Shrinking Valuations Drive Bank Payroll Cuts to Buoy Profits
Financial firms, shunned by investors to a degree seen only once in the last 20 years, are becoming a smaller part of the U.S. economy as they deal with a past that won’t go away and a future of lower revenue and fewer jobs.
Shares of financial companies have fallen for three straight months and now have their lowest ratio to the Standard & Poor’s 500 Index since 2009. Net revenue at the six largest U.S. lenders -- Bank of America Corp. (BAC), JPMorgan Chase & Co. (JPM), Citigroup Inc. (C), Wells Fargo & Co. (WFC), Goldman Sachs Group Inc. (GS) and Morgan Stanley -- will probably fall 3.7 percent in the second quarter, the fourth year-over-year decline in five quarters, according to 100 analyst estimates compiled by Bloomberg.
Persistent low interest rates and stagnant loan growth are shrinking interest income as new regulations curtail fee revenue from retail banking. Analysts, including Meredith Whitney and Nomura Holding Inc.’s Glenn Schorr, expect the slow growth to result in job cuts on Wall Street in the coming months.
“Without any change, the financial sector is definitely set to shrink,” said John Garvey, head of the financial industry advisory practice at PricewaterhouseCoopers LLP. “You don’t have to be a scientist to figure out that tighter regulation and more onerous capital rules without economic growth will shrink the industry. It has to.”
Financial stocks have trailed the broader market for nine of the past 11 months. The ratio between the price of the 82- member S&P 500 Financials Index (S5FINL) and the S&P 500 Index (SPX) is less than 0.16, down from a peak of 0.36 in March 2004. The only other time in the past 20 years that the ratio dropped below 0.16 was a stretch from January to mid-April 2009, when some banks faced the prospect of nationalization after taking billions of dollars in rescue funds to survive a credit crisis.
David Tepper, founder of hedge fund Appaloosa Management LP, used his investments in the largest banks that year to drive a 132 percent return in 2009, making his fund the best performer among those with more than $1 billion in assets.
This time around, Tepper, 53, isn’t as bullish. Appaloosa cut its stakes in five banks -- Citigroup, Wells Fargo, Bank of America, Fifth Third Bancorp (FITB) and SunTrust Banks Inc. -- in the first quarter by an average of 43 percent.
“I wish it was 80 percent, because they’ve been absolute crap since we sold them,” said Tepper, whose fund is based in Short Hills, New Jersey. “So we were 40 percent right.”
Banks face at least 15 major “overhangs” to performance over the next few years, FBR Capital Markets analysts including Edward Mills wrote in a June 3 note to investors.
Drags on earnings include new regulations surrounding proprietary trading and debit-card interchange fees; state and federal investigations into mortgage practices; and stricter capital and liquidity requirements. New rules set by the Basel Committee on Banking Supervision, which begin to go into effect in 2013, may trim the return on equity of U.S. banks by 3 percentage points, according to estimates by McKinsey & Co. consultants. The requirements may be especially onerous at firms deemed systemically important.
“Those are pretty big clouds, there’s no arguing with that,” JPMorgan Chairman and Chief Executive Officer Jamie Dimon, 55, said last week at an investor conference in New York. “So, if you’re an investor, you’re going to look at it and say there is a lot of uncertainty.”
As less revenue comes into banks, more money may be drained by mounting legal risks, according to FBR.
Bank of America, based in Charlotte, North Carolina, paid about $3 billion to resolve some mortgage repurchase demands from Fannie Mae and Freddie Mac in the fourth quarter, and it may face more claims as housing prices slide this year. The largest mortgage servicers, including Bank of America, Wells Fargo and New York-based JPMorgan, also may have to spend $5 billion to $17 billion to settle state probes into documentation lapses during home seizures, according to the FBR note.
Goldman Sachs, which paid $550 million to settle Securities and Exchange Commission charges related to its marketing of mortgage-related securities, now faces investigations by the Department of Justice and the Manhattan District Attorney’s office after U.S. Senate investigators focused on the bank in a probe of Wall Street’s role in the housing-market collapse.
“U.S. banking profitability will be considerably less in my view in the period ahead than it was in the early part of this century,” Berkshire Hathaway Inc. Chairman Warren Buffett, 80, told the company’s shareholders April 30 during their annual meeting in Omaha, Nebraska.
One key reason is that banks won’t be able to use as much leverage -- borrowing money to multiply their returns -- as regulators tighten capital rules, he said.
“That’s probably a good thing for society,” Buffett said. “That may be a bad thing for banks who can use leverage intelligently.”
Even U.S. banks’ core lending mission is under pressure. Average net interest margin, the difference between what banks charge for loans and pay on their own borrowings, rebounded from an all-time low at the end of 2008 as the Federal Reserve cut interest rates, climbing from 3.15 percent to 3.84 percent in March 2010, according to data from the Federal Reserve Bank of St. Louis.
Since then, net interest margin has fallen for four straight quarters to 3.57 percent, the data show. That has come as banks run out of room to cut deposit rates, and higher- yielding loans are paid off or default and are replaced by lower-rate loans. While loans made up 49 percent of interest- earning assets at the four biggest banks last year, the same percentage as in 2005, the rate earned on those loans was 6 percent, down from 7.2 percent five years earlier, according to data compiled by Bloomberg.
Loan growth stalled as consumers cut back debt and demand for mortgages waned. Average loans among 37 banks with the largest market values fell 4 percent in the first quarter from last year, according to a May 10 report by Melissa Roberts and Elissa Niemiera, analysts at KBW Inc.
The four largest U.S. banks were looking to unload $751 billion of loans as of Dec. 31 as they exit some lending businesses and try to cut their riskiest assets, Brian Foran and Schorr, analysts at Nomura in New York, wrote in a March 1 research note. That represents 26 percent of their total lending, presenting a high hurdle for loan growth as banks try to make up for the loss of runoff loans, they wrote.
The lack of growth and mortgage-related issues, combined with what he called “attacks” on the industry, helped Appaloosa’s Tepper reach his decision to cut bank holdings last quarter, he said. The strength of the U.S. economy will largely determine whether the industry shrinks, and regulatory changes are already reflected in the share prices, he said.
“If the economy is OK, these stocks are probably getting attractive again,” Tepper said. “They’re not uninteresting now, but I don’t know if they’re interesting.”
Financial companies accounted for 29.3 percent of U.S. corporate profits over the 12 months ended March 31, compared with 31.6 percent over the previous decade, according to data from the Bureau of Economic Analysis. That’s off the high of 41.7 percent in the 12 months ended Sept. 30, 2002.
The number of U.S. financial-industry jobs dropped for the fourth straight year to an average of 7.63 million in 2010, according to the Bureau of Labor Statistics. That’s 8.4 percent below the 2006 peak, and the figure fell to 7.61 million in May. New York City lost about 14,600 jobs in investment banking, securities dealing and brokerage in the year ended Nov. 30, according to the New York State Department of Labor.
Four of the six largest banks reduced their staff in the first quarter, led by Wells Fargo’s 2,000 cuts, while Citigroup maintained its headcount and JPMorgan added about 3,000 workers.
Morgan Stanley, owner of the world’s largest brokerage, may eliminate more jobs at its wealth management unit, Chief Financial Officer Ruth Porat said at the Deutsche Bank Global Financial Services Conference in New York yesterday. The division, which had about 17,800 employees at the end of March, was previously aiming to reduce that figure to as little as 17,500, according to a spokesman for the bank.
“We may reduce our broker headcount below previously announced targets,” Porat said.
Barclays Plc, the British bank that acquired Lehman Brothers Holdings Inc.’s U.S. unit in 2008, cut as many as 50 jobs in its equities division worldwide, according to a person familiar with the matter. The reductions affected employees in sales, trading and research, said the person, who requested anonymity because the plan isn’t public. The move, part of a mid-year performance review, wasn’t made because of falling revenue, the person said.
‘Unsexy’ Housing Market
“I’ve looked for layoffs on Wall Street for the past six months,” Whitney said on Bloomberg Radio in May. “You have a clear issue: Wall Street’s revenues were driven by something as unsexy as the housing market.”
Falling bank stocks have discouraged executives from making acquisitions to drive revenue growth. Banks, thrifts and diversified financial firms have been acquirers in $40.2 billion of announced deals through May, an amount set to rival 2009 as the lowest year of acquisitions since 2002.
“Investors would like acquisitions to occur, but they have to be at a certain price point,” Stephen Steinour, CEO of Columbus, Ohio-based Huntington Bancshares Inc., the 17th- largest U.S. bank. “For us, at 1.5-times book, our stock is very cheap. Why would I want to give up that cheap stock to buy a problem?”
Bread and Butter
Instead, banks are shifting focus back to bread-and-butter businesses, such as retail banking, brokerage services and asset management, and dusting off past strategies, such as “cross- selling” additional products to existing customers.
Morgan Stanley, based in New York, has hired more than 170 private bankers to make loans and offer deposit products to its retail brokerage clients. Bank of America is looking to win banking business from the two-thirds of Merrill Lynch customers who have bank accounts with other lenders. Wells Fargo in San Francisco is building out its retail brokerage as it seeks to capture business from 5.2 million clients who hold $1.7 trillion in investment assets at other firms.
None of those strategies is likely to replace the mortgage securitization boom and leveraged bets that drove years of profits before the 2008 credit crisis, Whitney said.
“Nothing is compelling in terms of providing a great growth engine for the large banks,” Thomas Brown, CEO of Second Curve Capital LLC and a Bloomberg contributing editor, said on Bloomberg Television last month.
Banks will end up battling for market share in the U.S., said PricewaterhouseCoopers’ Garvey.
“Right now in the U.S., it’s much more about carving up the pie a different way rather than growing the pie,” he said.
That’s driving the country’s biggest banks to seek growth overseas, particularly in emerging markets. Citigroup CEO Vikram Pandit, 54, predicted in 2009 that his bank would become the “largest emerging-markets financial services company,” a goal he pursued last year by increasing assets in Latin America and Asia by 16 percent to more than $470 billion. The firm, based in New York, now gets more than half of its profit from emerging markets, Pandit said at a March 9 conference.
“We have a unique footprint that we believe will allow us to harness global growth trends and deliver value to our clients and shareholders over time,” said Shannon Bell, a Citigroup spokeswoman in New York.
Spokesmen for the other five banks declined to comment or didn’t return calls.
Bank of America CEO Brian Moynihan, 51, said in February that his bank would look to produce revenue increases that outpaced the growth of the U.S. economy by 1 percentage point, driven by its international opportunities. Goldman Sachs Chief Operating Officer Gary Cohn, 50, said this month that his firm’s hiring efforts are concentrated on China, India and Brazil.
Looking for revenue in developing countries won’t be easy, as banks face strong local competition, lower fees than in the U.S. and political obstacles.
“We expect to continue to see ferocious competition in these markets,” analysts from Oliver Wyman and Morgan Stanley said in a March research paper on investment banking. “The importance of emerging markets looks set to intensify, but rising costs and falling yields will mean less of the top-line growth comes through to the bottom line.”
The focus on emerging markets may also lead to more job cuts in the U.S., analysts said.
“You’ll have more banks going after the emerging markets business because it’s growing, and there’s probably less regulatory scrutiny,” said Keith Davis, an analyst at Farr, Miller & Washington LLC in Washington, which manages about $700 million. “I wouldn’t be surprised to see banks devote resources to the build out of their international network, especially in emerging markets, and more shrinkage in the U.S. as regulatory requirements get more onerous and returns fall.”
Morgan Stanley CEO James Gorman, 52, said at the firm’s annual shareholders meeting last month that financial companies are undervalued because investors are focused on worst-case scenarios and lack clarity about regulatory changes and new capital rules. Value investors may soon find the industry attractive as many firms are trading below book value, he said.
The 10 largest U.S. banks by assets are trading at about 91 percent of their book value, ranging from 50 percent at Bank of America to 161 percent at Minneapolis-based US Bancorp. That means investors don’t believe the assets of some banks are worth as much as the companies say.
Financial firms, led by New York-based Citigroup, were the most sold-off sector by hedge funds in the first quarter, according to filings by 817 hedge funds compiled by Bloomberg. Hedge funds cut positions in financials by 1.3 percent in the quarter, more than three times the decline for any other sector.
“We’ve had so many value investors that have gone into them, been burned and come back out that it is a tough time to sell brokerage stocks or banks” to investors, Brad Hintz, a Sanford C. Bernstein analyst, said in a Bloomberg Radio interview last month. “They cannot trade below their liquidation value. At some point, they become one-way bets.”
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