Sometimes a fresh set of eyes provides the quickest way to get where you want to go. Shares of Darde...
It's a wonderful bank
07/27/2010 8:30 am EST
Bank earnings to date—from the biggest and most aggressive investment banks such as Goldman Sachs (GS) to the do-everything behemoths such as JPMorgan Chase (JPM) to the lending-oriented banks such as US Bancorp (USB) to the specialist banks—don’t give a single definitive answer. It’s hard to tell if the old models are in need of serious overhaul or just taking a breather, and there are serious doubts about the future profitability of many classic banking activities.
And I think that’s healthy—even if it makes life hard for investors. The clear consensus on what a bank should be if it wanted to maximize growth and profits was, it turns out, one of the great weaknesses of the banking system before the financial crisis. Too many banks had decided to be the same kind of bank. And that left the industry as a whole exceedingly vulnerable to disruption and failure.
For the moment at least, investors are free again to look for the best bank among many styles of bank—rather than seeing which bank matches up best with a single model for success.
Here’s how the landscape looks to me right now and the names of some interesting banks—of different models.
Before the financial crisis bank CEOs thought they had a very clear answer to what the best bank would be like. They wouldn’t worry too much about building a big base of depositors since it was easy to raise all the money a bank needed to finance its lending and other activities in the financial markets. They’d build trading desks that traded for clients, of course, but that also put the bank’s own capital at risk in proprietary trades. And they’d work to build up investment banking activities ranging from underwriting stock and bond offerings to selling packages of securitized mortgages, credit card receipts, and car loans to complex derivatives that let clients bet on the direction of financial markets or let them hedge the risk of complicated trading strategies.
The bank these CEOs had in mind was about as far from Frank Capra’s Bailey Savings and Loan in It’s a Wonderful Life as possible.
But the financial crisis took some of the edge off that model.
For one thing, it demonstrated that the banks built on that model had put everything in one basket. They needed functioning financial markets not just to raise new capital but to roll over the existing debt that provided current capital. Gains from trading for a bank’s own account were dependent on being able to figure out the direction of the markets and revenue from trading for clients’ accounts were dependent on the willingness of those clients to be in the markets at all.
The model left banks with strikingly few alternatives in a crisis. At the end of It’s a Wonderful Life the savings and loan’s depositors ride to George Bailey’s rescue. In this crisis banks built around this model had no one to turn to but governments and reluctant taxpayers.
The investment bank/trading model isn’t dead but in the United States it faces huge challenges.
It’s not clear how damaged this model is. In the first quarter of 2010 it looked like it was back on top: trading and investment banking revenues soared—while revenue from commercial and consumer lending was still drowning in a sea of bad loans. In the just completed second quarter trading and investment banking revenue fell. The infallible traders of the first quarter turned out to be no better than the average investor at making a profit in a volatile and unpredictable market. Even the banks, such as Morgan Stanley (MS) that looked like they’d had successful trading quarters wound up making a good part of their trading revenue out of accounting gimmicks based on the price of their own debt.
But the biggest long-term threat to the trading and investment banking model as adopted by U.S. banks comes from the shift in global finance toward the world’s developing financial markets. The biggest stock offerings of 2010, for example, haven’t been in New York or London but in Sao Paulo, Hong Kong, and Shanghai. The big U.S.-based, pre-crisis powers such as Morgan Stanley haven’t been shut out of these deals, but they’ve had to share them with “local” banks such as HSBC (HBC) in Hong Kong and Itau Unibanco (ITUB) in Sao Paulo. Brazil’s Itau Unibanco, for example, climbed past Goldman Sachs in 2009 to become the fourth largest underwriter of overseas bond sales for Brazilian companies.
This global shift in what I’d call not financial power but instead financial weight puts the big U.S. banks who had adopted the investment banking/trading model at a disadvantage in two other ways. First, as a result of the financial crisis, many of the U.S. banks that had built up the biggest overseas networks of offices and contacts either sold off those units completely or scaled them back. And second, many of the U.S. banks built on the investment banking/trading model now can’t match the deposit gathering power of either big—Banco Santander (STD) and HSBC—or smaller—India’s HDFC Bank (HDB)—overseas banks.
Once the banks built on the investment bank/trading model have their bounce—and some of them clearly have—investors need to recognize that the U.S. banks that adopted this model face some of the toughest challenges in the banking sector. My favorite banks built on this model are, in fact, not U.S. banks. I much prefer overseas banks such as Itau Unibanco, HSBC, and Banco Santander.
In the middle-term, at least, U.S. banks still built on a more traditional mix of lending and deposit-taking present more opportunities for investors.
You could see that in the regional bank earnings announced on July 22 and in the earnings announced the day before by US Bancorp (USB), which has emerged as the fourth largest U.S. bank during the crisis.
These banks lagged the investment bank/trading banks in 2009 and in the first quarter of 2010 since the investment bank/trading banks saw a recovery in revenues from those areas well before the lending oriented banks saw any improvement in either bad loans or loan volume.
Now it looks like the roles are reversed. Trading revenue has faltered just as loan portfolios have started to improve.
PNC Financial (PNC), for example, reported earnings per share of $1.47 for the second quarter. That was 19 cents a share above the Wall Street consensus. Revenue climbed almost 3% from the second quarter of 2009. That beat projections of $3.78 billion by 3.4%.
The big story was the stabilization in the bank’s loan portfolios. Nonperforming assets fell by $465 million in the quarter. There’s still quite a way to go: The bank finished the quarter with $6.1 billion in nonperforming assets
Change the names and the story was the same at Fifth Third (FITB) and KeyCorp (KEY). Fifth Third reported its first profit since the fourth quarter of 2007 as non-performing loans fell by 8% from the first quarter. Keycorp reported its first profit in more than two years. Nonperforming loans fell by $362 million in the quarter.
My two favorite banks in this part of the industry are US Bancorp, which reported earnings on July 21 (For the details see my post http://jubakpicks.com/2010/07/22/update-us-bancorp-usb/), and Wilmington Trust (WL). Wilmington Trust is still very risky—its recovery seems to be lagging some similarly constructed banks but the bank’s July 23 earnings report definitely showed signs that it was catching up.
The best U.S. opportunities for investors, though, may lie with specialty banks, particularly small specialty banks in very wealthy communities.
So why do I like US Bancorp and Wilmington Trust among all the banks that still follow a traditional mix of lending and deposit gathering?
Because they’ve built up big fee-based wealth management businesses, and as the country ages that’s a piece of the banking industry that will become increasingly profitable.
But if you really want exposure to this revenue and profit stream you need to look at smaller banks where wealth management is a bigger part of revenue.
Bank of Marin Bancorp (BMRC), for example, reported second quarter earnings of $3.3 million, up 6.5% from the second quarter of 2009. Non-interest income—what the bank earns on its for fee businesses—however, did somewhat better than the bank as a whole. Non-interest income grew by 18.2% from the second quarter of 2009 to a total of $1.5 million. Non-interest income equaled 45% of the bank’s total income for the quarter. The biggest contributors to that growth came from higher merchant interchange income and higher wealth management service fees, the bank said in its earnings announcement.
If that kind of banking model tickles your investing bone, take a look at Bryn Mawr Bank (BMTC). Assets under management on June 30, 2010 in the bank’s wealth management division rose to $3.1 billion, up 37% from June 30, 2009. Revenue from that division climbed almost 8% from the second quarter of 2009.
You can invest in any of these three models or concentrate in just one of them. I think the stocks of the traditional lending/deposit-gathering banks are the most timely, the stocks of the big investment banking/trading the most volatile, and the stocks of the wealth management specialty banks least risky in the long run.
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