Commercial loan portfolios have stopped shrinking and commercial credit quality continues to improve, reaching what some bankers have called its best level in recent years. Consumers also continue to borrow, depsite a cooling off in the mortgage sector, though analysts say rising interest rates could crimp consumers' ability to service debt.
Meanwhile, with several big bank merger integrations underway this year, many are looking for the next big deal. Analysts at our quarterly bank stock roundtable talked about the trends.
The participants were Nancy Bush, the founder of NAB Research LLP in Annandale, N.J.; Jason Goldberg of Lehman Brothers; David Hendler of CreditSights; and Denis Laplante of Keefe, Bruyette & Woods.
NANCY BUSH: I think that "transitional quarters" are what we have to live with, at least until the interest rate scenario gets a bit more certain.
Banking trends simply reflect the uncertainty in the economy - and that looks like it's going to be there for a while longer.
The result - in this environment you get earnings wherever you can get them. One of the places is in the securities portfolio and in the releveraging of the balance sheet - and another place is in doing deals and hopefully getting cost saves from that activity.
But at some point we're going to have to stop saying this is "transitional" and start saying, "We've transitioned, and here is the new reality."
JASON GOLDBERG: For my coverage universe, the median bank witnessed 11% year-over-year and 10% linked-quarter annualized [earnings-per-share] growth - a tad ahead of expectations, as roughly two-thirds of my names beat consensus.
Still, growth was a bit slower than the prior quarter, and reserve releases and one-time gains did add 2 to 3 cents to the average bank's bottom line.
Commercial loan growth, which showed definite signs of improvement, was a bright spot, as 2Q marked the first improvement in C&I we have witnessed in 14 quarters. Consumer loan growth remained robust, and asset-quality metrics continued to improve. So, certainly: not all bad news.
BUSH: But if you look at where that commercial loan growth came from, it didn't come from the large-corporate sector. It came from the middle-market and small-business segment - and those are the sectors that are really closer to the consumer.
So if we see the consumer start to slow down his spending, I'm not at all sure that commercial growth continues either, while large corporate shows no signs whatsoever of coming back.
DAVID HENDLER: We sense that the banks are generating frictional loan growth, or the bare minimum, for the most part. It's more than we saw last year or in the previous quarter, but we believe that its nothing to write home about either.
And after recently polling some of the big banks, there's no definitive sentiment that it's going to be coming back strong in the next couple of quarters or so.
So we believe that the major business function in the banking industry is more on asset-liability management than commercial lending. "Deposit growth" is just a code word for asset-liability management, because these proceeds need to be adequately managed for growth as well as risk management purposes. If a bank cannot consistently - via asset-liability management - generate returns in a risk-adjusted way, it's going to be tough sledding for maybe the next 12 to 18 months.
We've already seen financial entities hit big asset-liability potholes and craters in the Washington Mutual case.
And how do you model for these earnings?
HENDLER: Granted, it's tough to model. But you can approximate the effect on earnings by reviewing a bank's track record along various yield-curve environments over the last five trailing quarters.
Basically, you can look at how aggressive they've been in different interest rate environments. Then you factor in specifics such as their concentrations to mortgage loans, mortgage-backed securities, derivatives, and how that affects their revenue and expense lines on a prospective basis.
DENIS LAPLANTE: If you look at the second-quarter numbers, they were actually pretty decent. Credit trends were very positive.
Commercial credit costs are probably approaching a bottom, although we could bounce around these levels for several more quarters.
Several companies actually reported net recoveries. We will probably reach a point sometime in 2005 where commercial credit losses will bottom out and consumer credit quality will start to weaken.
BUSH: Consumers are in good shape, but ... those credit card and home equity vintages of 18 to 24 months ago are starting to age now. Credit ratios may continue to get better at the same time that provisions have to begin to rise.
LAPLANTE: Indeed, in Bank of America's case I have higher provision costs next year to take into account the relatively rapid growth in card receivables over the past two years. They have grown faster than the monoline card issuers.
So your point's right, Nancy, but I still don't see a significant deterioration in consumer credit, for the moment. However, because the consumer did not deleverage in this economic cycle, higher interest rates may put pressure on borrowers' ability to repay, and we will eventually see higher losses sometime later in 2005 or early 2006.
BUSH: We all have taken great comfort in the fact that four-fifths of new mortgages are fixed-rate debt.
Well, you know, if you can't service debt, you can't service it, and it doesn't matter whether it's fixed-rate or variable-rate. I'm very concerned that many of these mortgages were underwritten to very thin standards and with underlying assumptions about consumer cash flows that may prove to be inadequate in a time when many consumer costs - like energy and health care - are rising rapidly.
HENDLER: We think that FICO scores, the key consumer credit underwriting criteria for most banks, can be misleading. Many banks quote consumer portfolios with FICO scores in the low- to mid-700s. We sense that FICO scores are not as potent a definition of conservative underwriting as they used to be.
The scores have been tweaked over the years and even in the last month or so. For instance, FICO came out with a new type of alternative score for renters and people who just have telephone-bill payments to prove their creditworthiness, in an effort to help qualify more people without access to traditional channels for more consumer credit.
So with more consumer credit being loaned out at really more average credit scores, we believe that we will start to see more pressure on consumer credit than even the during last cycle or so.
How far along are J.P. Morgan Chase & Co. and Bank of America Corp. with their respective mergers?
LAPLANTE: It's too early to evaluate the Bank of America-Fleet integration, because the hard work hasn't started yet.
We're starting to see some signage changes, but the major systems conversions are really scheduled in the early part of next year.
We will be watching for account growth and customer attrition numbers at that time. Management claims they're on track and are maybe a little ahead of plan in getting the costs out.
GOLDBERG: On a positive note, you did see actually a nice acceleration in terms of net new checking and saving accounts coming from the Fleet franchise in the second quarter. Although, to Denis' point, they still have a ways to go.
The Boston newspapers also continue to make a lot of noise with respect to layoffs and the like.
HENDLER: With regard to the JPMorgan-Bank One merger, it has an integration advantage, since COO Jamie Dimon has a history of delivering these savings from his involvement in past financial-company deals with Travelers and Bank One.
And I think for JPMorgan the merger integration is going to be another major [earnings] driver for '05, and some of it more into '06. ... The stock and bond markets are expecting these savings, and they will receive it well when the results follow through.
GOLDBERG: Jamie's one of the few executives who can get on a conference call after earnings and say, "Despite expecting merger savings to be higher some analysts expectations are still too high", and have the stock outperform.
BUSH: It's deja vu all over again; it's so much like the re-formation of Bank One it's almost scary. Mr. Dimon and company are very far advanced in planning, and they are marching along on execution.
As to the Fleet-Bank of America deal - I just visited B of A in Charlotte, and they're quite pumped about how well the deal integration is going. I'm increasingly hearing people in Boston talk about positive changes at their local branches. I think that it's quite remarkable that they've been able to do this so quickly, particularly in the old Fleet culture - where service was NOT an established concept.
LAPLANTE: Well, the good news for Bank of America is that the cultural change started for FleetBoston a couple of years ago, prior to the acquisition.
Do you get the sense that banks are done with restructuring their balance sheets for rising interest rates? For now the yield curve's flattening. Is that as a challenge for asset-liability management?
GOLDBERG: Banks can withstand some flattening of the yield curve, in part given how steep it is relative to the past. Still, if we get back to the 1998-2000 scenario of a flat-to-inverted yield curve, it becomes much more problematic.
In my view, the two most important areas to watch as the short end backs up is which banks have the ability to retain and continue to grow their core deposit bases and, secondly, how those who have piled on fixed-rate mortgage-backed securities whose duration extends perform.
HENDLER: Asset-liability management is pretty much the name of the game for the next, I would say, 12 to 18 months. As the yield curve flattens, some banks get some gains in securities and swap books. But as gains are harvested, it is bound to adversely impact future earnings capability, unless that commercial loan cycle kicks in again.
Regarding the practice of asset-liability management, Bank of America has been savvier on that front. They have demonstrated that they can rework their strategy and pretty much turn on a dime. This is what they did going into the first and second quarters. They showed tremendous gains in the securities books and repositioned their derivatives book.
Wachovia and JPMorgan really picked up their contribution from discretionary portfolio trades, where they use securities and derivatives to augment earnings. Wachovia has a core earnings base to fall back on, although not as strong as B of A's. JPMorgan will be rebuilding that core earnings base under COO Dimon's stewardship.
LAPLANTE: Banks will make more money in a rising-rate environment. A major factor why we have had cyclical lows in net interest margins is due to low short-term rates.
It has hurt the spread that banks get on their free funds, namely equity capital and demand deposits. These free funds will be worth more as short-term rates increase, and banks will see spreads widen in that environment.
So I'm looking for margins to improve next year. In the short run, I think we're going to see a little more margin weakness in the third quarter; we'll start to see some stabilization of margins in the fourth quarter.
BUSH: But I think you also have to be aware, though, that this is really just the beginning of the rise, and the increases thus far really have not been all that significant.
I hope the market is just ready for the true transitional quarter - the one when the rate environment really shifts a bit more dramatically and the impacts really begin to be felt. That quarter has probably been pushed off into 2005, and perhaps late in 2005, at this point.
What do you think the appropriate level of provisioning is, and when is it time to actually increase provision levels?
BUSH: I don't look at a provision level versus chargeoffs and say, "Gee, that was too much" or "That was too little." It's "How did the loan-loss provision relate to earnings?"
The provision must be looked at in relation to loan losses and reserve levels and whether resulting releases of the loan-loss reserve have been a significant factor in a company's earnings growth.
GOLDBERG: It's what the reserve level is, and that's in large part indicative of what's in your loan portfolio. Obviously, an unsecured credit card loan should have a higher reserve against it than a first mortgage, which is secured by a house.
One of the reasons we have not seen C&I growth is because corporate cash flows have been robust in light of the improving economy. This tends to cure NPAs and has also helped lead to a reduction in reserve levels.
But to Nancy's point: It is an unsustainable source of earnings growth that these banks have relied on. If my coverage universe kept its reserve/loan ratio stable in 2Q '04 relative to 2Q '03, year-over-year EPS growth would have been 3%, not 11%.
And to the extent commercial loan growth does pick up robustly, you're going to have to build reserves to cover potential losses.
LAPLANTE: Part of the reserve releases we're seeing is pressure from the accountants, which is really driven by pressures from the SEC.
I think if the SEC had its way they would do away with reserves altogether and go to an experience method whereby provisions would just be equal to net chargeoffs. I think it would be the wrong thing to do, because bank regulators want to be able to segregate reserves and capital.
HENDLER: If you look at the top 10 banks, they're about 200% reserved for nonperforming assets, which is historically high. In general, we believe that the banking industry is becoming more thrift-like, with all this emphasis on different types of collateralized mortgage lending.
So from this basis you can make a case that banks are way overreserved, since mortgage-type loans usually require less reserves and due to the low loan growth. Banks have not really cranked out new loans over the last five years, and the late-1990s credit burnout has pretty much run its course.
So we can see underprovisioning and reserve releases continuing to bolster bank bottom lines.
Looking back at the deposit boom of the past couple of years, did all banks do as well as they should have, or do you think some have fallen behind?
LAPLANTE: I would address it more broadly: "Who's doing a better job in retail banking?"
Wells Fargo has probably been the most consistent retail bank over the past decade, although we think Bank of America and Wachovia have probably improved the most over the past five years. They have both have put more resources into the business and are much more focused on customer service than they were.
BUSH: I agree with Denis' point. You can't just look at the deposit number or deposit growth trends. You have to look at actually what's going on in the retail culture of a company and what's going in the branches from a sales and service perspective.
One bank that has struggled with deposit growth and with reshaping the whole branch culture that I think has finally turned the corner … is U.S. Bancorp.
They've had residual issues from the old USB since Jerry Grundhofer took over the role of CEO in the deal, and Richard Davis really started to pound on the retail branch structure and culture very early on in the integration process. They're finally beginning to show some improvements in their deposit numbers and in their other branch metrics. But it has been a long and sometimes frustrating struggle to get there.
Merger and acquisition activity among larger banks has slowed somewhat. Will this be permanent, or is it just a summer thing?
GOLDBERG: Maybe it takes a summer breather. Maybe companies wait to either get more clarity on how fast interest rates are headed higher or more clarity on the economy, given that the data has been uneven over the last several months. But we believe consolidation is secular trend.
LAPLANTE: The pace of deals has slowed from the beginning of the year, but we're not going to see deal flow evaporate altogether.
GOLDBERG: If you exclude Fleet and Bank One, the megadeals, and look at the other sellers - whether it's Charter One, GreenPoint, National Commerce, Provident, Union Planners, or SouthTrust - all had either above-average exposure to mortgage-backed securities or mortgage banking or both.
One has to wonder, did those CEOs look out and see rates up 200 or 300 basis points and didn't like what they saw? And if that is the case, they're probably not the only ones.
BUSH: We've got several banks in the industry that are hanging on but that obviously have got some major revenue challenges, and you have got to wonder how they're going to continue to justify their independence to the world.
The names are well known - Huntington Bancshares immediately comes to mind - but there are others.
HENDLER: There are some banks that have takeover desires as targets but little regional appeal. For instance, Huntington has a good deposit footprint, but they are pretty much stuck in low-loan-growth Ohio, thus lowering their appeal.
More likely we could see maybe Citigroup trying to boost its presence in the New Jersey suburbs, possibly looking at PNC. That may be conditioned on whether a Citigroup-Wamu deal happens fast or happens at all.
And Wells Fargo has a high P/E valuation, which is a strength that may make them reconsider the takeover trail. A similar case can be made for U.S. Bancorp, which also has a higher P/E valuation and improving ratings. Being that its regions are slow-to-no loan growth, they may be more willing to use their strength to penetrate the East or Southeast.
What stock would you recommend investors not to buy?
HENDLER: Our only negative, because it's high-valuation and we think they're just too mortgage- and mortgage-banking-oriented, is Wells Fargo. We think a lot of the cross-sells are into the mortgage area, and they have to start developing a credit card business that's sizable.
Their capital markets business also needs to be sized higher, even though they've been much more cautious here. I think there's deal risk with them as a buyer.
We're neutral on Citigroup. At this point we believe that their global exposures are more of a brake on results than a catalyst, because the rest of the world's growth is fairly sluggish.
Also, we continue to be somewhat wary of more legal risk related to Enron.
GOLDBERG: Generally speaking our midcap bank universe's valuations appear to reflect more than their operating potential in this consolidating industry, particularly for those names that either have above-average exposure to mortgage-backed securities or haven't differentiated themselves in the market place.
We'd keep an eye on names like AmSouth, BB&T, or Regions.
LAPLANTE: In the large-cap space I would add KeyCorp. The valuation is a little above average, although I think the earnings growth is going to be a little below average.
In addition, the quality of earnings has not been particularly good. Henry Meyer and his team have done a better job, but the competition has raised the performance bar, so on a relative basis they have not made up ground.
BUSH: I agree with Denis on KeyCorp.
The other one is National City. Declining earnings are not a good thing, and earnings there will be coming down in 2005.
And I strongly believe that their emphasis on subprime mortgage is really going to come back to bite them.
