a half or so. They have by far the best Internet offering - 1.7 million customers. Twenty-five percent of their total households are now on the Internet. Chase Manhattan is a long-term buying opportunity. Over the last couple of months we've been a little bit more cautious on Chase near-term because of the impact that capital markets would have on their earnings stream.

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