There are plenty of issues for banks besides Asia and interest rate spreads, according to market watchers at this quarter's American Banker bank analysts roundtable. Mergers and questions about preparations for 2000 will affect bank stocks.
Roundtable participants were Nancy A. Bush, Brown Brothers Harriman & Co.; Yun Jae Chung, Bessemer Trust Co.; Joseph A. Stieven, Stifel, Nicolaus & Co.; and roundtable newcomer David Berry, research director at Keefe, Bruyette & Woods.
Could you comment on how extended economic problems in Asia could affect the banks you cover?
BERRY: It's been the real focus of investor concern and I believe it's overdone. Two names in particular come to mind-Citicorp and Chase Manhattan Corp. We think there are really great values here. Assuming the world financial system does not totally melt down, the Asian crisis will create opportunities for Citicorp and allow the company to deepen its presence.
CHUNG: Just because Chase has a loss in trading doesn't mean that every single bank with an overseas trading business is going to be impacted. The good trading results out of Morgan Stanley and Lehman Brothers should give us some comfort. Asia is going to be very dependent in the next few months on what happens to China. What's going on in Japan is actually a bigger issue and we can't get a handle on that right now. That's why there is uncertainty.
BERRY: There's a history lesson here. You can go back and look at Chase's trading results in the wake of the peso devaluation. Debt trading was a minus number in the fourth quarter of 1994 and the first quarter of 1995. And then it bounced back. That's the great thing about trading-you find out in a real hurry what your mistakes are. And since everything is marked to market, when the storm is over, it's over. It's not like some credit issues that can linger on for years.
STIEVEN: I follow regional banks in the central part of the country, and our stocks are impacted along with the large banks. That could continue as the Asian problems increase. Or the linking could end as investors realize regional banks do very little overseas.
The yield curve has suddenly become an issue. What are your thoughts on that?
BERRY: Long rates have come down a lot-it's just been a breathtaking move in the last couple of weeks. If you're an adjustable-rate portfolio lender, you're going to see a lot of prepayment activity and your portfolio is going to get refinanced over the next few quarters. At the same time, a lot of banks invest in mortgage-backed securities that are subject to prepayment risk. It's a relatively minor issue for most of the commercial banks that we follow. But at some recently converted savings banks, mortgage securities make up a good part of balance sheets.
Just to pick on one, Roslyn Savings Bank is a huge holder of mortgage- backeds, and so there's some vulnerability there. The more interesting question is whether the shape of the yield curve is portending a reduction by the Federal Reserve Board of short-term interest rates. That could put additional pressure on all retail deposit-oriented banks.
CHUNG: We have seen prepayments pick up. But I differentiate between the companies and think about exactly what type of lending they're doing, how far out on the yield curve they are, and how they are funded.
STIEVEN: The current level of interest rates will start to squeeze margins for a good number of regional banks. If you're core-funded, you can't drop your rates that fast. The other aspect is that you can't pay below zero-and we keep moving toward that number.
What are some of the upsides to the current volatility?
BERRY: With interest rates where they are, if you do get a big refinance wave you're going to be putting a lot of money in homeowners' pockets and that could have a favorable impact on consumer credit quality. In 1994, we had a very low level of credit card writeoffs following the 1993 refinance boom. Also, if you're a Chase or a Bankers Trust and one of your big businesses is high-yield finance, there will be corporations looking at refinancing opportunities over the next year. So I think we should not paint an entirely gloomy picture.
CHUNG: Also, there will be a lot of debt underwriting activity-there's a huge pipeline for the first quarter.
Does the merger wave keep rolling?
CHUNG: I never bought into this premise that every bank is going to get taken over at four times book value. So I'm kind of glad to see a little breather in merger and acquisition activity.
STIEVEN: A slowdown in earnings growth could help acquisition activity because some rational sellers might say, "My earnings are starting to slip; the right thing to do is to sell the company." The risk is you have a chief executive who says, "My earnings are slipping, tough luck, I'm not old enough to sell the bank." Then they take the franchise and continue to try to run it, and they miss a window. I truly believe there is a window for selling companies because there are fewer buyers out there due to the consolidation. People who thought they could wait three or four years and sell out in a bidding contest could be making a huge mistake.
BERRY: I wholeheartedly agree that some of these banks don't really deliver the goods and can overstay. But I wouldn't go so far as to say interest has dried up for smaller banks. I wouldn't say all of these little New England savings banks are stranded. Last year there were 21 deals. Consolidation is happening at many, many levels.
STIEVEN: I'm not trying to say the game is going to shut down-there are always more willing buyers out there than willing sellers. But for those who continue to believe that these franchise values will always go up, I think they could be mistaken. Some institutions, once they have watched their earnings peak and start heading down, are going to recognize they have diminished value for their stockholders. The window is shutting on the peak valuation they might have received, not really on deals getting done.
BUSH: Small banks will continue getting eaten up. Midsize banks have to think very hard right now about valuations.
BERRY: Mellon Bank Corp., Fleet Financial Group, SunTrust Banks, Wachovia Corp.-every one of those is a trophy franchise. Should they decide to combine or get bought out, buyers are going to make amazing assumptions and stretch on every one of those, just because there is nothing else like a Mellon Bank or there is nothing else like a Wells Fargo & Co. At this level, every one of these will be a strategic deal the way a CoreStates Financial or a Boatmen's Bancshares was. But once these big consolidators start to get the national franchises put together, the smaller deals must really deliver financially for the buyers. And the kind of pricing you're going to get there is not going to be the kind of pricing that you've seen in the last six months.
BUSH: A big issue is how all this talk of deflation and a slowdown impacts acquisition activity. Does it accelerate it or retard it? I would also throw out a question: Do mergers of equals come back? I ask because two chief executives in the last month asked me what would I think if they did a merger of equals.
STIEVEN: It's interesting. It's hard to find a true merger of equal partners, though.
BUSH: We have to go with the assumption that one set is more equal than others and one set disbands. A merger of equals is going to come to mean different things than it has in the past.
BERRY: There are potential mergers of equal partners out there. We've been talking about SunTrust and Wachovia Corp. for about a decade. Fleet Financial and PNC Bank Corp. would not be a bad marriage. We just had a newspaper account about Bank of New York and Mellon Bank Corp. I think the Street would have cheered if that deal had come off.
BUSH: But the social issues have to be settled right off the bat. ...
STIEVEN: Are you saying social issues can get in the way of shareholder issues? Funny, I can't imagine that.
What about these takeout packages for "merger costs" and settling with departing management?
BUSH: There's still the effect of Charlie Rice (chairman of Barnett Banks Inc., who received a large severance package through the sale to NationsBank). Now I'm hearing everybody wants a package like Charlie Rice.
STIEVEN: Some of these acquisition charges nearly rattle your teeth.
BUSH: A billion dollars plus. ...
STIEVEN: Do these management teams think that we don't care when they charge off all this extra stuff? Management says that earnings growth is the only thing that matters. Maybe I'm a dinosaur, but does anybody look at the growth of book value? A lot of these companies haven't shown book value growth for years.
BUSH: It's been put aside in the heat of the moment. Book value will start getting more attention as acquisition activity slows.
What is the earnings picture going to be like and how much of a diminution of earnings growth is going to be taking place?
STIEVEN: Potentially, some of the regionals will show a little bit slower growth than some of the money-centers. We're expecting our group to show average earnings-per-share growth somewhere between 7% and 10% next year. On the positive side, our banks don't have Asian exposure. So, while their growth might be a little bit slower, it's typically a more predictable growth. That might be one of the reasons investors don't mind paying a little bit higher multiple.
BERRY: We haven't changed the estimates in the last few weeks-we're still looking for 12% growth for 1997 and another 12% for 1998, focusing on the larger banks. The larger banks grow faster because they tend to be more fee-oriented and active in share repurchase. If we were to get a reduction in short rates, I think that would come out of regional banks and community banks that don't hedge as much.
Upcoming reports will highlight the fact that some larger banks have had and are likely to continue having better growth rates than some of the smaller banks. That's another issue if you're thinking about selling your small bank. If you wait, the number of shares of the acquirer you will get in exchange for your shares is probably going down, because his stock is probably going up more than yours.
BUSH: I haven't revised any earnings estimates, but I am cautious. Everybody is at the drawing board right now working on earnings estimates or composition of earnings. There's a rethinking of the wonderful, everything is fine, don't-worry-be-happy scenario. And that's not a bad thing. The group as a whole needed to return to reality.
CHUNG: I haven't changed my earnings outlook for this year or next year. Asia really doesn't change things all that much unless we have another disastrous trading quarter. But I don't expect that. However, the relative earnings momentum for the region will be tougher this year than it was in 1997. And the deceleration of the momentum might have some implication for the stocks and the multiples, aside from all this domestic merger and acquisition activity. I still do favor the money-centers.
Do bank stocks outperform the market again this year?
STIEVEN: If we start from today (Jan. 8), when banks are getting pounded, I will say yes. The fundamentals for the banking industry, contrary to some of these things we hear, are pretty good. Capital is strong, and asset quality is good. You have more prudent management teams left because mergers have knocked out a third of the bad ones. As a result, you're going to see relatively healthy earnings momentum for most of the group. And I think it's going to translate into relatively good stock prices.
BUSH: Bank stocks should perform well-extremely well-relative to the rest of the market. But does this mean bank stocks will not lose as much as the rest of the market? Also, there are particular companies that have been extraordinarily conservative in the last few years in their accounting and have stashed away earnings. They are generally good situations that will become safe harbors on their own. It's going to be a very spotty story.
BERRY: Someone recently said it's going to be a year for stock picking, and I think that's probably right.
BUSH: If some of the deals in process now don't go well, there could be a psychological impact on the group.
CHUNG: At this point, it's more like a process of elimination versus the rest of the market. The banks still look pretty attractive on a relative basis versus the market and the other sectors of the financial services industry. But is it going to be another year of broad major gains? I don't think so.
BERRY: If we keep the merger wave rolling, you're going to do real well. If something unhinges that, then it's easy to imagine the group will underperform. Right now, the wave is at full crest.
Let's talk a bit about the year 2000.
STIEVEN: It looks like preparation for the year 2000 could be a larger problem than expected. A lot of small banks think if they're outsourcing, they will have no problem. But bank regulators are saying these banks must make sure their outsourcer is prepared for the year 2000.
BERRY: The banks are actually probably a little ahead of the game versus a lot of other industries. It could be because banks already have a lot of loans with maturities that fall into the next millennium. It could be because they have regulators reminding them about issues like this. I think most banks are going to get there.
BUSH: Banks told us a year ago it would cost around $50 million to get on-line for the year 2000. Now I've heard Fleet say $100 million to $150 million. The estimates are being ramped up. I don't think any of my companies, except maybe Fleet, have a real firm grasp on all the costs that are going to be involved in the issue. It's not something that's going to make me run out and change an earning estimates but the costs are pretty big.
BERRY: A straw in the wind: A well-managed regional bank I follow recently announced the acquisition of a $250 million-asset bank. It's going to close in the first quarter, and they have told me they're going to defer systems conversion for a year after that, because they don't want to take any programming staff off of year-2000 issues.
What are your stock picks as we start the new year?
BERRY: Moments of fear like this, historically, have been your great buying opportunities. The concerns about Asia have been directed primarily at the international banks. Chase has been touched by fears, but I don't think people recognize how domestically focused the company is. Chase's involvement in the emerging markets is about on par with BankAmerica's and rather less than a Bankers Trust, a J.P. Morgan, or a Citi.
CHUNG: There are some analysts who say Citi has lost its luster of being a revenue-growth story. I disagree with that, because I don't think that Citi ever had the multiple that it would have gotten if it was truly accepted as a revenue growth story. And I think on a relative basis, the revenue growth is going to look much better than a lot of other domestic institutions.
One thing I wanted to add on Chase is that within the next six to 12 months we could possibly get another major announcement at about a restructuring and/or capital management. I think that will be a big positive.
BUSH: I'll include some of the words from Raphael Soifer, my money- center colleague at Brown Brothers Harriman. He is also recommending Citi and Chase as the stocks having overreflected the issues. He's also recommending U.S. Trust Corp.
Right now my only recommendation, my only outperform-rated stock, is Banc One. Fears regarding slowdowns in the economy are impacting the stock. I've got four names that I want to add-two "quality names" and two low- value names. I expect, because of market conditions, to act soon.