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Land was sold this week for a new 60-story office building in San Francisco. Full recovery in the commercial real estate market is now evident, at least in one market. Location is First & Market Streets. Read More Here: http://shar.es/d2cW4

Georgia's banking institutions continue to repair themselves, as documented by a local news article published on December 4, 2012 (read this article for more details).  Profitability exists in 74% of the 227 charters who survived the downturn since 2007 -- we see approximately 85 to 90 fewer institutions today than prior to the credit cycle downturn (i.e., a 28% decline in charters statewide). The institutions who are still losing money have also declined in number and percentage: since four quarters ago, 38% of the charters, or 87 institutions, could not turn an after-tax profit.

Earlier this week we read that North Carolina state tax revenues slipped in July which spawned a review of the major areas across the FIG Partners Research Coverage universe.  Most states operate on a Fiscal Year ending June 30th, so the most available revenue data tracks June 2011 to March 2012 or 9 months of the current fiscal year.  Certain states (like NC) provide faster intelligence on a monthly basis but comparable figures are seldom available on a national basis unless one goes back to March 31st.  The data below illustrates total revenue from Personal, Corporate, and Sales tax receipts plus other miscellaneous fees.  Only 4 out of 39 states we examined had declines in revenue in Fiscal 2012 YTD.  Southeast and Western states averaged near 3% while the Midwest has continue strength in both of the Dakotas as well as improvements in Michigan.  

While economic activity may be perceived to be sluggish, the fact that state revenues are rising is a positive indicator in our opinion.  Moreover, we remind investors that Banks are a mirror of the communities that they serve - therefore, we cannot help but have a slight tone of optimism after preparing this analysis.

Voters in Georgia have struck down a proposed 1% tax increase to fund statewide transportation initiatives. The Transportation Special Purpose Local Option Sales Tax (T-SPLOST) failed by a margin of 63% to 37%, as voters on July 31st stopped the proposal (of course a mere 654,000 voters out of 5.47 million GA residents came out to vote).  Local news recap highlights the details.

Unfortunately, other Southeastern states seeking to woo corporations to relocate into their areas now have large ammunition to out-compete Georgia and in particular the Metropolitan Atlanta region.  No matter what one's political views may be, the fact is that corporations consider vehicle traffic to be a tremendous issue to attracting employees.  The perception is that traffic in the Atlanta MSA is a challenge compared to Charlotte, Raleigh, Nashville, Birmingham, or other large metropolitan locations in Mississippi or Florida.   Further, another key point is that traffic may be swaying younger residents Ages 25 to 34 away from Atlanta.  While traffic is not directly cited, we suggest reading the October 2011 research paper by The Brookings Institution outlining that young adults moving into Atlanta had slowed considerably in the past 4+ years since 2007 (i.e., Atlanta had the 3rd highest in-migration of young adults in 2005 to 2007, but since 2007 has slowed to the 23rd most active city).

We see this as more of an issue for banks within the Atlanta MSA who benefit when new companies relocate and/or expand into the metro area, with its vast reaching Airport and Transportation capabilities and 5.4 million population.  Other banks around Georgia had less at stake with regards to the benefits of improved transportation funded by the 1% tax hike.  While bank stock investors should not make decisions based on local politics, this is one more reason economic activity could remain slow.  Moreover, consolidation of Banks must eventually take place (particularly in Atlanta).  Over the intermediate-term, it would not surprise us to see higher gas taxes and other measures implemented in GA to enhance the transportation/infrastructure spending that was slated for the tax proposal that failed this week.

Busloads of banks reported their 2Q-2012 EPS in the past 10 days, which provides a good place to stop and smell the roses for Bank Industry performance as of 6-30-12.  Through Friday 7/27, we note over 340 public institutions have reported (although varying degrees of disclosure are available on the smallest banks).  Rather than bore you with a litany of useless statistics, we rather focus on a handful of the important observations from the past quarter’s reports:

How Many Banks Made Money?  Over 96% of the stocks we screened who reported as of 7-27-12 were profitable for 2Q-2012.  This was a near replica of 1Q12.

How Many Stocks Grew Tangible Book Value Linked-Quarter?  As our table indicates, the vast majority of public financial institutions were able to grow tangible book value.  A slightly lower number of the banks less than $3 Billion had tangible book growth, but this figure was still in excess of 70%.

Did Loan Loss Provision Expense Exceed Net Charge-Offs?  At least half of the banks reported provision expenses that fell below their actual net charge-off figure.  Among the largest companies with more than $50 Billion in Assets, the percentage was above 80%.

Did Net Charge-Offs Fall Linked-Quarter?  You bet they did … at least 50% for all the reporting companies thru Friday 7/27 with 70% of the Banks between $8 Billion to $15 Billion and 83% of those banks with greater than $50 Billion in size.

How Much Coverage Do Reserves Provide On Annualized Charge-Offs?  The average figures in our table below have a wide range, but, we feel plenty of room still exists for lower reserves beyond 2Q-2012.

During 2Q-2012 earnings conference calls, many large banks have disclosed their estimated Basel III Tier 1 Common capital ratios and seemingly investors have been reacting negatively with what is perceived to be too-low capital figures.  Never mind that these capital rules are 2 1/2 years or 30 months away (i.e., when greater retained earnings accumulation should occur and plenty of time exists to change contracts on the size of loan commitments, the level of high LTV mortgages retained, etc.).  Investors concluded that Basel III ratios are already too low and that banks would immediately cease buyback activity, change cash dividend policy, and other restrictive actions that are very shareholder unfriendly.  Heavy selling in certain names in recent days seemed to be quite knee-jerk and not validated by real facts that these companies’ activities are actually being curtailed.

By way of background, in Mid-June, the Federal Reserve issued a Notice of Proposed Rulemaking (“NPR”) which gave new capital guidelines for all banks with more than $500 million in Total Assets which would begin phase-in at the beginning of 2015.  This trumps the international standard called Basel III which reached a final conclusion on how it would treat Banks’ Tier 1 Common.  In fact, we authored an entire Weekly Musings industry note on  June 25, 2012 to explain the impact on a key element of the Fed’s NPR, the unused commitments on Commercial C&I and HELOC loans since risk-weighted assets (RWA) would undoubtedly rise by a large amount unless the banks change behavior.

In our own discussions with bank CEOs & CFOs, it has been emphatically stated to us that Banks are not going to take the Fed’s NPR sitting down.  They intend to proactively change the size of loan commitments, price for unused credit lines, exit mortgage loan types, and even consider vacating the mortgage servicing business if the return on the higher capital asked by the Fed and Basel III was not profitable given the inherent risk.  Therefore, we think the initial reaction to the Banks’ preliminary figures on Basel III Tier 1 Common has been unrealistic.  

Do investors really think that Banks will do nothing and maintain low 8% capital ratios?  Really?  The issue is that the Fed rule is pending commentary from the public, it is not yet final (but should be by December 2012), and the banks have barely disclosed their precise risk-weighted asset levels let alone the possible changes they can or will make.  We expect the negative reaction in recent days gives way to some further disclosures in 10-Q filings by early August as well as additional slides in the Fall investor conference circuit on which many large banks will travel.  As investors form bad impressions of Banks’ Basel III capital ratios, they may want to consider the truth that the impact of these new rules is far from solidified.

Loans from FDIC-assisted bank closings should continue to decline when outstanding balances within 2Q-2012 EPS are reported next month.

We examined the 15 largest Covered Loan portfolios and judged how much these have fallen from their Peak Level since 2010. The average drop is 35% and BBVA-Compass boasts the largest decline at over 68%.  See the chart below for details.

The weekly data from the Federal Reserve Bank of St. Louis has a 14-day lag, but yesterday’ addition of the June 6^th data for all loans at commercial banks in the U.S. confirms that the pace of loan growth year-over-year has not yet slowed.  Despite investors’ fears to the contrary, bank loans according to the FRED Graph we include below, are now 5.7% ahead of the same week in early June 2011.  In fact, in the past quarter the pace of year/year loan growth nationwide has actually increased.  We are far from raging bulls on the US Economy and nearly all readers can appreciate the challenges and uncertainties that lie ahead.  However, we continue to expect a relatively solid loan report from Banks in the upcoming 2Q-2012 EPS reporting season next month and we think any loan expansion at companies can be quite helpful in offsetting near-term pressure on NIM-Net Interest Margin.

The Federal Reserve along with the FDIC and OCC made a final rule on capital which is effective January 1, 2015 that says nearly all banks must maintain common equity of at least 4.5% of risk-based assets plus another 2.5% in a buffer against future risks.  At first look when this news hit last Thursday 6-7-12, this was simply the final order that was anticipated long ago by both investors and analysts.  However, press reports expressing “surprise” and “we did not expect this” by industry professionals along with complaints from small bank executives caused us to reflect more on the Fed/FDIC/OCC capital plan. 

First, Tier 1 Common Equity is the new gold standard.  Next, this clearly signals that trust preferred securities are a second-class form of capital for ALL financial institutions above $500 million, not just the largest banks above $10 Billion.  Despite the Collins Amendment within the 2010 Dodd-Frank Act, the regulatory agencies are overriding this prior guidance and replacing it with a one-size-fits-all capital standard.  As Mom once told us, life is not always fair.

We understand why community bankers feel somewhat short-changed … but is this really a body-blow to small banks?  We are not surprised to see this capital rule proposed and frankly we doubt that much change occurs after the 90-day comment period that is now underway.  However, it is important to recognize that out of the approximately 1,100 publicly traded Banks and Thrifts in SNL Financial’s database, over 480 stocks reported total assets above $500 million, but less than the $10 Billion cutoff within the Dodd-Frank legislation. Most of these public companies already have qualifying ratios - the average Common Equity to Risk-Weighted Assets ratio was a healthy 13.6% and only about 10% of the list currently falls below the new 7% threshold. 

For those companies not meeting these capital standards, there are 2.5 years to correct the issue.  Surely, this could eventually lead to more consolidation in the Banking industry—but we already knew this change was pending.  The real question in our minds is whether this uniform capital approach really makes a difference.  Beyond the small banks’ griping about the regulatory capital proposal, there are real changes already anticipated on how risk-weighted assets are calculated—but this was supposed to keep the largest banks behaving “in-line”.

Perhaps the real take-away should be that trust preferred is no longer a viable form of capital (as a practical matter) and that Banks are better off repaying these issues (at par) sooner-rather-than-later as they stick with only Common Equity.  This could be a terrific environment for any large bank TRUPs still trading below par.  We noticed large banks C-Citigroup Inc. and STI-SunTrust Banks redeeming TRUPs late last week, even though the interest rate was not cost prohibitive.  In our minds, this is a clear signal of future activity by the largest banks to remove these subordinated debentures from their balance sheets—a phenomenon that should occur at institutions beyond $10 Billion.

Former Wachovia Chairman John Medlin died yesterday, and the Banking industry has lost one of the better minds from the past 80 years.  Mr. Medlin preceded the leaders many investors remember from Wachovia, Bud Baker and Ken Thompson, since he retired long before the issues that faced the company (i.e., competitive position the led to the 2001 marriage with First Union and the 2008 demise of capital and liquidity which led to the low price sale to Wells Fargo).

A good read on John Medlin's principles can be found online back from 1999 -- it is worth a few minutes of your time.  In my 20 years as a bank analyst, I was fortunate to have a small amount of overlap with Mr. Medlin and in particular many individuals whom he trained.  His attitude about Banking was that it is a personal relationship on both a corporate and an individual level, and that extending the proper amount of credit to a borrower was crucial to success.  What permitted the old Wachovia to survive the 1973-1974 real estate crisis or the 1989-1991 industry downturn was the capacity to avoid providing more credit than a customer really needed.  Mr. Medlin was steadfast in his belief that if you provided extra capacity, customers will likely use it and get themselves into trouble when industry conditions are challenging.  This standard, of course, repeated itself in 2005-2007 and we continue to pay the price today in low interest rates and restrained profits.

Mr. Medlin may have missed some opportunities over his career, namely not positioning Wachovia as the surviving leader in Southeast commercial banking.  This position was ceded to Hugh McColl at NCNB/NationsBanc/Bank of America, and later John Allison at BBT-BB&T Corporation.  The old Wachovia passed on several M&A deals, some of which were quite smart but others cost shareholders the benefit of scale and large EPS upside.  However, rather than comment on past expansion and profits that might have occurred, we remember John Medlin as an incredibly principled banker who was right on credit far more often than his competition, and one of the most creative and innovative bankers of his era in the 1980s and early 1990s.  We wish his ideas could be bottled and sold to a generation of new bankers who could use his training and intuition to remain conservative while other banks aggressively chase growth.  Mr. Medlin taught us that there is merit in being conservative, especially when the clouds turn dark and dangerous.

 WIB_Diversifying_into_Corp_Bonds.pdf

The market is now expecting lower interest rates and less interest rate volatility. For new investments, this means that buyers need to assume more duration risk to earn a given yield and are getting less yield for taking on call risk. On the other hand, corporate balance sheets are generally very strong, there are signs of domestic economic improvement and corporate bonds offer a meaningful yield pick-up versus other investments. This could be a good opportunity to add corporate bonds to your portfolio.

On Sunday morning before dawn, we were woken from bed by a TV news reporter calling for a last minute appearance to discuss JPM-J.P. Morgan Chase’s $2 Billion trading loss.  We respectfully declined (after all, it was Mothers Day), but the thought occurred to us that the press may have run out of good topics to discuss within the Banking industry.  We are far from experts on JPM, but for a company with $2 Trillion in assets and $130 Billion in tangible common equity (TCE), we have difficulty losing too much sleep (other than our early Sunday AM phone call) over JPM’s trading error.

It seems to us that more emphasis should be placed on the Banking industry’s capacity to generate earnings and cash flow and less about specific wins and losses.  Yes, JPM is embarrassed by its $2 Billion mistake disclosed on May 10th but how many times have you heard about the $5.2 Billion increase in core capital at the company in the 91 days from December 31, 2011 to March 31, 2012?  Most likely, you may not realize that JPM retained this much earnings during 1Q-2012.  If the focus was properly calibrated on JPM or any public bank stock, we would be touting the internal capital formation capacity at these institutions and not crying over the spilled milk from bad trades in one month.  Moreover, 92% of all FDIC bank charters (large & small) earned a profit in the past quarter!

Our prediction is that by the time Mid-July rolls around and JPM releases its final results for 2Q-2012, there are other trading gains and positive revenue items that override the May 2012 trading loss.  Maybe another quarter of positive earnings across the industry will create greater appreciation for the fundamental capacity of financial institutions.

To be sure, there are clearly regulatory ramifications from JPM’s blunder since the company and its leadership have been actively lobbying against greater regulations and particularly implementation of The Volcker Rule which bans how large banks previously engaged in proprietary trading with their capital and securities portfolios.  Implementation of the Volcker policies were scheduled for 2013 or later, but now new arguments likely are made for faster adoption.  Whatever occurs, we see a shift in power in favor of the regulators.  Further, this should support our long-standing thesis that smaller banks in the $1 to $10 Billion size range stand to gain more prominence.  Investors only pay attention when and if these institutions can execute on advancing both EPS and Returns on Assets (ROA) and Tangible Equity (ROTCE) — for these companies as the saying goes, the turkey is on the table.

 Musings_4-2-12_EPS_1Q-2012_Best__Worst_Stocks.pdf

Bank and Thrift stocks enjoyed robust price performance in 1Q-2012 as positive performance occurred for many public companies.  While the main sector benchmarks exceeded 21% on the BIX-S&P Bank and 28% on the SNL Bank & Thrift Index, not every stock performed as strong and some still failed to produce a gain.  

See our Best & Worst list of stocks among public financial institutions

FIG Partners Research Analyst Tim Coffey was interviewed by The Wall Street Transcript, where he discussed the tactics banks in the Western U.S. may employ to boost profitability, his outlook for M&A, and the further impact of the regulatory burden on banks and how they wil handle the expenses of increased compliance.

The article is republished here with permission.