Valuing Banking securities

James K. Schmidt, CFA

Managing Director and Chief Investment Strategist
Freedom Capital Management

Banking assets are rarely worth significantly more than face value, but they may be worth
much less. Examining earnings and asset quality must therefore be undertaken with a
bias toward finding hidden problems rather than uncovering buried treasure.

Bank stocks have performed well in the past decade,

but they have also been quite volatile. Figure 1
shows that, according to the Dow Jones Regional
Bank Index-a capitalization-weighted index of 53
regional banks-bank stocks have performed very
well since the index was created in 1982. Figure 2
shows the performance of the regional bank index
relative to the S&P 500. On a relative basis, performance does not look as strong as it does on an absolute basis.
Banks are a small-capitalization stock industry;
none is among the top 50 stocks in market capitalization. Therefore, it is not surprising that the relative
performance of a broad-based bank index will approximate what small stocks do relative to the S&P
500. Small-capitalization stocks performed well in
the 1982-83 bull market and then underperformed
until 1989.
The summer of 1986 was a peak in bank stock
relative performance. Frenetic merger activity was
taking place during the first six months, and takeover
speculation was built into bank stock prices. "Bank
stock hell" began in October 1989. The problems
began with the collapse of the United Airlines buyout
financing, which in tum generated concern about the
amount of leverage in the economy as a whole. Coupled with real estate problems and various regulatory factors, this was the beginning of a disastrous
year for bank stocks. Bank stock prices began to
improve again in November 1990.

Bank Stock selection

We have developed a process we use to select bank
stocks and structure a portfolio. The process involves first understanding what is going on in the
national economy. Then, we look into regional fac42

tors-economic growth prospects and the competitive and regulatory environment for banking. We
then develop and maintain a model portfolio.

National Overview
The national overview has two important aspects: the economic growth outlook and the interest
rate forecast. The first step is to determine where the
economy is going. Banks are related to the economy,
but only in one direction-down. A healthy economy can mean bank earnings are up somewhat, perhaps 8 or 10 percent, but a bad economy or a weak
segment within the economy can cause disaster.
The second macro factor is interest rates, and
both the basic direction of interest rates and the
spreads are important for banks. Figure 3 and Figure
4 compare bank performance to three-month Treasury bills on an absolute and relative basis, respectively. Absolute bank performance is inversely correlated with interest rates. As interest rates go down,
bank stock prices go up. Taken relative to the S&P
500, the correlation between bank stock prices and
interest rates disappears, so the apparent correlation
is a market effect.
The relationship between interest rates and bank
stock relative performance is not strong when you
look at correlations over different periods and at
different points on the yield curve. Bank stock performance is difficult to relate to interest rates. That
makes sense because bank earnings are affected by
interest rates, but not in a simplistic way. Banks are
asset sensitive rather than liability sensitive. On average, they make more money when rates are high
than when rates are low. Sometimes funding
spreads open up as rates decline, however, so rates
in the act of falling are more favorable than those in
the act of rising. The celebrated credit card case is a

Figure 1. Dow Jones Regional Bank Stock Price

Index

Figure 2. Dow Jones Regional Bank Index versus

S&PSOO

1982 = 100
400 r - - - - - - - - - - - - - - - - - - - - - - - ,

1982 = 100
140r------------------------,

350

120

300
100

250
200

80

150
60
100
50 L----J_----'-_-----'-_----'--_----L_---'-_--'---_...L.-_-'--------'
'83 '84 '85 '86 '87 '88 '89 '90 '91

40'----'----L---'-------'-------'-----_-'--_-'--_-'--_-'-----'
'83
'84
'85
'86
'87
'88
'89
'90
'91

Source: Freedom Capital Management.

Source: Freedom Capital Management.

good example: As rates have fallen, the spreads on

credit cards have skyrocketed. In addition, the maturity structure of a bank is somewhat complicated
because there are various imbedded options on the
asset side. So no simplistic formula exists to relate
bank earnings to interest rates other than to say the
correlation is low. Thrifts, in contrast, are typically
very liability sensitive.

in an area that provides some growth, earnings can

increase even if margins are stable.
Asset growth sometimes provides a clue about
what is going to happen to asset quality, and changes
in growth rates often foreshadow changes in the loan
quality or the level of noncurrent loans at a bank.
Currently, the most important category to examine
for asset quality is real estate. Table 1 shows loans
outstanding and the percent that are nonperforming
or noncurrent in various real-estate-related categories. Note that construction and development loans
are by far the most troublesome, while loans collateralized by residences tend to produce few problems.
Figure 5 is a map of the United States showing
the percentage of troubled real estate assets by state
and region. The map clearly shows differences in
states and regions. In Massachusetts, for example, 17
percent of all of the real estate assets are nonperforming, which means they are either repossessed real
estate or they are loans that are not being kept current. In contrast, the rates in Idaho and Iowa are only
2 percent. With such wide discrepancies, the poten-

Regional Characteristics
Because the banking system is fractionalized, the
characteristics of different regions of the country are
an important consideration. Three characteristics
are particularly important: growth prospects, asset
values and credit quality, and the banking environment.
The economic growth of a region as measured by
growth of employment or payroll is important because it forms a foundation for balance sheet growth.
Simplistically, growth in bank earnings is a function
of the growth of the earning assets and the interest
margin the bank is earning on the assets. If a bank is
Figure 3. Bank and 91-Day Treasuries Perfonnance

Figure 4. Relative Bank Perfonnance and

Treasuries Perfonnance
1982 = 100

1982 = 100
400,..----------------------,16
350
300
250
200

\
\ \

120

12
/\
\ / - /
./

ISO

1 4 0 , - - - - - - - - - - - - - - - - - - - , 16

14
'"d

10
\

'

"

"'-

100
80
60

50 L-~~;:;_;_~=--=_~=___:_::!::_~!_:_~:__:.,L___----.J 4
'83 '84 '85 '86 '87 '88 '89 '90 '91

40

"_-"/'
\

- - Dow Jones Regional Banks

- - - 91-Day Treasuries

Source: Freedom Capital Management.

12

\
\

"\

'/

/
/",/

/'

"0

\
'\,.

8
6

100

14
\

10]
/

"-

'-

""

....... "

"

"

'---.....,_"_,..--~_____,_'_=_---:-:'-----'-::,_____--"----L-.....,-"---'-----J

'83

'84

'85

'86

'87

'88

'89

'90

'91

6
4

- - Dow Jones Regional Banks

Relative Performance
- - - 91-Day Treasuries
Source: Freedom Capital Management.

43

Table 1. Real Estate Loans Outstanding and Percent of Noncurrent Loans

as of June 30, 1991

All
Banks

Asset Size
$100 Million $1 Billion
Less Than
to
to
$100 Million
$1 Billion $10 Billion

$10 Billion
or More

Total Loans Outstanding ($billions!

All real estate loans
Construction & development
Commercial real estate
Multifamily residential
1-4 family residential
Home equity lines of credit
Commercial real estate loans
not secured by real estate
Highly leveraged transactions
Loans to foreign governments and
institutions

$847.8
116.9
246.3
22.6
353.1
66.0

$97.4
6.3
25.6
1.9
50.7
3.1

$211.1
19.9
68.6
6.5
96.6
14.2

$265.3
43.4
88.1
7.2
98.0
25.8

$274.1
47.4
64.0
7.0
107.8
23.0

28.3
68.2

2.1
0.0

4.7
0.6

8.7
14.3

12.7
53.3

24.9

0.0

0.2

1.5

23.3

4.89%
14.07
6.16
7.65
1.57
0.73

1.98%
3.35
2.73
2.73
1.42
1.23

2.55%
6.41
3.34
3.45
1.40
0.83

5.02%
13.77
5.70
6.45
1.57
0.61

7.59%
18.99
11.20
14.20
1.81
0.73

Percent of Loans Noncurrent

All real estate loans
Construction & development
Commercial real estate
Multifamily residential
1-4 family residential
Home equity lines of credit
Commercial real estate loans not
secured by real estate
Highly leveraged transactions
Loans to foreign governments and
institutions

8.03
11.07

8.42
N/M

8.96
5.59

6.23
10.14

8.86
11.38

16.01

N/M

22.69

13.57

16.11

Source: Federal Deposit Insurance Corporation.

tial for troubled real estate loans at a bank is obviously highly related to geography.
The map also shows the importance of inflection
points, or changes in direction, in the economy. During the past 5 or 10 years, those states that have
grown the most are not necessarily those that have
the fewest real estate problems, and those that have
grown the least do not necessarily have the most
problems. The best correlation of growth with real
estate problems is found by examining those states
where growth exceeded its prior trend line and the
states where growth fell short of the prior trend line.
The dislocations in the real estate market occur when
growth rates change relative to their trend.
For example, during the past 10 years, Iowa went
through very slow growth. The state's economy had
real problems during the early 1980s with the farm
economy in depression and many farms being repossessed. In the late 1980s, the state did not grow, but
things stopped getting worse. Farm land bottomed
at about $1,000 an acre in 1985, and it is about $1,200
an acre now. Things are not going gangbusters, but
they went from being disastrous to being good. That
44

means Iowa has no danger of overbuilt real estate.

Banks in Iowa do not have a lot of speculative condominium loans because not a lot of condominiums
were built. Banks did not have a chance to get into
trouble as they did in other areas, and the nonperforming real estate loan rate is only 2 percent.
In contrast, the Northeast states like Massachusetts and Connecticut experienced a huge problem in
their real estate markets when their economies declined somewhat after being so strong in the mid- to
late 1980s. Massachusetts and Michigan are an interesting contrast. Massachusetts has an unemployment rate a little above 9 percent, which all the politicians are fretting about. Actually, 9 percent is not
that high; it has been higher than that in Michigan for
years. The nonperforming loan rate in Michigan is
fairly low compared to Massachusetts because Michigan has been living with a slow-growth pace for a
decade, while for Massachusetts it represents a radical readjustment. So the change from rapid growth
to poor growth is what gets people into trouble.
The other important point illustrated in Figure 5
is how long it takes to work out of bad real estate

Figure 5. Troubled Real Estate Asset Rates by State, June 30, 1991
Midwest

West

Central

Northeast

MA
7.15

RI

\, "--12.86

---'CT
NJ 16.83
11.76
'DE
4.29

Southwest

~o 'W

HA
0.84
~p-

()

Less than 4 percent

Between 4 percent and 8 percent
More than 8 percent
Source: Federal Deposit Insurance Corporation.

loans. In 1991, the Southwest region looked bad;

several states were posting nonperforming asset ratios of around 10 percent. Those are fairly high numbers, but they disguise the underlying reality. In
Texas, the real estate problems have been much more
severe than in Massachusetts, but the banks with the
really bad ratios have failed, and they are not in the
FDIC sample anymore. If the data are adjusted to
include the failed institutions, Texas has been a disaster. Texas real estate is still producing nonperformers even though we are several years into the
recovery of the economy.
To illustrate the magnitude of the problem, I will
relay the experiences of a savings bank in Washington state that has a loan out on a commercial building
in Houston. It made the loan in 1984. It was originallya $40 million credit, and in 1987, the savings
bank wrote it down to the appraised value of $20
million. In 1989, it took a $9 million writedown on
this property, from $20 million to $11 million.
The timing on this project is insightful. Oil prices
peaked in November 1980, and the economy in Texas
started rolling over. At the time, the price of a barrel
of oil was forecast to be $80 to $90 by the end of the

decade, but it soon became clear that that would not

happen. The first big writeoffs on energy loans were
taken by Texas banks in spring 1982: InterFirst announced in May that it would lose money due to a
big loss provision. Banks in Texas started failing in
plentiful numbers in 1985 and 1986. The real estate
market bottomed in Texas in 1986, but in 1989, people
were still discovering they had to mark their properties down by 45 percent. This seems awfully late in
the game to find out you have problems.
My view of the real estate valuation cycle is
illustrated in Figure 6. This shows the relationship
between when a market turns and when it shows up
in bank earnings statements and balance sheets. It is
not a scientifically produced exhibit; it is a qualitative
representation. Assume we are talking about a particular piece of real estate, such as a condominium in
downtown Boston. On the time cycle, Year 2 represents the peak in the market. Assume our hypothetical one-bedroom condominium in a nice area had a
market value of $250,000 in August 1987, having
risen steadily over the prior years. We did not know
it then, but 1987 turned out to be the peak in the real
estate market. In fact, market values started declin45

Figure 6. Real Estate Valuation Cycle

Initial Value = 1.0
2.4r------------------2.2

- -

/'"-

--,

....

2.0
/

1.8
1.6
1.4
1.2
1.0
0.8 L -_ _- L_ _-----.l

- : -_ _- ' ;_ _- - - :

Years
- - Market Value
- - - Appraised Value
----- Book Value

Source: Freedom Capital Management.

ing from that point forward. A year later that property was worth $200,000; a year and a half later it was
worth $175,000.
Appraised values lag market values for quite
some time. There is a general rule that people have
come to rely on in real estate. Any property is worth
more this year than it was last year. This is treated
as a basic law of physics by a lot of people in the real
estate business and certainly in the appraisal business. Into the first year of the bear market in real
estate, appraised values keep rising, even though
market values are falling. This creates a gap in which
the property appraisals are totally out of sync with
the market.
Another lag occurs before appraisals show up on
the bank balance sheet, because not everything is
appraised every day. So six months or more go by
before the carrying value of nonaccrualloans in bank
repossessed real estate reflects what the appraised
values are. These themselves lag the tum of the
market quite a bit. As a result, a year or two after the
real estate market turns, a very large gap exists between what a bank says its real estate is worth and
what the true market value is. That is the phenomenon we saw in Texas, we are starting to see in New
England, and we will see in California.

Solving the Asset Quality Riddle

The health of a bank can be assessed by analyzing various categories of a balance sheet and how
loans flow in and out of the various categories. I will
use Barnett Banks to illustrate how to solve the asset
quality riddle.
In the current environment, people are very concerned about trends in nonperforming assets. A non46

performing asset is either a nonperforming loan-a

loan that is not current on interest payments-or it is
real estate repossessed and owned by the bank. A lot
of emphasis has been placed on determining whether
a bank's nonperforming assets have peaked.
Barnett's nonperforming asset ratios peaked in the
second quarter and declined in the third quarter,
according to the bank. Five of the six research reports
on Barnett banks that I reviewed recently responded
positively to the fact that nonperformers would decline in the third quarter. Not everyone was bullish
on Barnett, but all analysts agreed that a peak in
nonperforming assets was a good sign.
Many things influence nonperforming asset ratios, but the effects can be sorted out. Using Barnett
Bank's third-quarter report, I will illustrate the relevant cash flows and estimate what happened. The
bank stated in its report that "real estate owned rose
to $383 million" and that "our sales of foreclosed real
estate did increase to more than $30 million." First,
look at the $30 million. The real estate owned is
supposed to be marked to market, so theoretically all
of the $350 million Barnett had in real estate owned
in June is sellable at that value and could be moved
out without a loss. In fact, the bank was only able to
move 8 percent of it. I am not encouraged to know
that only 8 percent of Barnett's portfolio can actually
be moved at the value at which it is carried. In
addition, the bank probably sold its better properties:
If it had 800 properties, it probably picked the best
100 to move out. So selling $30 million is not a
particularly optimistic note.
If its real estate owned went from $350 million to
$383 million, even though it sold $30 million, then the
bank acquired $63 million of additional real estate
during the period. I am assuming that this came
from loans previously considered nonperforming.
As those loans migrated from nonperforming real
estate to real estate owned, the bank foreclosed on
them. There are other paths the balances could move
in that could make that number over- or understated.
For simplicity, however, lets assume that the $63
million migrated from nonperforming loans to other
real estate.
The nonperforming loans category dropped
from $593 million to $558 million during the quarter,
but $79 million was written off and $63 million was
moved to repossessed real estate. With a little arithmetic, it appears that $107 million was actually
added to nonperforming loans during the period
($593-$79-$63 + Y =$558; therefore, Y = $107). This
shows continued deterioration in real estate. That
certainly makes sense because the economy is not
recovering. You would not think you could reverse
all of the problems Barnett has in one quarter this

early on in the real estate cycle. Nevertheless, the

optimistic tone of its report has been accepted at face
value by a few analysts.
In looking at the Northeastern banks, I notice
that of those with a lot of real estate problems, a fair
number also had surprising stabilization or a slight
decline in nonperformers. They are placing a lot of
emphasis on controlling the nonperforming asset
number and being able to record a lower number. I
think that is making people a little too sanguine
about what is going to happen in the real estate
markets generally.

Management Quality

mainly correlated with the size of the bank. The

number of options granted is correlated with the size
of the bank; the price action matters little because
each year more options are granted at current market. As long as the stock price is volatile, the options
will be valuable.
Another problem with managements that own a
lot of stock is that as the percentage of management
ownership increases, the ability to trample on the
rights of the minority shareholders also increases, as
does the ability to plunder the bank for their own
ends if things get bad. So I am not happy to see that
degree of insider concentration because it allows
things to happen that do not always benefit stockholders.

The quality of bank management is an important

consideration. A management can be evaluated by
looking at its past record. Because we are in a tran- Bank Stock Pricing
sition point, particularly in real estate, historical records on some asset quality items are not always
Our philosophy is to buy bank stocks that are cheap.
indicative of what is happening going forward. A lot
When screening banks, many price anomalies can be
of the banks in New England that failed in 1990 had
discovered because the industry is so fractionalized.
impeccable asset quality and very low chargeoffs
Figure 7 shows how bank stocks have traded on a
through 1988. So the past chargeoff record may not
price-earnings ratio (PIE) basis during the past 30
be indicative of the future.
years. The bank PIE has varied over time, but it
Another thing I look for in management is sharealmost always is below the PIE of the S&P 500.
holder orientation. Although a shareholder orientaBanks do not get a lot of respect in the marketplace.
tion is important in most industries, the divergence
Bank stocks last sold at a premium to the market in
between management's payoff matrix and what
the mid-1970s, and now they are just above 60 pershareholders want to see seems to be wider in the
cent; they still are selling at a steep discount.
banking industry. Bank executives' goal in life is not
A good regional bank may sell at 9.5 times this
necessarily maximizing the value of their stock, beyear's earnings, which is about where a low-quality
cause being the head of a large bank or of any bank
utility stock would be. This is puzzling because over
makes you a prominent figure in a community. It
the long term, bank stocks have been big outgives you a certain influence that you cannot put a
performers, and many studies show that bank earnmonetary value on. Remaining the head of the bank
ings-per-share growth over a 10- or IS-year period is
and continuing to make the bank grow is the most
very competitive with that of the market, and often
important goal for a lot of bankers.
better. One explanation is that the market is ineffiTo determine whether banks are shareholder
cient and banks are underpriced. This is true to a
oriented, analysts have to watch what they do rather
point, and I believe that the gap will narrow during
than listen to what they say. Their actions must be
the next five years.
consistent with maximizing shareholder wealth. A
Figure 7. Relative PIE Ratios-Keefe, Bruyette, &
number of analysts use the amount of stock held by
Woods Index versus S&P 500,1961-91
management as a measure of whether management
120
has the interest of the shareholder at heart. I think
this yardstick has a number of problems. First, assuming management's sole goal is increasing their
own personal wealth, the amount of stock ownership
..... 80
@
would have to be tremendous before their wealth is
~
more correlated to the price movements in the stock
0'::: 60
than it is to their compensation plan. If the bank
grows, the compensation packages keep growing
40
and ensures wealth regardless of stock performance.
Stock option plans are often cited as incentives
20 L..l..::----,,-l-:-----,,,L------,-,l ----.l...--.....L------.J
'61
'66
'71
'76
'81
'86
'90
for improving stock performance. However, in these
plans, the wealth accumulated from stock options is
Source: Keefe, Bruyette, & Woods, Inc.

47

Bank stocks are not as alarmingly underpriced as

they might appear statistically. The reason for this is
the method a lot of analysts use to calculate bank
statistics. Too often, problem banks are removed
from samples because they distort statistics. Because
of this practice, banks as a whole appear to have very
good earnings progressions. For example, a portfolio of favorite banks in 1980 would have included
Texas Commerce, Mcorp, SeaFirst, and a lot of banks
that failed or were taken over at distressed prices in
the 1980s. Yet most people who do retrospective
studies tend to exclude these banks. That is true of
loan-loss provisioning, too. Whenever a loan provision is sufficient to produce a quarterly loss, the
number is removed from the sample. Severe loan
losses cannot be ignored. So I do not think that banks
are nearly as undervalued as some of the PIE statistics might show. There are always risks to bank
earnings streams that are greater than would be evident from retrospective analysis of "cleansed" data.

The Banking Environment

Figure 8. Bank Acquisitions Announced--Total

Assets by Quarter
250

214.9
200
~ 150

r:o

fFt

1.

lOOt,
.

5~t

. . . _.. 3.9

HW

7,1

14.6

3.4

8.9

->~,

4/'89 1/'90 2/'90 3/,90 4/'90 1/'91 2/'91 3/'91

Source: SNL Securities Monthly.

markets. Phenomenal expense savings are one result

of this type of merger, which tends to benefit both
banks. It also is good for the industry as a whole. In
each of the deals pending right now, between 8,000
and 10,000 employees may be cut to achieve the
efficiencies that will make the merger work. For all
the deals now outstanding, the number of jobs to be
lost is between 50,000 and 60,000. That is not good
news for those 50,000 or 60,000 people, of course, but
for those remaining, it is a tremendous capacity reduction in the industry. Having fewer bankers and
fewer banks has some positive implications for the
overall competitive structure in the industry.

The banking environment is another important consideration. The United States has about 13,000
banks; in Canada, 10 banks dominate the country.
The fractionalization of our banking system is the
byproduct of regulation. To a large extent, these
rules now have changed. Banks have been deregu- Conclusion
lated on the product front and also geographically,
state by state. A measure before Congress would
Commercial banks represent an inexpensive group
allow full nationwide banking.
of stocks that should benefit over the upcoming years
A great deal of merger activity lies ahead. Figure
from consolidation activity. This will provide an
opportunity for shareholders of target banks to re8 shows the volume of deals announced during the
ceive takeover premiums, and it will reduce compepast eight quarters. You can see this volume has
tition and allow the entire industry to operate more
exploded this year. Banks were out of the merger
efficiently. The main challenge for analysts is to
game somewhat when they were under regulatory
avoid pitfalls-those banks whose financial statepressure in 1989 and 1990. That has now subsided,
ments do not relate the true underlying values. Unso we are seeing a lot of deals. The volume exploded
fortunately, banking assets are rarely worth signifiin the third quarter of 1991. In the fourth quarter so
cantly more than face value, but they may be worth
far, a couple of major deals have already been anmuch less. Examination of earnings and asset qualnounced-Manufacturers National and Comerica,
ity must therefore be undertaken with a bias toward
and National City and Merchants National.
finding hidden problems rather than uncovering
A new type of acquisition is more common now:
buried treasure.
mergers of equals-that is, banks in overlapping

48