To hear Gerard Cassidy's take on bank M&A, it should be renamed mergers and accounting.
Cassidy, the managing director of equity research at RBC Capital Markets, said in a recent interview that he is convinced more than ever that changes in accounting rules are the biggest reason why merger and acquisition activity is slower now than after the thrift and banking crises of the late 1980s and early 1990s.
Today, banks have to use "purchase acquisition" accounting, which means they must add the target's assets at fair market value. The difference between that and the deal price is reflected as goodwill and must be subtracted from future earnings. Previously, buyers and sellers could use "pooling of interests" accounting, where the balance sheets of the two companies were added together. Goodwill was not an issue, and the pooling method led to higher reported earnings.
"The banks cannot accelerate the recovery in earnings today through acquisition because purchase accounting makes it difficult to do," he said. "We were originally thinking that the M&A market by this time would have already heated up and that was over a year ago."
The number of deals through April 30 exceeded 2011's pace, he acknowledged — but the asset sizes of the sellers are smaller. "We could actually see this year a greater number of deals announced than last year, but the average size of those deals is going to be smaller," he said.
Below is an edited transcript of his analysis and some of what has to change for M&A to catch fire.
Are buyers and sellers still very far apart on price, as some executives have said?
GERARD CASSIDY: I would say yes. When you look at the lack of M&A activity versus a similar time period, which we believe to be the early 1990s. One of the real interesting aspects of the recovery back then was that banks were in a position to grow their earnings coming out of that downturn. This cycle they have not been able to do that. It is our contention that the primary reason is purchase accounting.
Back in the early '90s, pooling of interests was the accounting methodology that was permitted. Today it is not. As a result of purchase accounting, buyers have to go in and mark everything to market. With the economy in recovery, but real estate not fully recovered yet, many of the loans on the books — though they are current and they are paying and they are not expected to default — are being marked down. These loan marks in our view are a major impediment to get big deals done because the marks are too large and they reduce the value of the targets' book value. The buyers are willing to pay premiums but they are willing to pay premiums on the marked-down book value.
Often times when that happens … the resulting price is not satisfactory to the potential seller. If you are a potential seller and you are not forced to sell, you'll just wait. The marks are anywhere from, in the stronger regions of the country, 2% to 4%, and in the weaker, the economies that were hit harder in the real estate downturn, 6% to 9%. It's generally our belief that when the marks fall below 4%, that's sufficiently narrow to enable the buyer and the seller to get much closer in price.
When you ask the banks where is the sweet spot, you hear it is below 4% because banks that sell out will have reserves already established for loan losses. If you have a loan mark of 4% and reserves are 2% of loans, the net number is 2%. That's truly the net mark to the potential seller, and this is very accessible.
What do you foresee for deal activity this year based on the numbers so far?
We would think it would be more active than last year, but at the same time it is going to be concentrated probably in the smaller names because [for] the larger regional names, accounting is still an issue. Until we get stronger real estate markets and stronger credit markets, this purchase accounting issue is going to remain a challenge for the M&A marketplace.
What do you read into the fact that price to tangible book values seemed to rise in the first quarter?
Marks have improved somewhat. The loan marks were the worst in 2009 and in our view they have certainly increased from that level. As the loans marks improve, we will see better pricing for deals because the book values will not be penalized as much and the premiums can be higher. As the economy strengthens and the banking industry strengthens, premiums will rise relative to tangible book value and book value because there is less risk [for the buyer] to do the deal.
Does that trend encourage sellers, or make them want to hold out longer?
Higher prices will bring out more sellers, absolutely. There will be folks that will hold on further. But you have to be careful. Think back for a moment to 2007, right before the crash of the financial markets. We don't know who they are, but we know there were banks who missed the window, that were too greedy, and said, 'Even though my competitors just sold out for three times book value, I want to wait and get three and a half times book value.' We think a number of banks that should have sold, or were considering selling, decided to wait, and the window shut.
Will the strong earnings in the first quarter encourage or discourage deals?
It is going to encourage the buyers because they see that their businesses are strengthening and they are willing to take more risk — potentially doing a deal at a higher price than they were anticipating a year ago. For sellers, it can work both ways. For some sellers, it might give them reasons not to have to consider selling. For others, it gives them a reason to sell because they know they can receive a better price now because their business has improved and they can show the trajectory to the potential buyer. Stronger earnings generally should lead to more activity because the buyers are willing to take on more risk and the sellers can get a better price.
Will we see more banks swoop in and outbid another bank, like when PacWest Bancorp (PACW) offered more for American Perspective than Umpqua Holdings (UMPQ)?
Because there are a limited number of sellers, you might see more of it. Therefore the buyers have to put in very strong provisions in their contracts that if someone comes in and attempts to pay more for the target, that it is financially very challenging for the new buyer to do that.
When will conditions be ripe for bank M&A?
It could really could pick up next year.
RBC Capital held a financial institutions conference last week in Boston. What were your biggest takeaways?
Among the smaller regional banks, selected banks are performing very well today because they kept their credit quality very strong through the downturn. Their markets are robust and healthy, which is leading to record profits in some cases. … I would also point out that there is a debate ongoing about the direction of interest rates and when they will start to go higher. Some of the banks in the stronger economies, whether it's Arkansas or Texas or parts of Florida, are suggesting that they are seeing evidence of inflation in their marketplaces. In the past when this has materialized, rising rates came shortly thereafter. The big banks [on earnings calls] all seemed to say that their outlook is what the [Federal Reserve] is calling for, which is rates don't go up until the end of '14. The smaller banks are not in that camp. Some of them are saying they see rates going up sooner than that. On mergers and acquisitions deal flow is out there, albeit it is slow. The marks in the mid-Atlantic, Northeast, down into Virginia are very reasonable, enabling deal flow to take place. When you go to Florida or Georgia or North Carolina, it's not the case. M&A in our view will always be there. It's just a matter of finding the willing sellers.
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