We’ve made our annual list of themes that we believe are critical when assessing the New Year. This applies to any and all professionals who are intertwined with the banking industry and reflecting on how this business will evolve in 2016.
1. The Possible “Madam President”
Like it or not, bank stock investors must anticipate political change later in 2016. It is a Presidential year of major proportions, and how the next leader at 1600 Pennsylvania Avenue perceives banking and small banks is quite important.
There seems to be a whiff of reform in the air that might tweak parts of the Dodd-Frank Act and perhaps loosen the reigns on some regulations. How does our next President feel about reforming the strict Dodd-Frank rules? Does she (or he) even care to make this a campaign topic as they hit the trail over the next 10 months?
In our view, investors must consider the political landscape in 2016, if for any other reason to judge whether Boards of Directors feel that zero change in the regulatory climate will occur and therefore conclude that their best course of action is to sell to another bank. The election and regulation are critical factors for the speed of bank M&A transactions. This is why the election leads our list of themes for the next year.
2. M&A Gains Speed & Pricing Altitude
As of early December, there have been just under 250 bank and thrift M&A deals in 2015 with a $742 million average asset size at the seller. There were 267 transactions in 2014 and 209 in 2013, both with sellers just over $560 million in average assets.
It is less important that the average asset size is higher—the percentage of deals above $1 billion consistently has been around 10%. Big bank M&A is not the trend and this was true back in the late 1990s (see our chart below). In 2016, we expect M&A deals to increase, but the sellers’ size is unlikely to change much at all.
Small bank consolidation is the real trend — frankly, it always has been. Although some larger institutions may merge, we feel the large bank deals such as First Niagara (FNFG) and Astoria Financial (AF) in the past few weeks are quite unique.
The clearer trend is that small banks continue as the most active sellers. We note that sale premiums to the “Day-Before” price remain healthy (above 30%) and the median price-to-tangible book ratio is slowly getting better, but still trails the sale prices from 1996 to 2001. Remember that pricing in the late 1990s included the benefit of the pooling-of-interests accounting method, which permitted high prices.
3. Expect More Mergers Long Before The $10 Billion Threshold (Some May Cross-The Line)
In our opinion, not enough attention is being paid to the banks between $5.0 to $9.9 billion who operate below the Dodd-Frank asset threshold of $10 billion, which engages stress testing, lower debit card fees and presumably greater regulatory scrutiny.
We think the perception of $10 billion in assets could have a greater influence on M&A decisions inside boardrooms and in the minds of CEOs and Chairs of Bank Boards of Directors. From ongoing conversations with managements, regulatory examinations lead to the application of “best practices” and early risk management planning for banks even as they exceed the $5 billion mark.
One CEO has been outspoken and feels $1 million per year in additional expense is needed for every $1 billion in assets added at his company in order to keep his regulators happy. Organic vs. acquired does not matter, compliance expenses simply rise with asset growth. Thus the cost of being larger, let alone crossing-the-line above $10 billion in assets, has become an intricate decision.
We think certain banks may tire of the perceived regulatory headache and the real additional costs associated with expansion towards the $10 billion threshold.
Instead, these companies may pull the ripcord and sell themselves in an M&A transaction. Just look back at the surprise sale of National Penn Bancshares (NPBC) to BB&T Corp. (BBT) back in August for a strong price. We think there are more of these kinds of deals likely to occur in 2016.
While we believe that small bank M&A remains the majority of deal activity in 2016, some exceptions always occur. These larger-sized community banks could be a source of surprise M&A. Investors should consider this angle and be prepared.
4. Expect Higher Interest Rates From The Fed. But, NIM Is A Challenge
Yes, the Federal Reserve may increase short-term interest rates. But, we assert that 25 or 50 basis points is all that occurs. This may not be enough to make a real difference to banks’ income statements and net interest margins (NIM), a key ratio we watch.
The companies who benefit the most tend to be institutions with a large emphasis on commercial loans that are tied to a short-term LIBOR index that would adjust upward with any Fed policy rate change or the largest banks with credit card and home equity loans tied to the prime rate. We anticipate all major banks raise their prime rate in lock-step with the Federal Reserve.
NIM remains a challenge for most financial institutions even though loan payoffs could slow as many companies have already reset their prior high-rate customers. Additional leverage exists within the earning asset mix to reduce securities and cash in favor of a higher loan percentage. Low NIMs remain at many banks with 52% of the 320 public banks and thrifts between $30 billion to $900 million in assets have a NIM below 3.50%, up from 41% in Fall 2013.
5. Credit Issues Seem Quiet, Will This Continue To Be A Non-Event? Our preferred way to judge credit is the combination of nonaccruals and OREO plus disclosed credits rated “special mention” and “substandard” in 10-Qs. This data is available for nearly 80% of the 320 public banks between $30 billion and $900 billion in assets as of September 30, 2015.
Credit is quite sanguine today since over 85% of the companies have less than a 3% nonperforming asset (NPA) ratio (i.e., as a percentage of total loans + OREO), and then over 70% of the same companies enjoy below a 3.0% substandard loan percentage.
Energy-related ranks are the exception here. We think reserves could stand a slight uptick at many companies, but until net charge-offs see a real increase, the level of reserve building is likely to stay modest. We particularly think reserves grow at the companies with the highest net loan growth (i.e. examiners desire new provision charges to cover new loan balance expansion). Even if loan growth is moderate, loan provision expense may still be higher at several banks in 2016 vs. 2015.
The Last Word: Bank Stocks In 2015
Through Friday, December 4, it has been a positive year for bank stocks in 2015 with the SNL Bank and Thrift Index rising 4.7%, and NASDAQ Bank Index up a whopping 12.5%.
The Bank sector had far outpaced the S&P 500’s modest 1.6% increase and the small 1.8% decline in the Russell 2000. In fact, when we look at a list of 320 stocks between $30 billion and $900 million in assets, about 60% of large-cap stocks have exceeded the SNL Bank & Thrift Index, while 80% of the mid-, small-, and micro-cap companies have outperformed.
The history of the bank sector and equity market percentage changes is shared from 2007 to 2015 in the table below. Clearly, recent years have been positive with the SNL index beating the S&P 500 in 2012, 2013, and so far in 2015.
Separately, we also examined the median P/E multiple using forward earnings which has had a slow upward bias during this year (although pricing has not yet hit the same level as in March 2014).
Find out how the FIG Partners Research Team can help you meet the challenges of the banking industry in 2016. Click here to learn more.