Chief Investment Officer
Commercial Loan Automation
2008 outlook - the second stab
This is the first column for 2008, and I'm ready to put my foot in my mouth again. I'm more gloomy than usual, but if you've been reading pre-releases for 4Q07, you'd be too... Thanks in advance for setting me straight and sharing with me your perspective.
Have a healthful, prosperous, joyous and fun 2008,
2008 OUTLOOK - THE SECOND STAB
The last few months have been difficult ones for banks. Our stocks have been hammered, our credit quality is deteriorating rapidly, and shareholders are getting nervous. The current picture looks anything but rosy: housing, a major factor in the economy (responsible for 33% of new jobs; 50% of US GDP is tied to housing) and in many bank earnings, is in a bailout mode for some borrower sectors, and the entire business is retrenching; new construction is down significantly (unsold inventory of homes is the highest since 1993). Further, the asset quality melt-down we have been predicting is well underway; non-current loans have risen in each of the last four quarters, and reserves, provisions and write-offs are following, and the regulators are getting extremely tight in their examinations. It appears that the days of loan loss reserve reversals are behind us for quite some time. Growth prospects aren't too promising either: during the twelve months ended March 31, 2007, assets of FDIC insured institutions grew by 6.9%, the slowest 12 months growth rate in 4.5 years.
Market performance trends have been mixed to negative. 52% of the largest 50 banks and thrifts have seen reduced estimates for 2007 EPS, and 68% of the same universe are trading at less than 90% of their 52 week high.
Other elements in the quiver of the bears: our economy is overdue for a downturn, having experienced 16 consecutive years of consumer expansion and unprecedented residential mortgage volume and price appreciation. The yield curve is still flat, and robust loan demand continues to put pressure on liquidity. Is it time to call it a day and sell to the highest bidder? My outlook says, pressures are mounting, but opportunities are ever-present.
The Economy (Many of the insights herein have come from Metrostudy)
The economy continues to send us mixed signals. On the plus side, government spending is very strong, as is job formation in the services sector, especially in education and health services. Despite some deceleration in job growth, the unemployment rate remains low at 4.7%. The Purchasing Managers' Index is close to predicting neutral growth in Manufacturing over the next twelve months, and initial unemployment claims indicate that jobs are still available. Corporate profits appear quite healthy, and GDP growth remains firm (3.8% in 2Q07). At the same time, inflation concerns continue to rise, reflected in cautious Fed action and major stock market jitters.
Signs for 2008 are troubling, though. While consumer confidence is well above 100, some uncertainty has appeared. Unemployment has bottomed out, and consumers' intentions of buying a home are falling as they experience doubts regarding qualifying for a mortgage.
The real estate front is also unclear, and regional variations are wide. Overall, though, the home buying market is suffering, and consumer confidence as reflected in home buying plans has been declining since August. New home affordability index is the lowest it's been since 1Q04, despite relatively low mortgage rates. Average home prices will have to decline $191,000 to reach the buyer who was qualified to buy the same home in 1Q04!
Finished vacant home inventory is climbed steadily in 2006, but is beginning to decline in 2007, and months of supply are well above the two months market average levels, and, while improved, the "improvement" has been entirely limited to the reduction in Under Construction Inventory, with the standing, Finished Vacant Inventory at its highest total unit count ever! Inventory will need to decline by 116,000 units to achieve a 2 months supply level and return the inventory market to equilibrium.
It appears that the production side of the housing market has made a significant adjustment (27% drop in annual starts) in 2007, and builders are signaling no further additions to the inventory problem going forward. The key question, which is answered differently in various markets, is how long will it take builders to get rid of the existing inventory overhang.
In the past ten years, average margins in the US fell 16%, from 4.5% to 3.8%. Other countries, from Italy to the UK, suffered even greater erosion, up to 44% reduction in the UK (from 2.7% to 1.5%). Margins in the US remain over double those in its European brethrens, which might imply further declines are in store.
Margin pressures will persist for many banks throughout 2008, mainly due to stiff pricing competition. The recent Fed rate drops have not been fully reflected in market deposit pricing, which exacerbates the margin problem. While loans margins have temporarily spiked (remember the LIBOR peak this summer?), those are normalizing as well.
At the same time, the yield curve is showing signs of curving, which might bring about limited relief in 2008. Trends are still unclear, and depend greatly on the heat of the economy, inflation fears and the perceived "credit crunch". Additional pressure is put on the margin by the on-going shrinkage of non-interest bearing accounts as a percent of total deposits, down from 55% in 1960 to 10% in 2006. Margin won't experience relief from additional deployment of liquidity, since industry-wide loan-to-deposit ratios have climbed from 52% in 1960 to 89% in 2006. Further negative impetus is caused by the shift in deposit mix away from DDAs and into CDs, a trend that was most pronounced in 2007 and will persist in 2008.
At the same time, one must note that there is a wide range of bank responses to this uncertain rate environment, from heavy margin compression to great expansion. Further, pricing rationalization is evident in small pockets (such as Construction Lending), and might expand as some players exit markets and others realize that irrational pricing cannot be justified over the long haul. Overall, compression is expected to continue through 2008, but it is not inevitable: effective DDA and deposit strategy development and execution at the individual bank level can shift the picture significantly for any bank.
The credit crunch?
A credit crunch might still come in 2008, but the rumors of its presence are greatly exaggerated. Loan growth is robust in most parts of the country, including those with modest economic growth and even areas where banks are experiencing asset quality weakness. Overall, loan growth has improved from 8.7% in 2Q07 up to 15.8% projected in 4Q07. C&I loans in particular have been growing at impressive rates as well, up from 9.8% in 2Q07 to 31.8% projected for 4Q07, an almost scary number. Certain credit markets are under pressure, particularly housing-related, for both commercial and retail customers (e.g. contractors; Alt A mortgages), and overall consumer loans are projected to decline from an already-anemic 5.1% 2Q07 to 4.1% 4Q07. That situation has been exacerbated by the almost instant drying up of the secondary markets for certain credit products such as sub-prime retail product and some home equity loans, causing both alarm and a perception (in some cases, a reality) of a crunch.
If there is a credit crunch in certain credit markets, it is a good thing. We have compromised too long on terms and covenants and on basic pricing, and, as an industry, have not been fairly compensated for the risk we take in certain loans. A correction, a shakeup if you will, could improve overall industry health in 2008 and result in better pricing as we work out our credit problems next year.
As always, being a contrarian in this market presents opportunities to snag bargains and establish a foothold at a time of weakness.
The deposit story: the next chapter
Deposit balances are growing, albeit at a slower pace than loans. Industry-wide deposits are expected to grow at 11.% annually in 2007. Forth quarter deposit levels are expected to post their highest growth since 2Q04, and Fed data might indicate as high as 14% annually. Competition is still intense but growth is comfortable in many markets. Consumers are willing to invest in CDs, a 2007 phenomenon, and might be willing to lengthen maturities further in 2008 depending upon the yield curve movements. The greatest issue on the deposit front is the precipitous decline of interest-free transaction accounts. This shift is occurring at almost all banks. Even DDA-rich banks are experiencing declines from stratospheric DDA levels (say, 40%) to lower levels (say, 35%), which, while great by any standard, are still below their traditional highs. Banks continue to address the problem by offering high-yield deposit accounts through all channels, with special attention to the internet, thereby averting liquidity issues but prolonging margin problems.
In their quest to drum up interest-free DDA business, and recognizing that the "mail and gift" DDA strategy is on its last legs, the "6% DDA with many strings" has emerged as an alternative and is being sold aggressively by consultants. While the concept is appealing, accurate bank-specific profitability information is necessary to make this value proposition work for both shareholders and customers, and balance and transaction monitoring at the account level are necessary as well.
Addressing the DDA issue in 2008 is a first order of business for any bank and industry-wide, since its impact on profitability and other key ratios is so profound.
Credit is definitely getting worse
The long-predicted credit deterioration has started; liberalized terms, covenants and razor-thin pricing have come home to roost and will get worse in 2008 as foreclosures start working their way through the system. Also, given the liberal terms many borrowers enjoyed, they will enter non-accrual much later in the cycle than in past cycles, which means that the magnitude of credit problems has been understated in 2007 and will be fully revealed in 2008.
Some sectors, particularly real-estate related, have been hit hard in some parts of the country. The housing inventory also will not fully reflect the sub-prime impact until foreclosures run their course throughout 2008. In the meantime, real estate development has halted in many markets. Builders are sitting on unimproved land and waiting for the storm to pass and the market to turn. Some are strong enough to get through it; others won't be able to weather the storm to its conclusion.
This is a good time to encourage and enliven an "early warning" culture among lenders and relationship managers, to ensure that problems are spotted early and worked out while the borrower still has assets that can be salvaged.
The payment opportunity - still underutilized and growing
Payments continue to grow, and astute players are making early moves to capture an even greater share of the market. Capital One has decoupled the debit card from its originating bank such that their own rewards program might win the war over the customers' loyalty to Plastic.
The opportunity for banks is still large, growing and non-capital intensive. Debit and credit card acquisition, building and activation are significant opportunities, but the window will close as major players trump SuperCommunity Banks' hands with strategic focus, effective execution, unbeatable offers and technology.
Consider these facts: The number of non-cash payments in 2006, as reported by the Fed, has growth 4.6% CAGR since 2003, and reached 93.3 billion payments with a value of $75.8 trillion. Of that total, 30.6 billion checks were paid, reflecting a CAGR decline of 6.4%. Note that checks are still the largest type of non-cash payment in the system, and they also represent the greatest value at $41.7 trillion. At the same time, they are also the only one that is declining in number (6.7 billion less checked were cashed in '06 vs. '03). Interestingly, 2.6 billions of checks written wree converted into ACH before they were cashed.
Debit cards are growing at 17.5%, and are approaching the check payment vehicle in number at 25.3 billion. They have already surpassed credit card transactions at 21.7 billion, with CAGR since 2003 of 4.6%.
Also note that the number of signature-based debit card transactions is growing faster than the number of PIN-based transaction, which is good news. Debit card transactions account for 27.1% of non-cash payments in 2006, but a meager 1.3% by value.
Interestingly, the fastest growing payment vehicle is ACH (18.6% CAGR). They currently constitute only 15.6% of non-cash payments but a whopping 40.8% of the value.
Similarly, remote capture is still on a steep growth trajectory, but the opportunity window is beginning to close as players start offering limited time fee waivers, and others lead the way to retail remote capture (check out USAA's usage of any scanner to allow consumers to deposit checks through these devices; they are reportedly acquiring upward of 100,000 customers a month using this technique).
One more relevant dimension: ATM activity (as per the Card Industry Directory) per machine has plunged to new lows, as their numbers increase and cash-back at point-of-sale transactions grow as well, displacing the need for ATMs. System-wide, we now have almost 400,000 machines, but the monthly volume has peaked in 2004 and is currently 25% off the peak at 750 million transactions per month. Transactions per ATM, on average, have plummeted from 6300 per month on average in 1996 to slightly over 2000 per month. The lifecycle of most ATM machines is at its sunset, as the need for cash declines and the availability of cash at point-of-sale grows.
The Payments Business will ultimately call for out-of-the-box thinking, but the fruit on the ground (not even the low hanging fruit) is plentiful and available. While checks aren't going away any time soon, the growth sectors are debit cards and ACH, and the value embedded in both (fee income for the first, balances for the second) is HUGE.
The acquisition business - hot and heavy? ALL depends on the stock market
The acquisition market started heating up in 2007, despite depressed bank valuations, for banks of all sizes. The persistently flat yield curve and high regulatory compliance costs drove banks at all levels to seek mergers, and the larger banks are capitalizing upon their buying power to pick off franchises. Pricing is getting better, and will improve even further in 2008 among credit-pressed banks, but it is still not rational, especially in growth market.
An important trend in 2008 is the major role mega banks will play in the acquisition market. Their performance is measurably better than smaller banks, given the major strides they made in efficiency gains and revenue source diversification. They have the currency and they are shopping. Aggregators at all levels are following suit, and 2008 will see more of these deals if bank stock prices will recover.
Mergers of Equals are also beginning to resurface as a way to gorw in a depressed bank stock market, and more will be seen in 2008.
There are more sellers than buyers in the market, and many "busted" deals and failed auctions that are not publicized.
The sense of urgency on deal closing will also increase, as unpleasant surprises in the credit and secondary markets might cause deal terms to be broken through, so timeliness will become more relevant going forward.
Competition for deals will intensify in 2008 as de novos slow down, bank growth decelerates and deposit premiums continue to break 30%. However, as long as bank equity currency are depressed, we'll see more Mergers Of Equals and large bank acquisitions.
What's on the regulators' mind?
Credit will be a key word in 2008 on the regulatory calendar, as further credit deterioration seeps through the system. This, coupled with greater fraud risk for both commercial and retail customers, will give the regulators plenty to worry about. While BSA never goes off the map, including civil money penalties, 2008 will be the year of credit quality for the examiners, possibly to be followed by renewed attention to liquidity, given the anticipated credit issues.
Large vs. small
In a recent BEV issue I highlighted the performance of mega-banks vs. the rest of the industry, noting that they are outperforming the community banks for the second year running. The reaction to this assessment was skeptical, particularly in light of the huge losses several mega-banks recently announced.
Unfortunately, 2007 (and, I predict, 2008) continues to reflect the growing success of larger banks in garnering market share and profits from their smaller brethren. On the deposit size, the industry is expected to experience an 11% growth; large banks' deposits are expected to growth 17.9%, while small banks are projected to grow at 1.5%, with a declining link-quarter 3Q-4Q. This will be the fourth quarter when deposit growth continues to meaningfully lag loan growth at the smaller banks.
Industry-wide loan growth is expected to reach 15.8% annualized, with large banks delivering 20.7% annualized, which is nearly double the 11.2% posted in 3Q07, driven by extremely strong C&I loans and double digit real estate growth. Small banks' loans are expected to grow at 8.3%, with strong C&I loan growth, albeit at slower rates than 3Q07, and a significant slowdown in consumer loan growth.
I expect this trend to continue in 2008, as community banks seek their "niche" and look for effective combat techniques against the mega banks, especially in mass-market retail and small business.
These facts paint a clear picture: the industry continues to be profitable, but growth is decelerating (6.9% for the 12 months ending 3/31/07, the slowest in 4.5 years) and larger banks are clearly more profitable than smaller ones. The big banks are doing better than mid- and small cap companies, primarily because of their diversified revenue streams. More banks are having profitability hiccups; median data for 141 community banks show all five major performance measures (margin; efficiency; charge-offs; NPL; provision coverage) weakening 6/30/06-6/30/07.
2008 will be a tough year for banks, but also a year of great opportunity to separate your bank from the pack, show your uniqueness and demonstrate to liquidity-flushed investors why your institution is the right one for them to invest in. Staying the course on prudent C&I lending while improving deposit gathering tactics and making major strides in the payments business can be a wining combination for SuperCommunity Banks, one which the markets will reward.