Optimism on Performance, Worry on Buybacks

Questions about consumer credit quality and share buyback programs at banks dominated the American Banker's most recent quarterly bank analyst roundtable.

The panelists met on March 21, with the expectation that the Federal Reserve would soon increase short-term interest rates. The central bank did so four days later.

The analysts were optimistic about prospects for most banking stocks and for a continued "Goldilocks" economy. That's Wall Street shorthand for an economy that's like the porridge mentioned in the children's story-"not too hot, not too cold."

The analysts were also generally upbeat about the recently announced acquisition of U.S. Bancorp, Portland, Ore., by First Bank System, Minneapolis. They expect banking industry consolidation to go forward relatively rapidly, but to be primarily concentrated among the nation's smaller banks and thrifts.

Participants in the quarterly discussion in New York were Stephen Berman of Stein Roe & Farnham Inc., Lawrence W. Cohn of PaineWebber Inc. and Catherine Murray of J.P. Morgan Securities. Joseph Stieven of Stifel Nicolaus & Co. joined the discussion by telephone from St. Louis.

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What is your general outlook for the industry and the economy?

STIEVEN: At this stage of the cycle, you'd better be with companies that have sound asset quality. We've been talking about this for six to nine months.

Due to being in an extended economic expansion, we have been expecting some weakening of credit quality. You're seeing a lot of stress on the consumer right now. And while banks have said they haven't lowered their credit standards for commercial borrowers, personal guarantees are being waived many times.

If banks continue to price things thinner and thinner they are going to negatively impact their long-term profitability. For example, the same loans made two years ago priced at the prime (lending rate), are now easily (being priced) subprime, and they're Libor-based.

Long term, the fundamentals of the banking industry are very good. Short term, we are going to see some potholes.

BERMAN: Certainly the jump that these stocks have had during the first two months of this year caused them to become overbought, technically. They were probably somewhat ahead of the fundamentals.

I think we are in for at least two small, upward moves in interest rates (from the Federal Reserve), and I would say the jury is still out on whether there will be a third one. But overall, I expect that the "Goldilocks" economy is going to persist.

And if that is true, I would expect the banking industry to deliver earnings (growth annually) in the range of 10% to 15%. The companies that might have some restructuring and consolidation going for themselves will produce earnings gains at the upper end of the range.

In that context, I feel the group is still relatively attractive on a price basis. Managements of many of these companies are better than they have been for 20-some odd years. I do think the largest banks in particular have truly improved their ability to manage the risk. And I believe that will be translated into more consistent earnings going forward.

COHN: We remain convinced that banking is a cyclical industry. This has been a very long expansion, and we suspect that we're now a lot closer to the end of it than we are to the beginning.

We think the market has increasingly valued the (bank) group as if the cyclicality in this industry is going to be substantially less than it has been in the past. And yet you can see some obvious problems are popping up, with subprime autos and credit cards. The industry keeps dodging these bullets, but I don't think you can do it forever, so we're getting much more cautious.

MURRAY: We are still optimistic, especially in the medium term. I expect the banks to remain solid outperformers over a one- to three-year investment horizon, thanks to low and stable economic growth, industry consolidation, and excess capital.

The worst-case scenario is that the banks remain market performers for six months or so, while we work through the uncertainty regarding the outlook for interest rates. But I still think in a six-month to 12-month investment horizon, the banks will be very solid outperformers.

Are you worried about credit qualityin the commercial and consumer arenas?

BERMAN: I would say the trend in losses is going to continue to rise, at least for the next two to three quarters and maybe longer. In that circumstance, it wouldn't surprise me that some of the companies where credit cards are a very high percentage of their business could have modest disappointments in earnings.

My feeling is that we probably won't see any more surprises of the magnitude of Advanta, but the bank card business is clearly under pressure.

STIEVEN: We have several regional banks who have experimented with new marketing plans and have bought new customer lists. If they've ramped these up quickly, it's sometimes not done too well. But it's going to be very manageable for most of the industry, for a couple of reasons.

Reserves are right near record high levels, while nonperformers are very close to record low levels. Second, the best management teams have stuffed things away in the last 12 to 18 months, because they know that down the road they're going to need them.

So while we expect nonperformers and provisions to head north for the vast majority of the industry, I still think most of the banks are going to be enjoying record earnings, typically reporting 10% plus growth rates in earnings per share.

COHN: We're increasingly worried that the card industry could prove to be one of those examples where innocent bystanders can really be hurt badly. Bankers always worry about stupid competition, and dumb competitors can cause even a smart bank problems.

While there's no question that a large number of banks cut back on their marketing programs a year or longer ago, there isn't any bank whose loss experience hasn't continued to trend up.

The problem is that even if you're not pressing more credit on your customers, somebody else is. And if they then go bust, they've still got your card.

We talk with banks who say that when they do post-mortems, they find that they would have continued to give cards to the same people they gave them to; it's just that when the people finally go belly up, the banks find that instead of having three cards, these customers had eight, because a lot of other (card) issuers had piled in behind them. So the problem wasn't the cards the bank put out, but the cards their competitor and his next competitors put out as well.

Fortunately for the industry, there's enough earnings diversity that even if card (losses) get dramatically worse-and we're convinced they're certainly going to get worse-you can't do a lot of damage.

I see the situation as much more of a psychological overhang than a real threat.

MURRAY: In general, banks tend to have customers with a higher credit quality than the nonbank financial services providers. That's one of the reasons why returns in the banking sector have historically been lower than the returns of many of the nonbank financial services providers.

With the credit card companies, we're seeing an adjustment of expectations. And that changing expectation is just not as significant relative to the business base of the banks as it is for the monoline companies, which is why I think the bank valuations will not suffer as much as a result.

BERMAN: Do you think that top line growth is coming down for some of the monolines?

MURRAY: Well, that's the issue. There are very high expectations. And what could happen is that if top-line slows, and the portfolios continue to season, the sector will get a double negative hit.

BERMAN: Why is the top line going to slow? Because volume is going to slow, or because they can't reprice?

MURRAY: As chargeoffs grow, financial institutions have to question whether they want to continue to proceed at such high growth rates in solicitations and receivables. So volumes may come off, and revenues may be negatively impacted by both lower volume and potential difficulty with repricing.

COHN: One of the problems is that if you just start adding up everybody's plan to grow, there isn't enough market there. The end result of that situation is that revenue growth is just going to fall short of what the issuers are looking for.

What about consolidation? Is the pace going to slow down because of the prices?

STIEVEN: I think the First Bank transaction tells you there is a handful of exceptionally profitable superregionals with a huge appetite for transactions. Absolutely, last September's change in legislation capitalizing the SAIF fund will rapidly cause the consolidation of banks and thrifts.

Whether acquisition prices are too high is a complex discussion. You've got to remember that with the stocks at all-time highs, companies are trading their three-times-book dog for somebody else's three-times-book cat. As long as the acquirer can prove that there is accretion to earnings per share, the marketplace appears ready to accept these transactions.

BERMAN: When I look at the First Bank-U.S. Bancorp deal, it reminds me a lot of all those deals that Banc One did. Certainly, the expense saves are an important part of the U.S. Bancorp transaction. But I think at least as important a part is the high price of First Bank's paper going in.

We don't have a lot of guys like that around, and so I suspect we're not going to see many more transactions at these kinds of prices. Our view has been that, on the one hand, the economics of consolidation are overwhelming and have to occur. On the other hand, I'm not at all convinced that this is the time.

COHN: There really haven't been that many large transactions in the last couple of years, and we don't see a big rush for bigger transactions. On the other hand, the small deals happen all the time and we expect them to continue. The industry's intentions in terms of expanding into investment banking are already pretty clear. Whether we get legislative change or not, it's obviously happening.

BERMAN: But don't you think it's build versus buy?

COHN: I think the industry is really reluctant to buy. Cultural differences are very, very hard to overcome and managements say they really would prefer to build internally. On the other hand, they also say that if one of their competitors were to make a major acquisition, that might change the competitive landscape.

I think banks are making enough progress in the investment banking business now, that they don't feel really compelled to do something dramatic like a major acquisition.

I certainly feel that's true at Chase, Morgan, and Bankers Trust. BankAmerica is the one major bank that hasn't made really substantial progress in that area. And of course with the exception of J.P. Morgan, nobody has really made much progress on the equity side. That clearly has to come.

But when I talk with senior managements, away from large crowds, I've found their distaste for buying is more a matter of price than anything else. A lot of them say they're just not going to pay top dollar at the peak of a bull market to buy an investment bank.

I think the situation might change if the market rolls over and profits on the Street come down. They may be hoping to pick somebody off at a much more reasonable price later in the cycle.

MURRAY: Over the next two years, I think it's highly unlikely that banks will buy investment banks. And I think the decision to build, rather than buy, is the correct one.

But over a three- to five-year time horizon, it's going to be imperative that all major banks with a middle market or a large corporate customer base have well-developed capital markets capabilities. So boosting capital markets capabilities becomes an increasingly important strategic decision for the big banks.

What do you think earnings are going to look like? And how do stock repurchases figure in the picture?

COHN: I think this is going to be a reasonably good quarter, but we're starting to see important differences of opinion on how to go forward with stock buybacks.

There's a class of companies that have essentially said they're going to buy back stock, come hell or high water. On the other hand, there are companies with a more rigorous view of the world, that look at the return they're receiving on the stock they're buying in. As those returns come down, with prices going up, they're increasingly less willing to buy in stock.

STIEVEN: I think the vast majority of institutions will be using share repurchases on an annual basis, going forward. Capital ratios are now at all-time highs, and many companies have recently done trust-preferred issues, which is by far the cheapest form of capital I've ever seen.

When you can get Tier 1 capital with an after-tax cost somewhere in the 5% to 6% range, that's the best capital you can ever get.

In general, most companies now believe that they have to use some form of capital management, which we think is positive. If you've got companies returning 17% on equity while paying out a third of net income as dividends, it means they have an internal capital generation rate of 11%- plus. It follows that if your core business is only growing by 7% or 8% (annually), you're going to be building up excess capital quickly.

We think shares repurchases are one of the best ways to deploy that capital, because there's such a low amount of risk involved. You're acquiring your own company stock. And if you don't know your own company, you're in trouble.

BERMAN: I think buybacks are going to continue. But as Larry said, it's going to be a less powerful factor because the higher prices of the shares have less impact. What's interesting is that there are some companies, Citicorp, Wells Fargo, Chase Manhattan, for example, where this is a capital management tool, and they're buying it back irrespective of the share price.

COHN: And I just object to the idea that price doesn't matter. I think if any of us went to our customers and told them that they should buy stock no matter what the price, we'd be thrown out on our ear. But you hear the banks telling us that that, in fact, is their intention.

MURRAY: I expect excess capital to continue to mount for several years to come. Returning that excess capital to shareholders, will be a phenomenon that continues. In my view, this scenario is very positive for the bank stocks.

COHN: I agree, but you don't have to do it by buying in your stock. You can always give them cash.

STIEVEN: But why would an investor want cash and get taxed on it?

COHN: Well, if the risk-free rate of return in the market place is seven, have I done my shareholders a good turn by investing their money at five, instead of giving them the opportunity to invest at seven?

STIEVEN: Okay, that's for untaxed investors.

COHN: But every shareholder has his alternate return potential. You could argue that instead of looking at the risk-free return, you should look at the long-run returns on the stock market.

What I'm saying, Joe, is that there's a price at which it counts. And some managements tell us they're going to buy, no matter what.

STIEVEN: Oh, I agree with that point. However, I'd much rather have the institution repurchasing their own shares with this excess capital. In the vast majority of cases, it proves accretive to earnings per share.

Larry, are you talking about the banks possibly raising their regular quarterly dividends or declaring special dividends?

COHN: I don't think it ought to matter.

I started in this business in the days when most banks had very high payout ratios (the percentage of profits paid out as dividends).

The banking industry struggled from the 1970s onward to get those payout ratios down. I'm sure that most people running banks now remember vividly how difficult it was to cope with those high pay-outs and don't want to get themselves locked into the same situation again.

So, of course, nobody in banking wants to cut their dividends. Historically, the implications of making dividend cuts have been so adverse to banks that managements just don't want to face that.

But that doesn't mean that can't change, right? If the industry is truly going to have some discipline, then in fact, the dividends ought to wax and wane over the (business) cycle. After all, the auto industry moves its dividends up and down with the cycle all the time.

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