The slumping housing market and lingering credit crunch have pummeled financial stocks over the past year to lows not seen in almost two decades. Last year, banks were feeling the pinch from writedowns related to securities backed by mortgages and unsold leveraged loans. This year, banks are getting socked in the stomach as a consumer-led recession results in the rapid deterioration in credit beyond just residential mortgages and into other consumer and commercial-related loans, such as credit cards and residential construction loans.
As a broad swath of banks and consumer finance companies begin to report second-quarter earnings results next week, profits -- if any -- will continue to be weak. Banks will be busy continuing to add to their pile of loan loss reserves, marking down leftover leveraged loans and mortgage-backed securities, and shoring up capital wherever they can, likely in the form of dividend cuts.
This week, TheStreet.com asked several high-profile equity analysts about how the credit crisis is affecting banks and other consumer finance businesses. In this final installment in the series, Gerard Cassidy, managing director of bank equity research at RBC Capital Markets, discusses how the credit crisis has affected trust and processing banks.
TheStreet.com: Goldman Sachs (GS) - Get Report recently said that it expects the banking sector to raise an additional $65 billion before the credit crisis peaks next year, but notes trust banks like Bank of New York Mellon (BK) - Get Report and State Street (STT) - Get Report are buys. Are trust banks better choices for investors during this market downturn? How are these businesses relatively safe from the credit crisis?
: The basic long-term business for the trust banks --
, Bank of New York Mellon and State Street -- are some of the best businesses a financial institution can be in today,
because they primarily bring in recurring fee-generated revenue from businesses like asset servicing for institutional customers, asset management, wealth management, securities lending and foreign exchange trading.
In the commercial banking system, companies that have exposure to the highest risk loan areas, which today are construction loans, commercial mortgages and leveraged loans, are witnessing a dramatic increase in credit problems. The trust banks do not have any meaningful exposure in those three areas, which is one of the reasons they have been identified as great hide-out names during this economic or credit crisis.
What are the biggest potential problems looming for these specific banks?
We're becoming increasingly concerned that if the global equity markets continue to decline, then the fee-based banks will be impacted negatively not by the credit defaults, but by
lower revenue growth from their fee-based businesses associated with the global equity markets. These trust banks are influenced more, and are impacted more, by the day-to-day levels of the equity markets than a traditional commercial bank. There aren't any credit issues per se with the trust banks, but the volatility that's created from the capital markets appears to be picking up.
The trust-based banks are paid on a percentage of assets under custody or assets under management, so if you've got rising equity and fixed income values and you don't even touch your pricing, you get an automatic price increase from your customers, which helps drive revenue and earnings growth. The opposite happens when the values decline.
Still the trust banks aren't totally immune to credit exposures.
Bank of New York Mellon has some corporate loan exposure.
The company also brought onto their balance sheet their asset-backed commercial paper conduit. When they did that they had to move the asset-backed commercial paper conduit onto their books and at that time they had to recognize the losses in the asset values and that was the charge they had taken.
Northern Trust has some construction loan exposure.
State Street has this asset-backed conduit off their books. They may be forced to bring it on to their balance sheet, which is one of the reasons we think they raised the capital, due to the fact that they're tangible common equity ratio would have plummeted if they were forced to take this asset-backed conduit onto the books. We anticipate they will have to take it onto the books, which is going to continue to pressure their price-to-earnings multiple, in our opinion, because now they do have some risk on the books.
Additionally, State Street is running into the problem with the mark-to-market accounting in their investment portfolio. That's now becoming an issue because they have a very large unrealized loss that may turn into a permanent loss, but right now it's being viewed as temporary.
Some firms are also facing various litigation. What's going on there?
State Street had a product that they sold to their customers -- an enhanced index product marketed to the clients as a safe alternative to a traditional money market fund. Unfortunately the enhanced index product invested in structured investment vehicles and other structured product-type investments and when those structured investments fell from grace then the owners of those investments took a beating in their funds. State Street funds that own these investments obviously reported negative returns and I think their customers were very surprised that there was that kind of risk in their portfolio and there has been a lawsuit filed. Their clients feel that they were not made fully aware of the risk that was in the funds.
Bank of New York has that Russian
money laundering lawsuit overhang.
Do you expect to see other large trust banks raise capital like State Street did?
Right now there is really no need for the other two banks to raise capital. It's interesting to note that the fee-based businesses are not as capital intense as lending businesses. And as a result they generate an enormous amount of equity capital from their basic operations. I would say that if there is a transaction that is a must-do transaction for any of these companies ...
they could raise equity capital, but I don't foresee them raising equity capital as a defensive measure, which is what the commercial banks have been doing this year.
What will Wall Street be looking at when the trust banks report?
The number one issue for investors will be the growth of their fee revenue relative to the growth of operating expenses. It's extremely important for these banks because there is much greater pressure on the fee-based banks to spend and invest money to maintain technology and improve technology that's needed to deliver their products to their customers. That technology is very expensive. As a result, expense growth can easily get out of hand, and even if you're growing your revenue at 20%, if you're operating expenses are growing at 25% to 30%, you're actually worse off.
What's your top pick among the trust bank group?
Of the three, Bank of New York to us looks like it's the best value to the money. It's got a low price-to-earnings ratio relative to its peers. Also, you still have the benefits coming in from the merger between Mellon and Bank of New York and those benefits will accrue to them in any type of capital market conditions.