Wachovia (WB) $25.5 billion bid for California's Golden West Financial (GDW) has the market abuzz: Is the long anticipated wave of bank mergers finally here?
Until now, the housing boom and an upbeat economy have kept the industry flush. But a persistently flat yield curve -- which has kept the gap between borrowing and lending costs frustratingly narrow -- is pulverizing margins. Fierce competition in payments and for deposits is cutting deep into profits. To keep earnings aloft, banks have been lowering reserves and underwriting more risky mortgages.
The game can't go on forever. Says Young Im, a senior research analyst at Chicago's Robert W. Baird & Co., a regional investment bank: "We've gone through this period where the drivers to bank earnings are starting to disappear. Before they were trying to ride it out. But now they are a little more willing to sell."
"GROWTH-CHALLENGED" INDUSTRY. Bank executives often resort to buyouts as a source of growth and fresh earnings. Mega-banks, such as Citigroup (C), JPMorgan Chase (JPM), and Bank of America (BAC) aren't expected to do large transformational deals, but rather small, strategic acquisitions. For example, Wachovia's acquisition of Golden West gives the Charlotte bank new branches in California, as well as bolt on expertise in the alternative mortgage-lending industry.
Large-cap universal banks are also eager to add new branches and expand their reach across the country. And so they are expected to take out profitable small (under $2 billion market cap) and medium-sized banks (from $2 billion to $10 billion market cap) in fast-growing communities such as Florida, California, Texas, and the Northeast. "The industry is growth-challenged," says Frederick Cannon, bank analyst with Keefe, Bruyette & Woods in San Francisco, who says M&A will be picking up from here. He figures that Washington Mutual (WM), Downey Financial (DSL), and FirstFed Financial (FED) could be among the first to mull over deals.
However, small and regional banks are also looking for partners to stave off takeovers and competition from the big boys. So they will likely drive M&A activity among themselves. "They are buying growth and critical mass so not to be a target themselves," explains James Owers, professor of corporate finance at the Robinson College of Business at Georgia State University in Atlanta, an expert on mergers and acquisitions in the banking industry.
PICKING THEIR PARTNERS. Jackie Reeves, a senior analyst at Ryan Beck & Co., a Livingston (N.J.) investment bank and brokerage specializing in financial services, agrees: "They'd rather pick their partners than be sold," she says. Her top list for who's in the market: Astoria Financial (AF), Washington Mutual, Westamerica Bancorp (WABC), and Associated Bancorp (ASBC). She also considers Region Financial (RF)
and AmSouth Bancorp (ASO) as good merger partners.
Higher prices portend a market that's heating up. Wachovia's bid gave Golden West's shareholder's a 15% premium over the May 5 closing price of $70.51. So far this year, the number of mergers and acquisitions has been on a par with last year. Yet the 112 deals through May 8 (vs. last year's 107) have pulled in six times the amount of money at $50 billion, vs. last year's $8 billion. In total, there were 331 bank deals last year, worth $82.39 billion, according to Thomson Financial.
High-profile financial-services mergers were relatively scarce in 2005. Bank of America's $35 billion acquisition of credit-card outfit MBNA in June -- one of the largest financial-sector deals in recent memory -- grabbed headlines. In the end, however, 2005 was one of the slowest ever for deals involving banks with at least $500 million in assets.
WAITING FOR CERTAINTY. Except for Wachovia's latest announcement, no one bank deal has wowed Wall Street. Indeed, shares of Wachovia, the nation's fourth-largest bank, fell on the Golden West acquisition news as investors expressed concerns about how the deal will affect future earnings.
Other announcements were taken in stride: On Apr. 8, JPMorgan Chase agreed to swap its corporate-trust unit for the Bank of New York's consumer and small-business banking unit in a deal worth about $3.1 billion. JPMorgan Chase will get 338 branches, mostly in the New York area, and $8 billion in business loans. Last month, Buffalo (N.Y.)-based M&T Bank agreed to acquire 21 Citibank branch offices in upstate New York. Also, credit-card issuer Capital One Financial (COF) is buying North Fork Bancorp (NFB) in a stock and cash transaction valued at nearly $15 billion.
Some observers say that big-time bank M&A won't begin in earnest until there's more certainty about interest rates and the housing market. "We're not expecting any kind of wave of bank activity until interest rates settle down and the patterns become clearer," says Thomas Burnett, director of research at Wall Street Access, an independent research firm. Housing is creating particular anxiety among bank executives, Burnett says. As inventories rise and sales slow, banks are worried that "the market may freeze up, and that could force them to mind their own balance sheets more carefully," he says. That would indeed put a damper on deals.