Let's see how the Banking Sector is making out with the
credit concerns in the economy.
A REVIEW OF WHERE WE STAND ON THE BANK SECTOR--OWN THE FEW BANKS THAT ARE
LEVERAGED TO A RECOVERY AND AVOID MOST OF THE REST
We have been indicating in our recent Weeklies that we believe investors
should own the stocks of companies which have the most earnings leverage to
an economic and capital markets recovery.
To some extent, we believe investors have been buying banks in anticipation
of significant earnings leverage to a recovery--bank stocks have risen 7% in
the last month (and have outperformed the market in 5 of the last 7 weeks).
But, as we noted in our Weekly dated October 26, earnings at most banks will
only benefit by a modest amount when the environment improves--and that it is
extremely important to differentiate among the banks. For example, we
estimated that there was 40% upside to Bank One's earnings in a recovery, but
just 2-4% at most of the more traditional regional banks. And in our Weekly
dated November 19, we noted that we believe risk in most of the traditional
bank stocks was rising--implying that investors should avoid most of these
names. Below, we summarize how we believe investors should be positioned
within the bank sector, which banks have the most earnings leverage to a
recovery, and what the risks are to the more traditional banks.
Buy banks with lots of earnings leverage...As we noted above, and in several
of our recent Weeklies, we believe investors should own stocks of banks which
have the most earnings leverage to rebound in the economy and capital markets
environment. In our Oct 26th Weekly, we estimated upside to EPS in an
economic and capital markets recovery. Among the largest 30 banks, the
median increase in earnings was about 4% versus our current 2002 estimates--
but the divergence in earnings upside was quite large.
We estimated that
only ONE, JPM, BAC and FBF have more than 10% EPS upside, while most banks
likely have only 2-4% upside. As expected, banks with the biggest upside
were the credit sensitives (i.e. those with the highest levels of credit
deterioration in 2001) and the market sensitives (companies with a high
percentage of earnings from capital markets-related businesses).
Companies which we estimate have the most earnings leverage to a recovery are
BAC and ONE (credit sensitive), BK, JPM and MEL (market sensitive), and FBF,
PNC, and WFC (both credit and market sensitive)--all of which we would be
comfortable adding to positions right now.
...and banks which consistently generate high-quality, high earnings growth.
Since there clearly is the risk that the economy will not rebound as quickly
as most expect (i.e. in 2Q/3Q02), we believe investors should also own banks
which consistently generate high-quality, high levels of earnings growth.
FITB, MTB, and TCB should all continue to produce high revenue and earnings
growth in 2002--likely greater than sector averages both economic scenarios.
Avoid most traditional bank stocks since we believe they'll lose earnings
momentum. Earnings at many of the traditional regional banks have benefited
this year from declining interest rates, widening loan spreads, strong
deposit growth, and improving deposit mixes (from higher-cost CDs to lower-
cost checking and money market accounts). These trends have resulted in high
net interest revenue growth despite low loan growth since net interest
margins have widened considerably. But since we believe net interest margins
may begin to decline, while credit costs continue to rise, we believe
fundamentals are likely to deteriorate at many of the regional banks
regardless of the economic scenario going forward (i.e. recovery or deeper
recession). Thus, we don't see any reason to own many of these bank stocks.
Below, we summarize what we view as the major risks for most of these
companies (also see Weekly, dated 11/19, for a more detailed analysis of
these issues).
* Net interest margins likely to decline--limiting revenue growth at many
regional banks. In our November 19 Weekly, we detailed why we expect net
interest margins to begin to decline at most banks in 1Q02. There are 4
main reasons we expect net interest margins to decline:
1. Less benefit of lower rates. There is likely to be less benefit
of lower interest rates due to likely less Fed easing and more asset
repricing than liability repricing.
2. Less benefit of deposit growth and mix change. Much of the NIM
widening this year has been driven by high deposit growth and favorable
deposit mix change. Even if these favorable trends continue, we believe this
will only modestly benefit the banks going forward.
3. Risk of deposit outflow or reversal of recent positive mix change.
One of our greatest fears is that the huge low-cost deposit inflow during
2001 that seems to be parked in the banking system will flow back out of
the banking system in 2002 or move bank to higher-cost deposits (i.e. CDs).
4. Risk of higher rates. When interest rates eventually do increase,
this will likely result in net interest margin compression at many banks
since funding costs will rise quicker than assets will reprice.
* Credit deterioration at regional banks may accelerate. While credit costs
have been rising at most banks, the largest increases have been at banks
with large amounts of large corporate and credit card exposure such as at
BAC, FBF, and ONE. On other hand, credit costs at many of the traditional
banks haven't risen as much since those banks' loan portfolios are more
concentrated in consumer credit, small business and middle market
commercial--in which deterioration tends to lag that of large corporate
and credit card. Since we believe the economy is likely to bottom in the
next 1-2 quarters, this implies that large corporate credit costs and
credit card losses should stabilize. However, small business, middle
market, and consumer may continue to deteriorate for several more
quarters.
* Earnings expectations for many regional banks are still too high, and some
managements may talk down numbers. Of the 30 largest banks, our 2002
estimates are at least 1% lower than the consensus estimate for 16
companies (almost all traditional regional banks). The largest
differences are at UB (8% below consensus, CYN (7%), NCC (6%, though we
might be a bit too low), RGBK (5%), and KEY, WB, ASO, and UPC (all 4%
below consensus). Very few managements guided estimates down following
9/11 (only FBF and MEL did). Other managements were either still
optimistic or were likely waiting to see how things played out. We
believe that as bank managements complete their 2002 budgets, they may
come back to investors with a bit more caution. As we've previously
noted, we would much rather own the stock of a company whose management
assumes virtually no recovery in their earnings guidance (such as BAC,
FBF, and MEL) versus companies who indicated during 3Q earnings that they
believed that the economy would rebound strongly early in 2002.
* Investors need to begin to think about rising rates. While there is still
much uncertainty regarding the economy, we do believe that there is
increased probability that we wake up one day and conclude that the
economy is recovering. This will likely result in a psychology shift
towards higher interest rates. If the entire bank sector came under
pressure in reaction to the fear of higher rates, we would again recommend
buying the stocks with the upside earnings leverage to the improving
environment. In rising rate environments, we believe only those banks
with very positive earnings momentum are likely to outperform.
OUR VALUATION MODEL NOW IMPLIES 7% LT GROWTH FOR THE INDUSTRY
In the past, our valuation model has generally signaled good buying
opportunities when stock prices are implying a long-term growth rate for the
industry below 8% (our lt growth outlook is in the 7-8% range). As of last
Friday, our model pointed to 7.0% implied growth which is up 90 bps from just
three weeks ago (Nov 9th). During the past three weeks, investor sentiment
regarding the prospects of an economic recovery have improved which helped
drive the 10 year treasury yield (a key input into our valuation model) up
nearly 50 bps while bank stocks held flat.
UPDATED ESTIMATE OF BANKS' EXPOSURE TO ENRON
In a FC note published last Thursday (11/29), we estimated Enron exposure for
banks we cover. Since then, we have revised some of our exposure estimates
at the banks we cover following conversations with managements and various
industry sources. In addition, we now believe losses on the $1.1b of
unsecured credit, as well as JPM's derivative exposure, are likely to be
about 50% (versus our previous estimate of 50-100%). We also now believe
that there is limited (if any) loss content to JPM's secured exposure to
Enron (none of the other banks we cover have any secured exposure).
Previously, we estimated 25% potential losses on the secured exposure at JPM.
After adjusting for our new estimates of exposure at the banks we cover, and
likely writedowns, there are only 3 banks we cover which may have writedowns
related to Enron in excess of 1% of annualized earnings--JPM (3%), STI (2%),
and WB (2%). As we discussed in a JPM note last Friday, we believe that
these levels of earnings hits are not bad given that Enron is the largest
corporate bankruptcy ever. Below, we summarize our exposure estimates for
the banks we cover.
JPM: As we summarized in a FC note on Friday, JPM has unsecured credit
exposure of $500m, secured loans of $400m, trading exposure to other secured
assets (which are backed by insurance), and a tiny equity investment. We
estimate that half of the $500m of unsecured exposure is derivatives with the
remaining in loans. We estimate likely writedowns on both of about 50%,
which represents about $0.10 per share in total. There are unlikely to be
meaningful losses to the secured assets since $180m of this will likely end
up as a claim on Dynegy (due to Northern Natural Gas acquisition), and the
remaining $220m is secured by the Transwestern pipeline, which we believe is
pledged to only the banks. See FC noted dated 11/30 on JPM for more details.
BAC: We continue to believe that BAC has about $200m of unsecured credit
exposure. This may result in writedowns of about $0.05 per share in 4Q, but
we believe this is likely to be offset with one-time gains. As we indicated
last week, we don't believe BAC has any trading-related exposure.
WB: We believe WB may have as much as $200m of unsecured credit exposure,
which may result in losses of about $0.05 per share.
FBF: We estimate that FBF has about $115m of unsecured credit exposure,
which may result in writedowns of about $0.03 per share.
ONE: Previously, we had estimated that ONE had about $90m of unsecured
credit exposure, but we now believe it may be a bit less (our best guess is
about $25m), which implies a write-down of only $0.01 per share.
STI: We believe STI has about $90m of unsecured exposure, which may result
in writedowns of $0.10 per share.
BK: We continue to believe that BK likely sold some of its original $90m of
unsecured credit exposure since it does not have a full relationship with
Enron, and it has been aggressively exiting relationships where it does not
have a full relationship. We estimate that BK may have about $25-50m of
exposure, which may result in losses of just $0.01-0.02 per share.
UPDATE ON LARGE CORPORATE CREDIT--4Q LARGE CORPORATE CREDIT DETERIORATION
SHOULD BE QUITE HIGH
After declining in 3Q, the increase in NPAs related to large corporate loan
defaults should be quite high in 4Q--implying that the increase in NPAs in 4Q
will be much higher than the recent 10-12%. So far in 4Q, $12.1b of loans
have already defaulted vs $5.4b in 3Q, $9b in 2Q, and $5.6b in 1Q. We
estimate US banks held $3.3b in exposure of the 4Q defaults ($1.6b of this is
Enron) so far this quarter, vs $738m in 3Q, $1.5b in 2Q, and $1.7b in 1Q. The
largest default is likely to be Enron at $4.5b, with the next two largest
being Federal Mogul-$2.1b and Dynatech-$858m. In Exhibit 1, we list US banks'
exposures to 4Q defaults. Note that we are presenting 3Q defaults excluding
Finova since Finova was removed from nonperforming status in 3Q. Also, keep
in mind that our estimates do not fully adjust for loans that may have been
sold.
Exhibit 1. Estimated Exposure To Loan Defaults
Exposure Exposure Finova Net 3Q
($m) To 4Q Defaults To 3Q Defaults Exposure Exposure
JP Morgan Chase $1,265 * $62 $263 $ (201)
Bank of America 474 109 295 (186)
Wachovia 462 110 100 10
FleetBoston 381 120 75 45 **
Bank One 125 100 218 (118)
Bank of New York 120 75 0 75
SunTrust 125 20 0 20
National City 65 32 0 32
US Bancorp 55 0 25 (25)
Mellon 53 15 0 15
PNC 35 10 0 10
Fifth Third 25 0 0 0
Huntington 25 0 0 0
UnionBancal 23 0 0 0
Comerica 18 15 70 (55) ***
Union Planters 15 0 0 0
Keycorp 8 11 0 11
Wells Fargo 0 60 75 (15)
Total $3,274 $739 $1,121 ($367)
*JPM has $900m total exposure to Enron ($400m is fully
secured)
**BAC likely sold down its exposure in the secondary market
***CMA sold $30m of original $70m exposure
Bank Managements Cautious on Large Corp Credit, Even Though Watch Lists Seem
To Be Stable
Prior to 9/11, several managements at the large banks (including BAC, FBF,
and JPM) were indicating that they were seeing a slowdown of new large
corporate inflows into their internal watch lists--implying that large
corporate credit would have likely stabilized. Following conversations with
several managements over the last few weeks, it appears that watch list
trends haven't changed that much since 9/11 (we view Enron as an unusual case
rather than a reflection of broader trends), but managements are being
cautious regarding the outlook since they believe that the impact of 9/11
hasn't yet been reflected throughout corporate America. Several managements
have noted that the Christmas season will be an important indicator of
whether credit will deteriorate much more or stabilize. We expect most banks
to maintain cautious regarding the outlook on large corporate credit when 4Q
earnings are reported--but in general, large corporate credit costs should
remain near their recent highs versus increasing dramatically (since they are
already at such high levels). BAC indicated just this last week at its
analyst conference.
THE LEADING INDICATORS OF COMMERICIAL CREDIT QUALITY ARE POINTING TO INITIAL
SIGNS OF A RECOVERY
In our July 31 Weekly, we showed that leading indicators of corporate credit
were pointing to a recovery. Following 9/11, all of these indicators
reversed as economic uncertainty rose. Although uncertainty is still high,
these leading indicators were once again pointing to a recovery (even
including the widening of spreads following the Enron downgrade).
High yield fund flows have turned positive. Flows into high yield bonds has
been a good leading indicator of investor sentiment about credit. There have
been net inflows over the past 7 weeks totaling $2.6b--with $1.8b added just
over the past couple weeks. This follows outflows totaling $1.6b following
Sept 11. The inflows adds to already high levels of cash at the funds.
High yield spreads have narrowed to pre Sept levels over the past several
weeks. The high yield bond spread (tracked by SSB Corporate Bond Research)
has narrowed 100bps to 670bp over treasuries over the past three weeks and
has returned to pre-Sept levels. (Note that spreads widened about 20bps since
Enron was downgraded last Wed.) Following Sept 11, the spread had widened
more than 100bp. The recent widening in spreads was putting additional
pressure on stressed companies needing to refinance. We also believe this
spread partly widened reflecting a concentration in stressed sectors such as
airlines and textile sectors (i.e. widened by about an average of 300bps
since Sept 11). On the other hand, telecom spreads have improved recently--
although spreads continue to remain at high levels.
The Salomon Smith Barney
high yield index shows that the spread between all high yield spreads vs.
telecom spreads has narrowed to 1200bps vs an avg of 1400bps prior to Sept 11
(this compares with an average of 500bps in 2Q and 200bps in 1Q).
Investment grade spreads were not hit as hard as high yield spreads following
Sept 11--spreads had widened 20bps to 86bps over treasuries. But over the
past month, spreads have tightened about 45bps.
Moody's default forecast remains bearish in the near term, but the outlook
for recovery in 2H02 looks positive. Moody's is still forecasting a peak in
the corporate bond default rate near 11% by the second quarter of 2002 and a
decline in the second half of 2002. Moody's notes that while the total number
of defaulting issuers has been declining throughout 2001, the total dollar
volume of defaults has been more unpredictable. Moody's speculative default
rate was 9.6% in Oct (representing $8.9b in defaults) vs. 9% in Sept. David
Hamilton, head of Moody's default research, notes that although the effect of
Sept 11 has been noticeable, there has not been a substantial number of
defaults and bankruptcies. Moody's expects to see some of these defaults in
the fourth quarter as restricted liquidity for leveraged issuers following
Sept 11 is bound to have some effect. Moody's estimates approximately $2.5b
of high yield bonds needs to be refinanced in 4Q, and $12.5b in 2002.
The rating upgrade and downgrade data is the largest driver of the default
forecast, and this has not yet reversed its negative trend. Moody's has put
80 companies on its watch list for possible downgrade this month. For the
first eight months the average was 45 per month, and last year it was around
33 per month. Although the deterioration in bank loan ratings is high, a
larger proportion of loans are being structured more conservatively and with
tighter loan covenants.
ACCELERATION IN LOAN WORKOUTS AND RECOVERIES LIKELY TO CONTRIBUTE TO CREDIT
RECOVERY
As we have noted in recent Weeklies, we expect loan recoveries, payoffs, and
returns to performing status to accelerate over the next year. Over the past
year, there has been over $11.2b in loan defaults (thru Oct.). Since
companies typically take 1-1 1/2 years to emerge from bankruptcy, we expect
to see an increased pace of recoveries on defaults over the next few
quarters. Recovery rates on loans are typically much higher than on bonds
since loans are typically senior to bonds (about 80% average recovery for
loans vs 40-50% for bonds).
We updated our analysis on potential recoveries. Since loan prices may be a
good proxy for estimated recovery values on the loans, we looked at the
average loan prices at the time of default vs. current loan prices. We assume
that banks would have written down the loans to close to what the secondary
value might have been at about the time of default.
There were a total of $11.2b defaults from 2Q00 through Oct 01. We did not
have prices available for a third of these loans, but we have used the rest
as a proxy for the entire list. We divided this list by industry and
reviewed whether prices had improved vs deteriorated. We found that for the
entire list of defaulted companies, the average price change was +17% on a
dollar-weighted basis. The largest industries with improving prices were
asbestos, movie theaters and healthcare--the sectors banks had the biggest
exposures to. Among large loans not falling into these sectors, Polaroid
appreciated 30%, Dade Behring improved 64%. The prices on telecom loans
declined an average 54%, while retail loans declined 37% (although US banks
had relatively less exposure to these sectors).
Our updated analysis shows there may be potential recoveries of $685m based
on secondary prices, although some banks have sold some of these loans.
Assuming that the banks wrote down the loans to about the level of the loan
price at the time of default, and assuming that the payment to the banks when
the companies emerge from bankruptcy are equal to the current trading price
(which is used as a proxy for the recovery rate), we estimate that there may
be potential recoveries of $685m. This likely overstates reality somewhat
since some banks have likely sold some of these loans, and some banks likely
did not write them down to the level that the loans were trading at when they
defaulted. In Exhibit 2, we summarize price changes by industry.
Exhibit 2: Changes in the Value of Defaulted Loans
original loan Wtg change since default
$M amount $M %
Auto 125 44 64%
Asbestos 2,003 375 47%
Movies 966 278 40%
Healthcare 1,131 170 23%
Imaging 190 29 30%
Utility 371 19 6%
Other 1,327 (5) -1%
Retail 665 (107) -37%
Telecom 670 (116) -54%
Sub-total 7,448 685 17%
NA 3,707
Total 11,155
* Loans without available prices
Source: SSB and LSTA/Loan Pricing
Average recovery rates have declined slightly. Average recoveries on
defaulted loans have averaged 78% vs 83% last year, according to PMD. Some
of the recovery erosion is attributable to the fact that turnaround
situations are taking longer to resolve. The senior bank debt holders are
willing to take bigger haircuts because the lender groups are filled
nontraditional creditors (i.e. CDO funds, vultures, and distressed
investors). In addition, telecom is having a negative impact on recovery
rates, since these companies are not asset rich.
We highlight below several situations we have been monitoring closely that
may contribute to a decline in credit costs in 3Q or in the next couple
quarters. |
