Since 1990, James J. McDermott, Jr., has been president of Keefe, Bruyette & Woods, Inc. (KBW), a New York-based investment banking and brokerage firm specializing in commercial bank and thrift institutions. With a staff of 130, the employee-owned firm typically publishes 60 research reports a year and has consistently handled transactions valued at more than $5 billion a year. A 20-year veteran of the industry, McDermott talks about the financial services industry, his business, changes in banking over the last 20 years, and what lies ahead.
MANAGEMENT STRATEGIES: Is there a trend toward foreign banks buying second-tier investment banking firms?
McDERMOTT: U.S. commercial banks are interested in growing their investment banking related businesses. A number are (attempting) to build their businesses, to hire people from Wall Street or marketing areas. They're keeping a watchful eye on buying businesses outright because they are concerned about high prices and the potential for exodus of personnel. At the same time, foreign banks have exhibited a high degree of interest in buying investment banking firms. Culturally, they are more aligned with the universal concept: commercial and investment banking housed under one entity. Secondly, foreign banks are seeking to grow their U.S. presence. Historically, they have not aggressively acquired U.S. banks. They look to wall Street to fill in the gaps and build a presence in the equity markets and in some retail distribution.
MS: What happens to banks which sold for high price/earnings (P/E) ratios when the Fed tightens interest rates and stock prices decline?
McDERMOTT: For a number of years this industry has enjoyed what we call excess capital position. Having viewed the options, many banking companies have decided to buy back stock. This is part of a capital management process at many banks, an enlightened one that deserves praise. In the '70s and '80s banks came in for criticism because they funneled excess capital into a lending hole from which they typically didn't recover. (We) had waves of prosperity and waves of depression as a result of loan losses.
This time around we don't think that's going to occur; any deterioration in credit quality will be more managed by commercial banks. Rather than pushing that excess capital down this lending hole, they are handing it back to shareholders, a more prudent way of proceeding at this stage of an economic cycle. It's probably as error-free a process as you are going to find. The potential of the loan loss is infinite; the share buy-back is simply criticized because shares are purchased at high levels. The capital profile of the industry remains in good shape.
MS: How do pension funds and mutual funds that worry about high P/E ratios influence banks?
McDERMOTT: High P/E ratios for banks are a relatively new phenomena. Banks have yet as a group to sell at a market multiple. They remain at a discount to the S&P on the order of 30 percent. That gives us relative comfort, particularly as this industry strategically matures and develops a (consistent) earnings profile. There will be an economic cycle and it will be tested, but the volatility of earnings reports is going to decrease. The performance standard is being increased and banks will hold to a higher standard for a longer period. There will be problems in the economy which will affect certain banks but it's not going to be a generic (situation). This industry will develop a characteristic of a high return on capital.
MS: What is the true gauge of bank performance, absolute or relative?
McDERMOTT: We are moving toward individualized strategies of banks; the industry is less homogenized. Relative performance continues to be an important backdrop. However, you can pinpoint individual company strategies that are moving that company's return on equity to new levels. For example, you can have a State Street Bank, which has a high return on capital, growing business, and double digit earnings per share growth. This may not be the operating standard for the industry, but we will see more companies join the ranks of State Street. Instead of a dozen companies with State Street characteristics, you will see two dozen or more. Successful strategies will develop revenue opportunities, minimize credit deterioration situations, and optimize efficiency of the institutions.
MS: Should shareholders accept bank executive compensation increases when stock prices go down?
McDERMOTT: Like the baseball player who signs a five-year contract for a guaranteed level of high compensation and then performs at a .200 hitter level, (the executive in question) ought to give some of it back. If the stock price goes up in the good times, you will be rewarded. If it goes down, you ought to be punished.
The test of the issue of compensation will come once boards get a little more aggressive measuring through all sorts of climates. There are some examples of management which has not done as well and a reflection of issues that bear on compensation; lack of revenue growth, slow growth in earnings per share, certain targets that weren't met. But the trend has been win-win.
MS: How do analysts get the inside track?
McDERMOTT: The analytical function is critical to understanding the management strategies and execution of banks. There are a variety of ways to approach it. One is a thorough grounding in the knowledge of the company, its strategies, management, markets, and technologies, the basic materials of understanding what you are dealing with. We recommend strongly that our analysts spend a lot of time in the companies they follow. That means not only senior management, but the managers throughout the organization in a variety of disciplines and areas.
MS: How can an analyst be impartial, honest, and forthcoming, when occasionally the messenger gets shot? The reference is to Laurence Cohn, the PaineWebber analyst who said there was a lot of window dressing on bank earnings and was fired.
McDERMOTT: (The statement) might have gone contrary to the investment views of the strategist and research director in the firm, and he lost out. In terms of the question whether analysts are driven by the investment banking side of the house, in this shop that is not the case. For instance, we follow so many financial companies that we tend to get tagged as being too bullish. We look at the sector and say, still sell at 30 percent of the market, but when certain stocks get ahead of themselves, we will recommend sale or hold, then reposition.
MS: How does Cohn's dismissal affect the credibility of analysts in general?
McDERMOTT: You gauge that by the vote of the investors and their willingness to use your research, analysis, and judgment. Forget individual stocks and whether you are a bear or a bull at a given point in time. Over time, the institutional market will judge and say, "By and large, this firm and its analysts provide positive contribution to my decision process." That is the ultimate arbiter.
You can be wrong on a stock, or a couple of stocks, but over time you have to be more right than wrong and your institutional investor will make the decision whether to do business with you, and pay you in the process. If you are out there saying the sky is green every day, sooner or later, you are out of business. You have to call them as you see them. We spend 100 percent of our resources, financial and human, invested in the financial services sector, so we have a lot on the line every day.
MS: At least one analyst is a superstar, which is not traditionally how we see people in that profession. How does that affect his credibility and your general credibility?
McDERMOTT: I would hope there is still an important focus on partiality in the process. I don't think that every dinner, every conference or every meeting necessarily compromises someone's judgment.
MS: It's the same criticism leveraged against the Washington press; you've got to be close enough to know what's going on, but not enough to be cozy.
McDERMOTT: Any good analyst or any good reporter is going to have to know when to step back and pull the trigger. That gets tested when a company or situation that you become very familiar with steps out of line or there is a problem with it. Then you are required analytically to give it your best assessment impartially as you can. If management is unable to successfully execute its strategy and it results in poor performance, for an analyst who has celebrity to maintain his credibility, he has to call it as he sees it. People have different points of view. That's fine. For myself, I am sometimes viewed as an optimist, seeing the industry in optimistic terms and I do. I think this industry has tremendous resiliency, that the evolutionary changes in the industry are worthwhile and indicative of the change in operating strategy, change in view, a view that is adapting to the changes in the economy. So I am bullish about the industry's prospects and have been since the early '90s. In 1990 that was not a popular view.
MS: How does celebrity stature affect your profession?
McDERMOTT: Increasingly, it appears as if the analytical roles are taking on greater prominence. The analyst is in the flow of assessing information and helping the market make judgments about management strategies and making managements aware of what is going on in the market and the response the investor has to those strategies. He is a conduit of information, an activist, a change coordinator if you will. Management and institutional investors are looking for guidance on who is (performing) well in the marketplace. Appreciating who is doing well and how far they are in the process requires someone with hands-on experience and knowledge of execution capability of the managers in the institutions.
MS: Putting together big loan syndications without spreads is a betting game. Is it smart?
McDERMOTT: There is some risk. There is also a risk in originating loans and holding them on the balance sheet, and in making no loans or no syndications. A lot depends on structure, terms and pricing. If all three elements are in place, the process is worthwhile. The numbers of syndication are growing exponentially. It's a market that needs to be watched and careful; it's not black or white these days.
MS: There is speculation about institutions like NationsBank dropping unprofitable business lines and becoming boutiques. At the same time, we have the formation of Morgan Stanley, Dean Witter & Discover. Are we going to end up with just very small and very large entities?
McDERMOTT: There is a lot of movement in the marketplace. Certain commercial banks are selling pieces of their businesses to focus on niche strategies. Others are adding to their businesses and developing a broader strategy. These banks are engaged in something they have not done to the same extent previously: strategic thinking. The ability to understand the profit dynamics of the product and the customer are enabling banks to make better strategy decisions about business and customers they want to go after. This is a healthy process that will result in appropriate strategies for most banks. They will be doing the right things to the right customers over time because they are constantly examining where they want to be and who they want to sell to. Information technology is helping commercial banking institutions get to that point more quickly. They know how many kids you have and how old they are, how many cars you have and how old they are. It's almost CIA-like in its dimensions. I see it as individual strategic adaptation.
MS: Which are the up-and-coming institutions?
McDERMOTT: One noteworthy example, among many, is Greenpoint Financial. This was a low doc, no doc lender in the New York metropolitan area, and through the purchase of Barclays mortgage operation it got a national platform from which to launch operations in cities across the country. The growth trends have been good; the asset quality has been good. We are impressed with the focus. They are taking the basic template developed in the New York area and applying it to the same demographics elsewhere. It's one of the most exciting strategies around, and it will catch the attention of some larger providers of financial services in the future.
First Union is another company we have a tremendous amount of respect for. It has done a superb job in acquisitions, in developing revenue opportunities in newly acquired banking companies and in new markets. When First Union acquired First Fidelity, in New Jersey, they took what was a strong southeastern franchise and enlarged it, and took marketing and product strengths and (expanded) them through the acquired franchise. You get attractive product offerings, attractive site locations, effective marketing techniques, and generation of new revenue opportunities in a new market.
MS: What are the most significant industry changes in the last two decades?
McDERMOTT: This is a great industry that has undergone profound changes over 20 years. If you want to understand the pulse of what is going on in the economy, look to your banking system. See where its involvements are and where its tentacles take it.
Some changes come from a regulatory structure that historically has hobbled the banking industry and is now enabling banking companies to be involved in more businesses. One way to trace this is to look back at bank share of financial assets in the country. At the start of the century, banks had about 85 percent of the pie. Today it's about 15 percent, depending on who's counting. It's been a dramatic loss in franchise, and what is most key to me is witnessing the industry's resiliency in the 1970s and '80s and early '90s in crunch situations, and the ability to bounce back with greater strength than before. I go back to the fall of 1990, the nadir of performance. In the first nine months of 1990, the top 25 market caps had hemorrhaged from something like $85 billion down to something like $55 billion, losing value in marketplace. Citicorp was at 9, someone else's bank was at 3. Today, the 25 largest banks support a market cap in excess of $550 billion, a tenfold increase in seven years. That speaks legions to the impact of Federal Reserve policy, the change in strategic direction and execution and improved profitability.