Managing Director of Equity Research,
RBC Capital Markets
|Recent Meet the Streets|
Glen J. Buco
Following Enron's meltdown, anything remotely related to off balance sheet activity has been enough to send investors running for the exits. The banking sector has been put under particular scrutiny because its business entails making trades, loans and other transactions on behalf of third parties, many of which tend to be kept off the balance sheet.
Just last week, the
Federal Reserve said it will be examining the sector's special-purpose entities more closely, and many expect that move will result in greater disclosure requirements for banks. TheStreet.com spoke with Gerard Cassidy, managing director of equity research with RBC Capital Markets, about what increased disclosure might mean for banks' bottom lines and share prices, as well as on his outlook for the banking sector in general. Cassidy says further disclosure will make these stocks riskier over the next six months, but that the direction of the economy and interest rates are bigger issues in the long term. He believes the sector as a whole is overbought, but companies that are suffering the most from rising credit costs may be the ones to buy later this year. TSC: How are the current disclosure issues likely to impact bottom lines and share prices in the banking sector? Cassidy: I'm not certain that increased disclosure alone will cause bank stock prices to go down. But should the market get jolted because of a derivatives problem, or should there be talk of forcing banks to consolidate their special-purpose subsidiaries that are off balance sheet to on balance sheet, should those things be discussed in the open markets, then it could hurt the bank stocks. Because banks will be giving greater details about the off balance sheet risk to their businesses, and people could put two and two together. The question is counter-party risk. Let's say there's a risk that a Japanese company is going to default on its derivatives contract. Right away everybody can see which banks have exposure to those derivatives contracts, under the new disclosure, and the stocks of these banks could get hit. TSC: Which banks are most liable to come under scrutiny? Cassidy: I would say it's going to be our large banks. They have the bigger risks to their balance sheets. J.P. Morgan ( JPM), Bank of New York ( BK), Bank of America ( BAC) -- that's where the potential impact could be. TSC: Will increased disclosure have any impact on banks' debt ratings? Cassidy: I don't think so, because rating agencies have access to information that the public typically does not. TSC: What about the consumer credit market? Is it likely that banks will become more conservative about their business if they are forced to disclose more of it? Cassidy: I would say that many of the businesses that will be disclosed now tend to be investment grade businesses. Most of the loans that are in the special purpose subsidiaries are of extremely high quality. Unlike PNC, most banks put good loans and not bad loans in their off balance sheet subsidiaries. So from a lending standpoint, I don't envision the increased disclosure that we all anticipate to negatively impact lending in any material fashion. Rather, if it's consumer subprime lending that a company is involved in, it's the trends in that business itself -- increased charge-offs and losses -- that will make banks more conservative. These things will have a greater impact than disclosure of prepayments or writeoffs. TSC: What is the overall outlook for the banking sector right now? Cassidy: The bigger issues for us are not so much disclosure, although there will be one or two big doozies out there, that are just totally unexpected, and we have that risk out there. But we're more focused on, what's the economy doing and what will interest rates do in the next 12 months. Those two issues will have a greater impact on banks' stock prices. The years 1994 and 1999 are the last two times that the Fed raised short-term interest rates. Should the Fed raise interest rates this year, though we don't expect them to, bank stocks would suffer as they did in 1994 and 1999. The other risk for the group is that they are over-owned by portfolio managers. In fact, if you look at the weightings in the S&P 500 for the sector, these are starting to come down. They peaked at 20% in the fall of last year, and they're down to 18% for the whole sector. The risk that we run is that there is a rotation out of the sector. If we see a sustained rise in the economy next year, and portfolio managers say, why do I want to own a bank when I can own Caterpillar ( CAT) or Dow Chemical ( DOW), those real basic-industry and deep cyclical stocks. That is the risk on the horizon, by which I mean, over a 12-month time period. In the near term, over the next six months, you have the risk of a big name having a real doozy of an announcement in its 10-K. That could affect the entire sector -- especially those companies that haven't released their 10-Ks. Not the bank of the Florida Keys, but if Morgan comes out with a big announcement in its 10-K, and all the other banks have not yet released their 10-Ks, they will be affected. But the real question in the near term for the banks is where they are going to get their revenue growth. National City, for example, got a third of its revenue last year from falling short-term interest rates. If the banking industry doesn't envision interest rates continuing to fall this year, how is it going to make up the lost revenue that it generated in 2001 from falling rates? TSC: What kind of push are banks making right now to make up for the lost revenues? Cassidy: They're not. They can't make additional loans, because they're worried about the commercial credits. TSC: What forecasts do you have for revenues and earnings for the sector in 2002? Cassidy: We expect earnings growth will be in the 6% to 7% range, revenue growth will a little bit lower -- maybe 4% to 5%. On valuations, we go back to February 2000 as the last time the stocks were cheap, at about 9.5 times projected 2000 numbers, and 45% of the P/E of the S&P 500. Today they're at 13 times projected 2002 numbers, and 65% of the P/E of the S&P 500. When they peaked in the summer of 1998, they traded at 18 times 1998 numbers, and 80% of the S&P 500's P/E. So we're kind of smack in the middle. You can't say sell them all, and you can't say buy them all. TSC: Which banks do you find most attractive? Cassidy: The ones that have proven to grow earnings in almost any kind of economic environment, recession or growth: Mercantile Bankshares ( MRBK), Fulton Financial ( FULT), Silicon Valley ( SIVB), Zions ( ZION) and Wells Fargo ( WFC). Those are the names we're sticking with at this time. But we're reviewing and analyzing when it is going to be time to own the companies that have suffered the most during the recession due to rising credit costs. Those credit-impaired stocks are going to be the ones to own sometime this year. The question is, do you buy them now, or do you wait? These companies include FleetBoston ( FBF), Comerica ( CMA), US Bancorp ( USB), Bank of America ( BAC), and J.P. Morgan ( JPM). All are credit-impaired banks that we think could be purchased some time in the next three months -- if you believe the economy is coming back.