With the Pope in town, it seems fitting to reflect on why the Fed won't admit that it does anything wrong, even in the face of glaring evidence. The reason is that the Fed Chairman is Infallible. Not only that, what is most amazing is that this infallibility extends throughout the System to every staff member of the Board of Governors. This circumstance reminds me of watching the thrilling moment when a newly minted pontiff appears for the first time on his balcony to receive the cheers of the crowd at St Peters. I couldn't help but wonder what must be going through his mind as he reaches the pinnacle of life. It occurred to me that he might be thinking, "If only I could be Chairman of the Federal Reserve System. Then I would be Infallible."
~ Robert Feinberg
Last week's earnings results for Citigroup (NYSE:C) and JPMorgan Chase (NYSE:JPM) heartened the bulls on Wall Street. The theme of the earnings release by C and JPM could be called "better than expected," even if the results were still dismal.
We'd love to tell you that the systemic storm is passed and that valuations for financials are stabilizing, but the fundamental data just does not support such a view. By way of a time frame reference, we're just barely into the third inning of the credit crisis ball game. And we cannot be sure that this will be a "normal" nine-inning contest. Extra innings takes us well into 2009.
Incidentally, we'll be holding forth at the Financial Services Roundtable 2008 Spring Meeting next week by participating in a panel appropriately entitled: "The Big Risks" A Look at 2008 and Beyond."
Why do we throw the bucket of ice cold water on the growing crowd of Sell Side touts encouraging clients to go long US financials? For the simple reason that the key sectors of the economy which determine US bank asset quality and revenue - real estate, home building, consumer spending and credit -- are continuing to sink into the mud. After a decade of earning supra-normal returns, the US banking sector is reverting to the mean - and then some -- so don't take relatively upbeat news last week as an indication of impending salvation.
The other thing to remember, this c/o of our colleague Alex Pollock at AEI in Washington, is that company earnings and disclosure generally are "constructed concepts." A series of assumptions and estimates go into the earnings statement of any company. Most companies and especially commercial banks with large trading and investment books can move results significantly one way or another to suite management's short-term agenda. Witness the results reported by C and JPM last week, not catastrophic, just bad.
Somewhere between the mechanistic certainty of company reporting promised by GAAP accounting and outright fraud lies the vast realm of IR spin for public company reporting. To us, pondering the implications of one earnings release or the other is poor use of time, particularly for investors trying to understand shifts in a given industry or business model. Only by looking at results over a series of quarters or even years does a reasonably accurate picture begin to come into focus. That's why IRA focuses on distillation of fundamental factors to gain insight into the safety and soundness of banking institutions and their business practices.
Consider a case in point: National City (NYSE:NCC), the $150 billion asset bank holding company based in Cleveland, OH.
We've been getting a lot of questions from readers of The IRA about "what's going to happen" with NCC. We also notice that some under-employed bank analysts are engaged in a food fight over who coulda, shoulda, woulda known what about NCC's sharp financial deterioration and when. In truth, virtually all of the Sell Side analysts missed this glaring outlier. Sorry Tom.
NCC closed at $8 per share Friday, 0.4x book and down 80% LTM. News reports have suggested that management has put a "for sale" sign in the front window, but selling a bank headquartered at ground zero of the US economic meltdown is hardly an easy task. We hear that possible white knights include FifthThird Bank (NASDAQ:FITB) and Bank of Nova Scotia (NYSE:BNS). But hold that thought.
NCC's asset and equity returns started to deteriorate in late 2006, thus those Street analysts who did not adjust their recommendations accordingly, at least by the beginning of 2007, look at tad late, in our humble view. Anyone with access to FDIC call reports or derivative indicators like The IRA Bank Monitor would know this.
Of course, the Street consensus has positive revenue and earnings growth for NCC for 2008 & 2009, even as asset returns are headed for zero. In fact, four Sell Side firms have upgraded NCC in the past four weeks, including KBW (NYSE:KBW), Friedman Billings Ramsey (NYSE:FBR) and RBC Capital Markets (TOR:RY). Maybe we'll get another earnings "surprise" on Tuesday. We can't predict the future, so we'll leave the earnings estimates to the Sell Side precogs.
NCC was a poster child for the supra-normal returns earned by the entire banking industry during the mortgage bubble. In Q1 2004, the aggregate bank units of NCC reported ROA over 2% and ROE of 25%, neither one a "normal" level of performance for any commercial bank and both well-above peer. Today, both indicators now are almost two standard deviations below peer, a very tangible measure of just how far NCC has fallen relative to other banks nationally. ROA for 2007 was 0.2% and ROE was just over 2%.
In terms of credit performance, the red flags were flying over NCC back in Q3 of 2005, when the bank's default rates and Loss Given Default both started to deviate significantly from the peer group. At 71bp for 2007, NCC's charge offs are 0.6 SDs above the 41bp peer average. The LGD of 78% calculated by The IRA Bank Monitor using data from the FDIC is half a SD above peer. At the end of 2007, non-accrual real estate loans equaled 10% of Tier One Risk Based Capital.
With an efficiency ratio of 71% as of year-end 2007 vs. 55% a year ago, NCC is losing ground in terms of its ability to compete with other regional players - though this trend is visible throughout the banking industry. The 4.7:1 ratio of Economic Capital to Tier One Risk Based Capital suggests a relatively low risk business stability profile, with the components of EC for lending, trading and investing evenly distributed.
When NCC's income is compared with the EC results, the RAROC of 2.6% tells the story - too little income vs. too little risk -- but this represents an improvement from the -2.6% RAROC for 2006. With 80% of the bank's assets deployed in loans, the roughly equal levels of EC attributed to investing and trading are remarkable, meaning that the tiny investment and trading books are generating far more noise than the below-peer lending performance. Of interest, the Maximum Probable Loss for NCC's lending book calculated by The IRA Bank Monitor was 104bp as of year-end 2007.
All in all, NCC looks to us quite a mess. We have serious doubts that the situation is going to improve during 2008. While an $8 stock may seem cheap, NCC could easily continue to see its credit and trading book performance deteriorate further. Thus comes the question: Who are the likely acquirers?
Cincinnati-based FITB comes to mind first, in part for defensive reasons, namely that it would not want to see NCC fall into the hands of a larger, hungrier institution based outside of its market. FITB is trading around $20 or 1.4x book, a reflection of the fact that management finally whipped that long-troubled organization back into shape after years living in the bottom quartile of the peer group.
With an ROA of 1% and ROE of 9% as of year-end, FITB is a peer performer. Credit performance is likewise at peer. With an EC to Tier 1 RBC ratio of 0.33:1 and a RAROC of -11.68%, FITB looks overly cautious in terms of risk profile, but right now that is probably not a bad thing.
Proponents of a FITB/NCC combo need to ask a basic question: What is the likely multiple to book for the $300 billion asset post-acquisition entity? Our guess is less that 1x book and it could get a good bit worse if our worst case scenario for NCC and mid-west banks generally comes to pass. Our message to FITB CEO Kevin T. Kabat and the long suffering folks at Cincinnati Financial, who stuck with FITB through the dark years, is to let this bitter cup pass to another, more worthy suitor.
Then there is BNS, a far larger and stronger buyer than FITB. In a bidding war, BNS wins hands down - at least that's our view. According data from CapIQ, BNS has an ROA of 0.9% and ROE of 19% as of year-end 2007, an odd configuration. With a $47 share price trading 2.4x book, BNS could have NCC if it really wanted to take the plunge into the struggling Cleveland market. But question is, would any rational acquirer want to pay anything more than a distressed price to win the right to clean up what's left of NCC?
Should the answer to that question turn out to be yes, then we recommend that BNS wait like a good vulture for the prey to almost die before dropping down from the tree of woe for that meal. If we are right about the depth of the credit sinkhole that stands before all US banks, NCC and most other lenders will be cheaper after Labor Day than they are today.
Disclosure: No positions