Valuing Banking securitiesJames K. Schmidt, CFAManaging DirectorandChief Investment StrategistFreedom Capital Management

Banking assets are rarely worth significantly more than face value, but they may be worthmuch less. Examining earnings and asset quality must therefore be undertaken with abias toward finding hidden problems rather than uncovering buried treasure.

Bankstocks have performed well in the past decade,but they have also been quite volatile. Figure 1shows that, according to the Dow Jones RegionalBank Index-a capitalization-weighted index of 53regional banks-bank stocks have performed verywell since the index was created in 1982. Figure 2shows the performance of the regional bank indexrelative to the S&P 500. On a relative basis, perfor­mance does not look as strong as it does on an abso­lute basis.

Banks are a small-capitalization stock industry;none is among the top 50 stocks in market capitaliza­tion. Therefore, it is not surprising that the relativeperformance of a broad-based bank index will ap­proximate what small stocks do relative to the S&P500. Small-capitalization stocks performed well inthe 1982-83 bull market and then underperformeduntil 1989.

The summer of 1986 was a peak in bank stockrelative performance. Frenetic merger activity wastaking place during the first six months, and takeoverspeculation was built into bank stock prices. "Bankstock hell" began in October 1989. The problemsbegan with the collapse of the United Airlines buyoutfinancing, which in tum generated concern about theamount of leverage in the economy as a whole. Cou­pled with real estate problems and various regula­tory factors, this was the beginning of a disastrousyear for bank stocks. Bank stock prices began toimprove again in November 1990.

Bank Stock selection

We have developed a process we use to select bankstocks and structure a portfolio. The process in­volves first understanding what is going on in thenational economy. Then, we look into regional fac-

42

tors-economic growth prospects and the competi­tive and regulatory environment for banking. Wethen develop and maintain a model portfolio.

National OverviewThe national overview has two important as­

pects: the economic growth outlook and the interestrate forecast. The first step is to determine where theeconomy is going. Banks are related to the economy,but only in one direction-down. A healthy econ­omy can mean bank earnings are up somewhat, per­haps 8 or 10 percent, but a bad economy or a weaksegment within the economy can cause disaster.

The second macro factor is interest rates, andboth the basic direction of interest rates and thespreads are important for banks. Figure 3 and Figure4 compare bank performance to three-month Trea­sury bills on an absolute and relative basis, respec­tively. Absolute bank performance is inversely cor­related with interest rates. As interest rates go down,bank stock prices go up. Taken relative to the S&P500, the correlation between bank stock prices andinterest rates disappears, so the apparent correlationis a market effect.

The relationship between interest rates and bankstock relative performance is not strong when youlook at correlations over different periods and atdifferent points on the yield curve. Bank stock per­formance is difficult to relate to interest rates. Thatmakes sense because bank earnings are affected byinterest rates, but not in a simplistic way. Banks areasset sensitive rather than liability sensitive. On av­erage, they make more money when rates are highthan when rates are low. Sometimes fundingspreads open up as rates decline, however, so ratesin the act of falling are more favorable than those inthe act of rising. The celebrated credit card case is a

Figure 1. Dow Jones Regional Bank Stock PriceIndex

Figure 2. Dow Jones Regional Bank Index versusS&PSOO

1982 = 100400 r-----------------------,

350

300

250

200

150

100

50 L----J_----'-_-----'-_----'--_----L_---'-_--'---_...L.-_-'--------'

'83 '84 '85 '86 '87 '88 '89 '90 '91

1982 = 100140r------------------------,

120

100

80

60

40'----'----L---'-------'-------'-----_-'--_-'--_-'--_-'-----''83 '84 '85 '86 '87 '88 '89 '90 '91

Source: Freedom Capital Management. Source: Freedom Capital Management.

good example: As rates have fallen, the spreads oncredit cards have skyrocketed. In addition, the ma­turity structure of a bank is somewhat complicatedbecause there are various imbedded options on theasset side. So no simplistic formula exists to relatebank earnings to interest rates other than to say thecorrelation is low. Thrifts, in contrast, are typicallyvery liability sensitive.

Regional CharacteristicsBecause the banking system is fractionalized, the

characteristics of different regions of the country arean important consideration. Three characteristicsare particularly important: growth prospects, assetvalues and credit quality, and the banking environ­ment.

The economic growth ofa region as measured bygrowth of employment or payroll is important be­cause it forms a foundation for balance sheet growth.Simplistically, growth in bank earnings is a functionof the growth of the earning assets and the interestmargin the bank is earning on the assets. If a bank is

in an area that provides some growth, earnings canincrease even if margins are stable.

Asset growth sometimes provides a clue aboutwhat is going to happen to asset quality, and changesin growth rates often foreshadow changes in the loanquality or the level of noncurrent loans at a bank.Currently, the most important category to examinefor asset quality is real estate. Table 1 shows loansoutstanding and the percent that are nonperformingor noncurrent in various real-estate-related catego­ries. Note that construction and development loansare by far the most troublesome, while loans collat­eralized by residences tend to produce few problems.

Figure 5 is a map of the United States showingthe percentage of troubled real estate assets by stateand region. The map clearly shows differences instates and regions. In Massachusetts, for example, 17percent ofall of the real estate assets are nonperform­ing, which means they are either repossessed realestate or they are loans that are not being kept cur­rent. In contrast, the rates in Idaho and Iowa are only2 percent. With such wide discrepancies, the poten-

Figure 3. Bank and 91-Day Treasuries Perfonnance Figure 4. Relative Bank Perfonnance andTreasuries Perfonnance

16

14

12"0

10]r

" 8

" 6

4'91

\

\

\ "\ / /' \

'/ /",/ '\,. , / '-

" - /

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80

40 '---.....,_"_,..--~_____,_'_=_---:-:'-----'-::,_____--"----L-.....,-"---'-----J

'83 '84 '85 '86 '87 '88 '89 '90

1982 =100140,-------------------,

100

120

1982 = 100400,..----------------------,16

350 14

300 \ 12

250 \ \ /\ '"d

200 \ / - / \ 10 ~./ \ / "'-

ISO ' " / 8,100 "_-"/' 6

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50 L-~~;:;_;_~=--=_~=___:_::!::_~!_:_~:__:.,L___----.J 4'83 '84 '85 '86 '87 '88 '89 '90 '91

-- Dow Jones Regional Banks

- - - 91-Day Treasuries

Source: Freedom Capital Management.

-- Dow Jones Regional BanksRelative Performance

- - - 91-Day Treasuries

Source: Freedom Capital Management.

43

Table 1. Real Estate Loans Outstanding and Percent of Noncurrent Loansas of June 30, 1991

Asset Size

AllBanks

Less Than$100 Million

$100 Millionto

$1 Billion

$1 Billionto

$10 Billion$10 Billionor More

Total Loans Outstanding ($billions!All real estate loans $847.8 $97.4 $211.1 $265.3 $274.1

Construction & development 116.9 6.3 19.9 43.4 47.4Commercial real estate 246.3 25.6 68.6 88.1 64.0Multifamily residential 22.6 1.9 6.5 7.2 7.01-4 family residential 353.1 50.7 96.6 98.0 107.8Home equity lines of credit 66.0 3.1 14.2 25.8 23.0

Commercial real estate loansnot secured by real estate 28.3 2.1 4.7 8.7 12.7

Highly leveraged transactions 68.2 0.0 0.6 14.3 53.3Loans to foreign governments and

institutions 24.9 0.0 0.2 1.5 23.3

Percent of Loans NoncurrentAll real estate loans 4.89% 1.98% 2.55% 5.02% 7.59%

Construction & development 14.07 3.35 6.41 13.77 18.99Commercial real estate 6.16 2.73 3.34 5.70 11.20Multifamily residential 7.65 2.73 3.45 6.45 14.201-4 family residential 1.57 1.42 1.40 1.57 1.81Home equity lines of credit 0.73 1.23 0.83 0.61 0.73

Commercial real estate loans notsecured by real estate 8.03 8.42 8.96 6.23 8.86

Highly leveraged transactions 11.07 N/M 5.59 10.14 11.38Loans to foreign governments and

institutions 16.01 N/M 22.69 13.57 16.11

Source: Federal Deposit Insurance Corporation.

tial for troubled real estate loans at a bank is obvi­ously highly related to geography.

The map also shows the importance of inflectionpoints, or changes in direction, in the economy. Dur­ing the past 5 or 10 years, those states that havegrown the most are not necessarily those that havethe fewest real estate problems, and those that havegrown the least do not necessarily have the mostproblems. The best correlation of growth with realestate problems is found by examining those stateswhere growth exceeded its prior trend line and thestates where growth fell short of the prior trend line.The dislocations in the real estate market occur whengrowth rates change relative to their trend.

For example, during the past 10 years, Iowa wentthrough very slow growth. The state's economy hadreal problems during the early 1980s with the farmeconomy in depression and many farms being repos­sessed. In the late 1980s, the state did not grow, butthings stopped getting worse. Farm land bottomedat about $1,000 an acre in 1985, and it is about $1,200an acre now. Things are not going gangbusters, butthey went from being disastrous to being good. That

44

means Iowa has no danger of overbuilt real estate.Banks in Iowa do not have a lot of speculative con­dominium loans because not a lot of condominiumswere built. Banks did not have a chance to get intotrouble as they did in other areas, and the nonper­forming real estate loan rate is only 2 percent.

In contrast, the Northeast states like Massachu­setts and Connecticut experienced a huge problem intheir real estate markets when their economies de­clined somewhat after being so strong in the mid- tolate 1980s. Massachusetts and Michigan are an inter­esting contrast. Massachusetts has an unemploy­ment rate a little above 9 percent, which all the poli­ticians are fretting about. Actually, 9 percent is notthat high; it has been higher than that in Michigan foryears. The nonperforming loan rate in Michigan isfairly low compared to Massachusetts because Mich­igan has been living with a slow-growth pace for adecade, while for Massachusetts it represents a radi­cal readjustment. So the change from rapid growthto poor growth is what gets people into trouble.

The other important point illustrated in Figure 5is how long it takes to work out of bad real estate

Figure 5. Troubled Real Estate Asset Rates by State, June 30, 1991

HA~o 'W 0.84

~p-

()

West Midwest

Southwest

Central Northeast

MA7.15

RI\, "--12.86---'CT

°NJ 16.8311.76

'DE4.29

Less than 4 percent

Between 4 percent and 8 percent

More than 8 percent

Source: Federal Deposit Insurance Corporation.

loans. In 1991, the Southwest region looked bad;several states were posting nonperforming asset ra­tios of around 10 percent. Those are fairly high num­bers, but they disguise the underlying reality. InTexas, the real estate problems have been much moresevere than in Massachusetts, but the banks with thereally bad ratios have failed, and they are not in theFDIC sample anymore. If the data are adjusted toinclude the failed institutions, Texas has been a di­saster. Texas real estate is still producing non­performers even though we are several years into therecovery of the economy.

To illustrate the magnitude of the problem, I willrelay the experiences of a savings bank in Washing­ton state that has a loan out on a commercial buildingin Houston. It made the loan in 1984. It was origi­nallya $40 million credit, and in 1987, the savingsbank wrote it down to the appraised value of $20million. In 1989, it took a $9 million writedown onthis property, from $20 million to $11 million.

The timing on this project is insightful. Oil pricespeaked in November 1980, and the economy in Texasstarted rolling over. At the time, the price of a barrelof oil was forecast to be $80 to $90 by the end of the

decade, but it soon became clear that that would nothappen. The first big writeoffs on energy loans weretaken by Texas banks in spring 1982: InterFirst an­nounced in May that it would lose money due to abig loss provision. Banks in Texas started failing inplentiful numbers in 1985 and 1986. The real estatemarket bottomed inTexas in 1986,but in 1989, peoplewere still discovering they had to mark their proper­ties down by 45 percent. This seems awfully late inthe game to find out you have problems.

My view of the real estate valuation cycle isillustrated in Figure 6. This shows the relationshipbetween when a market turns and when it shows upin bank earnings statements and balance sheets. It isnot a scientifically produced exhibit; it is a qualitativerepresentation. Assume we are talking about a par­ticular piece of real estate, such as a condominium indowntown Boston. On the time cycle, Year 2 repre­sents the peak in the market. Assume our hypothet­ical one-bedroom condominium in a nice area had amarket value of $250,000 in August 1987, havingrisen steadily over the prior years. We did not knowit then, but 1987 turned out to be the peak in the realestate market. In fact, market values started declin-

45

Initial Value = 1.0

Source: Freedom Capital Management.

Figure 6. Real Estate Valuation Cycle

-- Market Value

- - - Appraised Value

----- Book Value

performing asset is either a nonperforming loan-aloan that is not current on interest payments-or it isreal estate repossessed and owned by the bank. A lotofemphasis has been placed on determining whethera bank's nonperforming assets have peaked.Barnett's nonperforming asset ratios peaked in thesecond quarter and declined in the third quarter,according to the bank. Five of the six research reportson Barnett banks that I reviewed recently respondedpositively to the fact that nonperformers would de­cline in the third quarter. Not everyone was bullishon Barnett, but all analysts agreed that a peak innonperforming assets was a good sign.

Many things influence nonperforming asset ra­tios, but the effects can be sorted out. Using BarnettBank's third-quarter report, I will illustrate the rele­vant cash flows and estimate what happened. Thebank stated in its report that "real estate owned roseto $383 million" and that "our sales of foreclosed realestate did increase to more than $30 million." First,look at the $30 million. The real estate owned issupposed to be marked to market, so theoretically allof the $350 million Barnett had in real estate ownedin June is sellable at that value and could be movedout without a loss. In fact, the bank was only able tomove 8 percent of it. I am not encouraged to knowthat only 8 percent of Barnett's portfolio can actuallybe moved at the value at which it is carried. Inaddition, the bank probably sold its better properties:If it had 800 properties, it probably picked the best100 to move out. So selling $30 million is not aparticularly optimistic note.

If its real estate owned went from $350 million to$383 million, even though it sold $30 million, then thebank acquired $63 million of additional real estateduring the period. I am assuming that this camefrom loans previously considered nonperforming.As those loans migrated from nonperforming realestate to real estate owned, the bank foreclosed onthem. There are other paths the balances could movein that could make that number over- or understated.For simplicity, however, lets assume that the $63million migrated from nonperforming loans to otherreal estate.

The nonperforming loans category droppedfrom $593 million to $558 million during the quarter,but $79 million was written off and $63 million wasmoved to repossessed real estate. With a little arith­metic, it appears that $107 million was actuallyadded to nonperforming loans during the period($593-$79-$63 + Y=$558; therefore, Y = $107). Thisshows continued deterioration in real estate. Thatcertainly makes sense because the economy is notrecovering. You would not think you could reverseall of the problems Barnett has in one quarter this

/'"- - - - --,/ ....

/

Solving the Asset Quality RiddleThe health of a bank can be assessed by analyz­

ing various categories of a balance sheet and howloans flow in and out of the various categories. I willuse Barnett Banks to illustrate how to solve the assetquality riddle.

In the current environment, people are very con­cerned about trends in nonperforming assets. A non-

2.4r-------------------

2.2

2.0

1.8

1.6

1.4

1.2

1.0

0.8 L-__-L__-----.l -:-__-';__---:

2 3 4 5Years

ing from that point forward. A year later that prop­erty was worth $200,000; a year and a half later it wasworth $175,000.

Appraised values lag market values for quitesome time. There is a general rule that people havecome to rely on in real estate. Any property is worthmore this year than it was last year. This is treatedas a basic law of physics by a lot of people in the realestate business and certainly in the appraisal busi­ness. Into the first year of the bear market in realestate, appraised values keep rising, even thoughmarket values are falling. This creates a gap in whichthe property appraisals are totally out of sync withthe market.

Another lag occurs before appraisals show up onthe bank balance sheet, because not everything isappraised every day. So six months or more go bybefore the carrying value of nonaccrualloans in bankrepossessed real estate reflects what the appraisedvalues are. These themselves lag the tum of themarket quite a bit. As a result, a year or two after thereal estate market turns, a very large gap exists be­tween what a bank says its real estate is worth andwhat the true market value is. That is the phenome­non we saw in Texas, we are starting to see in NewEngland, and we will see in California.

46

120

Source: Keefe, Bruyette, & Woods, Inc.

'9020 L..l..::----,,-l-:-----,,,L------,-,l ----.l...--.....L------.J

'61 '66 '71 '76 '81 '86

40

Our philosophy is to buy bank stocks that are cheap.When screening banks, many price anomalies can bediscovered because the industry is so fractionalized.Figure 7 shows how bank stocks have traded on aprice-earnings ratio (PIE) basis during the past 30years. The bank PIE has varied over time, but italmost always is below the PIE of the S&P 500.Banks do not get a lot of respect in the marketplace.Bank stocks last sold at a premium to the market inthe mid-1970s, and now they are just above 60 per­cent; they still are selling at a steep discount.

A good regional bank may sell at 9.5 times thisyear's earnings, which is about where a low-qualityutility stock would be. This is puzzling because overthe long term, bank stocks have been big out­performers, and many studies show that bank earn­ings-per-share growth over a 10- or IS-year period isvery competitive with that of the market, and oftenbetter. One explanation is that the market is ineffi­cient and banks are underpriced. This is true to apoint, and I believe that the gap will narrow duringthe next five years.

Figure 7. Relative PIE Ratios-Keefe, Bruyette, &Woods Index versus S&P 500,1961-91

mainly correlated with the size of the bank. Thenumber of options granted is correlated with the sizeof the bank; the price action matters little becauseeach year more options are granted at current mar­ket. As long as the stock price is volatile, the optionswill be valuable.

Another problem with managements that own alot of stock is that as the percentage of managementownership increases, the ability to trample on therights of the minority shareholders also increases, asdoes the ability to plunder the bank for their ownends if things get bad. So I am not happy to see thatdegree of insider concentration because it allowsthings to happen that do not always benefit stock­holders.

..... 80@~

0'::: 60

Bank Stock Pricing

early on in the real estate cycle. Nevertheless, theoptimistic tone of its report has been accepted at facevalue by a few analysts.

In looking at the Northeastern banks, I noticethat of those with a lot of real estate problems, a fairnumber also had surprising stabilization or a slightdecline in nonperformers. They are placing a lot ofemphasis on controlling the nonperforming assetnumber and being able to record a lower number. Ithink that is making people a little too sanguineabout what is going to happen in the real estatemarkets generally.

Management QualityThe quality of bank management is an important

consideration. A management can be evaluated bylooking at its past record. Because we are in a tran­sition point, particularly in real estate, historical re­cords on some asset quality items are not alwaysindicative of what is happening going forward. A lotof the banks in New England that failed in 1990 hadimpeccable asset quality and very low chargeoffsthrough 1988. So the past chargeoff record may notbe indicative of the future.

Another thing I look for in management is share­holder orientation. Although a shareholder orienta­tion is important in most industries, the divergencebetween management's payoff matrix and whatshareholders want to see seems to be wider in thebanking industry. Bank executives' goal in life is notnecessarily maximizing the value of their stock, be­cause being the head of a large bank or of any bankmakes you a prominent figure in a community. Itgives you a certain influence that you cannot put amonetary value on. Remaining the head of the bankand continuing to make the bank grow is the mostimportant goal for a lot of bankers.

To determine whether banks are shareholderoriented, analysts have to watch what they do ratherthan listen to what they say. Their actions must beconsistent with maximizing shareholder wealth. Anumber of analysts use the amount of stock held bymanagement as a measure of whether managementhas the interest of the shareholder at heart. I thinkthis yardstick has a number of problems. First, as­suming management's sole goal is increasing theirown personal wealth, the amount ofstock ownershipwould have to be tremendous before their wealth ismore correlated to the price movements in the stockthan it is to their compensation plan. If the bankgrows, the compensation packages keep growingand ensures wealth regardless of stock performance.

Stock option plans are often cited as incentivesfor improving stock performance. However, in theseplans, the wealth accumulated from stock options is

47

250214.9

Source: SNL Securities Monthly.

3.9 HW 7,1 14.6 3.4 8.9....... _.. - ->~,4/'89 1/'90 2/'90 3/,90 4/'90 1/'91 2/'91 3/'91

Commercial banks represent an inexpensive groupofstocks that should benefit over the upcoming yearsfrom consolidation activity. This will provide anopportunity for shareholders of target banks to re­ceive takeover premiums, and it will reduce compe­tition and allow the entire industry to operate moreefficiently. The main challenge for analysts is toavoid pitfalls-those banks whose financial state­ments do not relate the true underlying values. Un­fortunately, banking assets are rarely worth signifi­cantly more than face value, but they may be worthmuch less. Examination of earnings and asset qual­ity must therefore be undertaken with a bias towardfinding hidden problems rather than uncoveringburied treasure.

markets. Phenomenal expense savings are one resultof this type of merger, which tends to benefit bothbanks. It also is good for the industry as a whole. Ineach of the deals pending right now, between 8,000and 10,000 employees may be cut to achieve theefficiencies that will make the merger work. For allthe deals now outstanding, the number of jobs to belost is between 50,000 and 60,000. That is not goodnews for those 50,000 or 60,000 people, of course, butfor those remaining, it is a tremendous capacity re­duction in the industry. Having fewer bankers andfewer banks has some positive implications for theoverall competitive structure in the industry.

Figure 8. Bank Acquisitions Announced--TotalAssets by Quarter

200

~ 150o§ 1.

r:o lOOt,fFt .

5~t

Conclusion

Bank stocks are not as alarmingly underpriced asthey might appear statistically. The reason for this isthe method a lot of analysts use to calculate bankstatistics. Too often, problem banks are removedfrom samples because they distort statistics. Becauseof this practice, banks as a whole appear to have verygood earnings progressions. For example, a portfo­lio of favorite banks in 1980 would have includedTexas Commerce, Mcorp, SeaFirst, and a lot of banksthat failed or were taken over at distressed prices inthe 1980s. Yet most people who do retrospectivestudies tend to exclude these banks. That is true ofloan-loss provisioning, too. Whenever a loan provi­sion is sufficient to produce a quarterly loss, thenumber is removed from the sample. Severe loanlosses cannot be ignored. So I do not think that banksare nearly as undervalued as some of the PIE statis­tics might show. There are always risks to bankearnings streams that are greater than would be evi­dent from retrospective analysis of "cleansed" data.

The Banking EnvironmentThe banking environment is another important con­sideration. The United States has about 13,000banks; in Canada, 10 banks dominate the country.The fractionalization of our banking system is thebyproduct of regulation. To a large extent, theserules now have changed. Banks have been deregu­lated on the product front and also geographically,state by state. A measure before Congress wouldallow full nationwide banking.

A great deal of merger activity lies ahead. Figure8 shows the volume of deals announced during thepast eight quarters. You can see this volume hasexploded this year. Banks were out of the mergergame somewhat when they were under regulatorypressure in 1989 and 1990. That has now subsided,so we are seeing a lot of deals. The volume explodedin the third quarter of 1991. In the fourth quarter sofar, a couple of major deals have already been an­nounced-Manufacturers National and Comerica,and National City and Merchants National.

A new type of acquisition is more common now:mergers of equals-that is, banks in overlapping

48