|
The US government is going to kill the
small banking industry in the US. The irony is hard to miss. It was not the
small banks that threatened the financial system in the crisis of 2008. Yet
they will bear the brunt of the regulatory costs imposed in its wake. The end
result will be that US banking assets will collect into the hands of even
larger banks.
It is a shame. Yet the death of the lamb is the life of the wolf, as an old
saying has it. In other words, it is not all bad for everybody, as I?ll
explain below.
First, let me begin with a piece of anecdotal evidence from the departing CEO
of Third Street Bancshares, based in Marietta, Ohio. His name is James Meagle
Jr., and he had been in banking for 40 years.
A CEO leaves some company somewhere every day. That, in itself, is not news.
But few CEOs depart by saying that the company he?s leaving might not
survive. Citing tremendous changes in regulatory costs and compliance issues,
Meagle said he ?didn?t have the patience anymore.? His old bank will have to
spend about $100,000 to meet new demands from regulators. For a little bank
with one branch, $100,000 is a lot of money. I bet it is a big chunk of the
money it makes in a year. Third Street is privately held, so we can?t know
for sure.
?I don?t know how we?re going to be able to make it,? Meagle tells SNL
Financial. ?We can [survive], but we?re just spending so much time and energy
complying with these new regulations.?
?Absolutely ludicrous,? is how he described the regulators? level of
scrutiny.
What?s this bank to do? Merge.
?We?ve been able to hold our earnings up and we?re still well capitalized,?
Meagle continues ?but what I see coming in the future is not pretty. We
really do not want to sell, but we may have no other options.?
It?s a story I?ve heard often from banking industry executives, as well as
from professional investors in the banking sector. The small banks will have
to sell out to larger banks, which can spread out those costs over a larger
asset base.
Some more color to the backdrop may help you focus in here. Let us consider
the US banking system. What does it look like? Well, the top 20 banks hold
nearly 80% of the industry?s assets today. Take a look at the nearby chart.
The question naturally arises: How big do you have to be to earn an attractive
return as a banking franchise in the US of A?
It?s an unsettled question, even among industry insiders. What?s nearly
certain is that the 2,490 banks on the bottom are toast. Those are the Third
Street Bancshares of the world. Way too small to even make a go of it, like a
9-year-old trying to block linebacker Ray Lewis.
The next level up will probably have to sellout as well. These are the
4,000-plus banks with assets up to $1 billion. In fact, regulatory costs, as
well as banks? net profit margins (from low interest rates), put pressure on
the next block up to consolidate.
Now here is the opportunity ? and more irony.
|
What big
banks know could cost you...
|
|
For good banks, buyouts occur at premiums to book value. Yet many healthy
small banks trade below book value. In fact, in a recent issue of Mayer?s Special Situations,
I urged my subscribers to invest in three specific small banks. Each of them
trades below book value. Each of them has plenty of capital. And my bet is
that at least one of them ? and maybe all of them ? gets bought out at a
premium to book value in the next five years.
I expect we?ll see many of the smaller banks combining over the next several
years, like droplets of water forming with other droplets of water to make
bigger and bigger drops of waters. As investors, you gain by owning the
undervalued, small banks.
But you can also play the acquirers. Here, you want to own the healthy predators,
such as Republic
Bancorp (NASDAQ:RBCAA), which has picked up a couple of
failed banks in the last couple of years. It is a consolidator of banks and
will grow as a result of the acquisitions.
Investors benefit from consolidation because larger banks get a better
multiple.
Some months ago, I spoke with John Palmer at PL Capital, an outstanding
investor in bank stocks. As John explained, ?The larger the bank, the better
they tend to trade off of book value.? Typically, a $3 billion bank will have
a higher trading multiple than a $1 billion bank. And a $1 billion bank will
have a higher trading multiple than a $500 million bank. So by moving up the
food chain, a bank can actually increase its trading value based on asset
size.
?That?s why these companies are looking to buy other banks and get bigger,?
John said. ?If they can move from $1.5 billion to $3 billion and get some
cost savings out of it, they are going to get a higher trading value. If they
can go from $3 billion to $5 billion, they are going to get a higher trading
value again.?
The unfortunate part is that the industry consolidation underway will mean
the death of the small community bank. The consequence of all those new rules
and regulations is that the US banking system will become even more
top-heavy. Banks will get even bigger. Banking assets will concentrate in
fewer hands. And while I expect there will be lots of foot-dragging and
resistance from entrenched boards and management teams, I think the deals
will get done. There is too much money at stake.
The eventual death of small banks ought to mean good returns over the next
few years as these dynamics play out. For investors in bank stocks, the irony
is profitable.
Regards,
Chris Mayer
|
Bob Woodward says he got email from WH saying, "you will regret doing this."
