Members of American Banker's Analyst Roundtable said they were stunned by the sudden decline in bank stocks in the third quarter, and that the effects of the international economic crisis would continue to be felt into next year.
Still, Richard X. Bove of Raymond James & Associates, David Berry of Keefe, Bruyette & Woods Inc., James Schmidt of John Hancock Advisers Inc., and Nancy Bush of Ryan, Beck & Co. each said there are some good stock buys.
What's the damage to banks of the emerging-market crises?
BERRY: There's a lot of damage in money-center land. And the shortfalls are pretty well advertised. We're seeing direct credit losses, losses on hedge funds doing business in Russia. Much more significantly we're seeing a very adverse trading environment, particularly for those businesses that suffer when fixed-income securities are doing poorly.
And then as much as that, it is the disappearance of revenues from corporate finance related activities and equity investment related activities.
Away from these headline issues, out in the regional banking land, I would say the outlook is a little dimmer than it was. But the typical regional bank is not involved in emerging markets, does not do underwriting for a living, and probably does not lend to hedge funds. These headline issues don't apply to most of the banks.
SCHMIDT: The good thing about the cuts in the money-center bank earnings is hopefully it's not a recurring sort of thing. These are events that are supposedly one of a kind, and probably they'll end up being two of a kind in the fourth quarter. But after that maybe not a lot more, as far as chargeoffs relating to the Far East and to Russia at least. So I think the money-centers won't be as bad going forward.
In the case of the regionals, it's possible that it could be a little more of a permanent slowing in the growth outlook. It's not radical, but loans seem to be growing a little more slowly. And my guess is most analysts for 1999 have loan growth estimates that are too high incorporated into their models.
BUSH: One thing I have heard in talking to companies is that there has been just the glimmer of core deposit growth, perhaps as a result of the fallout from the capital markets. Maybe consumers are beginning to flee the capital markets and leaving some liquid funds in the banks.
It looks like consumer credit quality, particularly with the card companies, is actually going to get better - and noticeably better.
Since July bank stocks have underperformed other sectors. Is this a trend that will continue?
BUSH: I think we're going to see soft comparisons through '99, or through at least the first half of '99, depending on how earnings turn out. But for us to believe that things would've stayed as they were in the second quarter would have been naive in the extreme. It was indeed the best of all possible worlds for most of these companies.
BOVE: The real issue now is, When do we start going back to buying? Because basically, it seems to me, you could take a template from 1973 to 1993 of what occurred in Latin America and place it on, let's say, 1983 to the year 2003 in Asia, and you would find that all the guideposts are there. Everything that you needed to know has already happened.
Based upon those guideposts, you are now in the panic phase related to what occurred in Asia, as 1989-91 was the panic phase in Latin America. And what you'll see is massive reliquefication of the system. You'll see huge drops in interests rates, maybe a 100-basis-point drop. I still think there'll be a recession in 1999.
So that I think we are getting very close to the turn, but I don't think anybody will be looking at earnings or the recession when they make the decision to buy these stocks, because when they make the decision to buy these stocks, earnings will be going down. And we might be in a recession.
BERRY: Just to follow on that, I see this sense of fear and panic that's out there. I've spent a lot of my time in the last few weeks responding to questions that boil down to "How much exposure does the bank have to X?" And X could be a country, it could be an industry, it could be hedge funds- whatever the "panic du jour" is.
I am struck by the fact that some of our investors and clients don't necessarily seem to understand the information that they are given. I had to explain to someone today how a repo agreement works, that the bank has possession of the collateral.
If you think about the hedge fund disclosures we've gotten recently, I think you'd be hard-pressed to see how credit losses of any magnitude could come out of this. And I've got a pretty gloomy view about the lifespan of a lot of hedge funds in the current environment. It's a very emotional environment.
BUSH: We also have to keep in mind that 1990 was not that long ago. And the banks have not historically acquitted themselves well in these periods of prosperity. They have tended to set up the seeds of their own destruction. And they've proven incredibly stupid about it in some regards. Some companies just keep making the same mistakes.
But having lived through that period of 1990, this one just feels very different. The perception, I think is the same, but the reality is very different.
SCHMIDT: As bad as things were in 1990, I don't think I recall the stocks going down as sharply, as quickly at any one point during the year. It just kind of was a continual erosion.
In past bear markets in bank stocks-the real estate problems in 1990, the oil related problems in the early '80s, and some of the problems that the agricultural lenders had before that-you always had the luxury of seeing things happen in the economy first. And then later on banks acknowledged problems relating to these economic developments, and then the stocks went down. You could wait to see some of the credits actually fall apart before the worst hit the stocks. And you still could get out with most of your money.
So this is kind of confounding.
Given the irrationality in the market, how do you decide when to get back in?
BOVE: We've set up a series of indicators based upon shifts in the values of bonds. And those indicators have proven to be extraordinarily good. If you take the spread between the 10-year Treasury and what I'll call junk and you do a regression of that spread against multiples on bank stocks, you'll see that it's a pretty good indicator of what is going to happen to bank stocks.
In 1990 that spread went up to about 800 basis points and bank multiples were at three times earnings. In the middle of the 1990s that spread came down to 300 to 350 basis points and bank stocks were selling at 80% of the market and in some cases at market multiples because of the takeover binge.
In January of this year that spread had shifted to 387, which meant that problems were coming. By Aug. 15, it was at 400 and bank stocks had underperformed the market all through 1998 as that spread was gradually widening. Then on Aug. 15 to the present time it just collapsed. I think it's about 675 basis points right now. And until that spread comes in, I wouldn't touch a bank stock for any reason whatsoever.
When that spread starts to contract, it will indicate two things: One, that there is increasing liquidity in the financial markets. And two, that there's an increasing degree of confidence in financial assets. When that happens then we'll go in and start buying bank stocks again.
Do the Federal Reserve's rate cuts make any difference at all on that spread?
BOVE: I think that what the Fed has done were the first two of what will be four or five steps to get rates down maybe 100 basis points on the short end. But the Fed is starting to panic, which is exactly what we want to see. Because when they panic, and the central bankers around the world panic a little bit, they will flood the area with cash, my spread should come in, and I think the time will come to buy the stocks.
How will banks respond if the economy slows down?
BERRY: The natural response the bankers will have is to readdress the cost side of the equation.
There were some major banks earlier this year who announced restructuring programs, and the benefits so derived were going to be reinvested in growth businesses. I think we're in a world now where we might just let those savings drop to the bottom line.
And whatever euphemism they like to use-curtail pace, pace spending, which I think is language for stopping - I think we are about to see some significant layoffs for the first time in a while.
On credit, I think if you slow the economy down, what you will do is just create an environment where the popcorn keeps popping. You know every time a loan goes problematic, goes problem status, it will always be characterized as "unusual." In a slower-growth environment, you're going to expose more of those "unusual" credits that go bad than you would in a high-growth environment.
I do think, in terms of lessons learned from last time, there is a very different profile in terms of concentrations of risk in the system today.
SCHMIDT: Of course the credit problem to hit you is always something that comes out of the woodwork. The risk management systems always address the last credit problem.
BUSH: Well I think there's an interesting example. BankBoston, for example, has always been so careful in Latin America and has been profitable through all cycles in Latin America. Where do they have problems? They have them in Boston on the emerging-markets desk, not in Buenos Aires.
Is the merger market going to revive?
SCHMIDT: The knee-jerk reaction is, "Well, gee, the stocks are down so the buying companies don't have as much power for acquisitions." But I'm not sure that theory holds water because the target stocks are down too. Nearly all bank stocks have gone down in this decline. And in many cases the arithmetic has actually improved. It's actually easier for some of the superregionals to buy midsize or smaller regionals now than it might have been two months ago.
What we're seeing relates first of all to the turmoil in the market, which just kind of makes everyone freeze. And you're less likely to do something when you feel you don't know what your stock is going to do next or you're not confident about the economy.
Second, there's sort of an inverse sticker shock. If one bank in town sells for a certain multiple, you figure you should get the same price plus 10%.
It takes a period of readjustment to these lower prices.
BERRY: The forces that favor consolidation are still with us, and the slower revenue environment that we described would underline the need for further consolidation. Once buyers and sellers adjust to the new price level - or maybe they've got to wait for the calendar to turn over in the year 2000 - I think you're going to see a tremendous number of deals done.
But if the pace of deal activity slows down, we're going to be getting past that magical SEC-inspired six-month moratorium on share repurchase after deals close. I would think that as you get to springtime next year, you'd see an awful lot of share repurchase capacity come back into the system.
BOVE: And if we have a recession next year no one's going to buy back stock. The Federal Reserve won't let them. When you go into a recessionary environment, the Fed acts in what one might argue is an irrational fashion because banks pull down reserves in good times and build reserves in bad times. Which obviates the whole meaning of the word "reserves."
What stocks do you like?
BOVE: First Tennessee's mortgage business is zooming because refinancing is giving tremendous opportunities in that sector. And because interest rates are shifting so dramatically, and most banks want to be interest rate neutral, its bond business, which is basically balancing the balance sheet of smaller banks, is doing extraordinarily well.
SunTrust is the other one that I'm strongly recommending. But those are the only two banks.
What we're pushing right now is Fannie Mae and Freddie Mac. The world has come to Fannie Mae and Freddie Mac. There aren't any two better investments on the New York Stock Exchange, period, than those two companies, because there was something like $2.1 trillion worth of mortgages which are likely to be refinanced over the next few years. The capacity of the industry to refinance is about $700 billion a year. So you've got a three-year backlog.
BERRY: First Union Corp. To us, always a very well-regarded bank. The concern has always been about the next deal, and deal risk is pretty low in this environment. The bill is pretty inexpensive to us.
I think the environment is quite attractive for the monoline credit card companies, and we like Capital One Financial quite a lot. It is virtually inconceivable that the company could only earn the estimate that we have posted for them for next year. Consumer credit is improving. Revenue momentum is quite high. And the company's marketing spending is going through the roof.
SCHMIDT: I like the midsize regional banks, say $20 to $30 billion of assets, in what I think of as battleground states-states where there's no dominant superregional bank yet and wide open for their superregional banks to try and gain share. I'll go with First American in Tennessee. And in Alabama I'll take Regions Financial Corp.
Then we have a lot of small-cap names in our funds. Two I've selected as being timely are First Merchants of Muncie, Ind., and Cascade Bancorp in Bend, Ore.
One other type of stock that I think is interesting is small-cap savings and loans. In any industry you want to pick, the small companies tend to have done very poorly compared to some of the S&P names. Boston Federal has just kind of drifted lower, on no particular news. It's headquartered just north of Boston in an area that's doing very well economically. And it's an example of one of a whole bunch of thrifts now that I think are selling below liquidation value.
BUSH: We've been very high on Northern Trust. High-wealth individuals who've been managing their own money are going to find it harder to do. And Northern is in the best position to garner that business.
We've also been looking at Bank of New York and Wilmington Trust as very high quality and cheap companies. Mercantile Bankshares down in Baltimore and Commerce Bancorp in New Jersey are some others.
I like Fleet Financial. I think that more than anybody else in the business (Fleet chairman) Terry Murray is absolutely allergic to credit quality surprises. And I think Quick & Reilly's going to do well through this period of volatility.
And if you like consumer credit and you like credit cards, you have to like Bank One Corp. It's a stock that's been demoralized and kicked around for some time now.