Analysts at American Banker's quarterly roundtable on March 26 predicted a surge of consolidation, spurred by year-2000 concerns, that would push bank stocks higher across the board. Barely two weeks later, the buying frenzy in the market was much in evidence amid an unprecedented wave of merger announcements that paired Citicorp and Travelers, NationsBank Corp. and BankAmerica Corp., and Banc One Corp. and First Chicago NBD Corp.
The participants were Sally Pope Davis of Goldman, Sachs & Co., Richard X. Bove of Raymond James & Associates Inc., and David S. Berry of Keefe, Bruyette & Woods Inc.
Do we know a lot more about the impact of Asia on bank stocks?
BERRY: We know more, but we're not done. The initial impact was in trading (results). We saw that in the fourth quarter. And the good news is it was sharp, short, and over. We have every reason to believe that trading results are likely to be very decent in the first quarter. But I think we had not even begun to really see much in terms of credit issues coming out of Asia. And I think we're certainly going to see some uptick in problem assets for some of the larger banks with operations overseas in the first quarter.
DAVIS: Asset quality is still clean as a whistle. Nonperforming assets may be up at an occasional bank, but we're still talking about a small variation around a very low number. What has probably surprised the entire market is how robust the U.S. economy has continued to be. And commercial loan growth is still very strong.
Consumers are hanging in there, and whether they are borrowing or just spending out of their own income, they're still spending. A lot of people started off worrying about the banks this year, but the market turned out to be pretty good in the first quarter.
BOVE: We don't look at Asia as a short-term banking problem because basically no one can afford to write anything off in Asia. The real question regarding Asia is what is it going to do to the economy, to interest rates? What is the long-term impact? I believe that it means slower economic growth, perhaps a recession in 1999, a major reduction in interest rates. And if that's the case, that's where the real impact is going to be on the banking system.
DAVIS: I agree with Dick that we haven't seen the full impact in terms of the U.S. economy, but we think America is going to get through this fairly well. It's just too soon to see that.
Does that mean that the bull run of bank stocks is about over?
BOVE: All of the near-term fundamental indicators that we see in banking are negative. All of the drivers that created strong earnings in the industry for the past five years seem to be gone.
That means that bank stocks are rising because of the liquidity in the market. Portfolio managers are under pressure to invest, and it must go to stocks. We're in a frenzy, a madness. Anything fundamental is irrelevant, it's just money chasing stocks.
BERRY: I don't disagree with your comments about liquidity, but I think I would draw a very different picture of the fundamentals.
I'm not sure the banks look so bad trading at a 25% discount to the market. The historical issues that have led banks to trade at discount valuation vis-a-vis the market maybe have not entirely gone away, but certainly look like they're going away. We're talking about an industry that's earning high returns, has prospects for continued efficiency improvement and is in the process of consolidation.
DAVIS: The call on a bank is always an economic call. So you have to be comfortable with the economy. But until the credit cycle rears its head-and we know it's out there-we're comfortable with bank stocks over the next several quarters.
BERRY: I think mergers are inherently risky. It's easy to forget that. I think in the competitive bidding situation, the buyer runs the risk of pushing the envelope in terms of forecasting synergies. And then there are execution issues of actually making it happen. That, however, is not the norm. Most of the active consolidators in this industry at this point have already done quite a lot of consolidation and have rather a lot of experience in how to manage this process. So, as a general statement, there's not an enormous amount of risk to the bank.
But a lot of these companies have not been through a credit cycle.
DAVIS: Well, they've all been through credit cycles. It's just they might not look like they do now. But I'm not sure that they're going to look that different or experience it differently.
BOVE: What you should be focusing on now is not whether some big bank is going to buy a bank in Alabama or Wisconsin, because there are still some banks there.
In 1999, you're going to see the Eurodollar take effect in 10 or 11 countries in Europe. So, you'll get consolidation in Europe similar to what occurred in the United States. All of that is creating a wonderful opportunity in banking in the longer term, but we still have the fact that these guys are going to fall on their faces in the next two years.
Is the year-2000 issue driving some of the mergers?
BOVE: For unimportant banks, it's very important. For important banks, it's meaningless.
BERRY: I hope you're right. You know, most times when there's something you're concerned about, you dig into it and you find out it's not as bad as you thought. Year-2000 is one of those things that the more you look into it, the more disturbed you become. So, it's hard to provide a lot of added value on this subject, except to say that the banks are all focused on the issue.
DAVIS: Year-2000 clearly is a big issue for investors and something that's on everybody's mind, and partly because it's a hard thing to frame and understand. There are also concerns about the counterparties and it may be - David alluded to the federal government-that state governments may even be a step behind the federal government.
The other issue that people are now just waking up to is conversion to the European monetary unit. That's also a big (concern) for international and U.S. banks. With year-2000, you're talking about changing two digits. With this, you're talking about changing the currency sign.
BERRY: The difference with the EMU is that if you don't get it right, you're not out of business; you've probably just lost some business opportunities.
Year-2000 is critical. In the near-term sense, I think it has an impact on how people are thinking about mergers and acquisitions. And it seems that a lot of small banks have made a decision to agree to sell in just the last few months.
My personal impression of the Washington Mutual-H.F. Ahmanson & Co. merger was that it came sooner than I would have expected, and year-2000 has been one reason why.
BOVE: In a couple of years you will forget there ever was a year-2000 problem. The Federal Reserve has got an issue with the payment system in the United States. In other words, the payment system of the United States cannot be allowed to fall.
So, therefore, the Federal Reserve and the Comptroller of the Currency and the FDIC have got to be combing through every bank in the United States. And the issue is, either you get yourself year-2000 compliant quickly, or you lose access to the payment system.
The fact of the matter is that there are some significant long-term issues in banking. There's a whole reshaping of the financial services industry and to get bogged down on the year 2000 or get bogged down on whether some bank in Podunk is going to be bought out is uninteresting.
BERRY: The reason why it is interesting to me is because my constituencies and investors are trying to figure out how to make money in bank stocks, and that really is the whole reason I show up for work every day. So if we can identify a bank in Podunk that will get taken out at a good premium, then that's interesting.
BOVE: But will they be taken out at the premium? I mean the mortgage portfolios are exploding. Their expense ratios are rising because they're growing into what could be a slowing economy. They've got the year-2000 problem ahead of them; they've got labor issues they've got to deal with. Why should an acquirer step up to buy a nontrophy franchise?
BERRY: I hear you, and that's why it's interesting, because we have gone through a period in the last six months looking at four times book, five times book. It used to be twice book was a big deal.
I never even saw three; we blew right through that. Now it's four and five. That kind of pricing presumably in part explains why a lot of the small banks trade the way they do.
I think there are potential sales built into their current share prices today. And it's very interesting to understand whether that's going to continue, accelerate, or come to a grinding halt.
DAVIS: With respect to the high prices, a lot of it is Economics 101, demand and supply, and we've seen the "trophy" prices. Trophy properties that get you 30% market share in Florida or a very large share in Philadelphia or elsewhere do command a premium price. But then when it comes time for the larger banks to circle back and maybe do some fill-in acquisitions, then you may find that the price starts to come down because it no longer has a demand-supply analogy.
What if rates fall further?
BERRY: If short rates were to go down, the margins of the regional banks would get squeezed There's just not a lot of room to lower deposit pricing any further. We never really raised deposit pricing very much after '93. This industry is popularly perceived to be at risk if rates go up, where I think the real risk is if rates go down.
DAVIS: You can never really look at rates in isolation.
You have to say, "Why are rates falling?" Because if rates are falling, that may mean the economy is really slowing up or it could mean that you're entering a down credit cycle. But I think when people say, "What do you worry about?" I would say I worry about the next recession.
It may not be that we have such a bad credit cycle, because of diversification and securitization and a number of different things. It's just that it may be accompanied by 50 to 75 to 100 basis points lower interest rates and, yes, you do have a margin issue at that point.
BERRY: But from the perspective, what does an investor do today? You can't sit around constantly worrying about the next recession. You look for relative valuation.
BOVE: Another issue we could take a look at is what's happening to loan pricing itself. Because interest rates may be coming down, but competition in banks to get loans is heightened to such a degree that they're driving interest rates down at a faster rate than would otherwise be the case.
BERRY: Many bankers at smaller institutions are very gloomy about loan pricing, very unequivocal about the impact on margins if interest rates came down. So, I think we're dead-on on the issues we're talking about, which gets back to the critical importance of getting your costs down, while consolidating the industry.
BOVE: The outlook just isn't that pretty.
DAVIS: Well, let me offer a silver lining. If you were to read Loan Pricing Corp.'s Gold Sheets, there probably is not a more competitive low- spread business than the investment-grade syndicated loan market. They're actually seeing pricing improve.
This is partly because the Japanese banks have pulled away from the market and, in fact, may actually be selling loans on the market versus buying them. And those banks have been a major source of absorption in the investment-grade market.
BOVE: If margins are under severe pressure because of mortgage refinancings, cutting prices on commercial loans, the year-2000 issue, and higher labor costs, how do banks internally grow their earnings? They've got to do it by driving loan product. That means more capital.
BERRY: No, no. Larger banks are more reliant on fee-based revenues, which are less constrained by deposit growth, and have a better revenue opportunity than a lot of the smaller banks who have not transformed themselves.
BOVE: And where are the fees coming from?
BERRY: Trust investment management is one. The propensity of the industry to charge for everything that is not nailed down is another. ATM surcharging, being the latest example, is not unique, is a long-term trend. Cross-marketing of insurance products is a whole opportunity for the industry over time.
What are you expecting for first-quarter earnings?
BOVE: We've been cutting earnings estimates on a continuous basis. I can't remember the last time we increased an earnings estimate on a bank. We're getting calls from bank presidents from the smaller banks saying, "Look, our margins are coming down sharply because we never expected prepayments to be that high."
Midsize banks are talking about the expense levels being under pressure. And we're dealing with accounting tomfoolery for the bigger banks. Any bank that can't make its quarter can go run out, grab a bunch of assets, securitize them, and bang in a gain-on-sale profit, and we'll never know about it.
What bank stocks do you like right now?
BOVE: Everything I can buy. The market's going up. People are putting $70 billion a month into it. Anybody who says to sell anything is asking for trouble. Just keep buying.
How do you reconcile that with your higher critical analysis?
BOVE: We're in a liquidity driven market; we're in a mania. Barton Biggs (managing director at Morgan Stanley, Dean Witter) said it best: (When it comes to this market) "fools are dancing, but the bigger fools are watching." I don't intend to watch. I'm a dancer.
DAVIS: I've spoken to every company I cover, and I haven't cut a single estimate, so I have a feeling it may be a matter of who you talk to. Although I haven't raised any estimates, I do see a few companies, like State Street Corp. and Northern Trust Corp. having the ability to perhaps have higher earnings than what the Street has forecast if the markets continue to be as robust as they have been so far this year.
BERRY: We have been cutting estimates on some of the smaller banks, particularly some of the smaller thrifts because of their prepayments. Citicorp and Chase Manhattan Corp. in particular, still suffer from a significant amount of Asia discount.
If Chase achieves double-digit revenue growth as it is targeting, we don't think it will still trade at a discount. Citi's earnings in the near term are suffering due to Asia, but in the long term they should be a clear beneficiary of the turmoil because it is already a financially strong player who will end up being a lot deeper in these countries than it has been historically.
Capital One Financial Corp. is a credit card specialist whose stock has been like a rocket ship. What we see here is a situation where the fundamentals of the credit card business clearly are turning for the better.