Sandler O’Neill’s Jimmy Dunne sees a 30% consolidation of public banks coming on the heels of the crisis.
By Steve Cocheo, executive editor
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Investment banker Jimmy Dunne sees good times ahead for banks that stuck to the basics
It was predicted that the meek shall inherit the earth, and that they who sowed the wind would reap the whirlwind. Some of that has been coming to pass, these days. But after today’s financial storm has moved through and things begin to settle, investment banker “Jimmy” Dunne thinks there is a cadre of financial institutions that will be standing tall and which will gain control of segments of the banking industry that will undergo significant, renewed consolidation.
For many today, looking ahead to such times has been difficult, with so much bad news. But Dunne—officially James J. Dunne III, senior managing principal at Sandler O’Neill & Partners, L.P.—believes that, as it gains traction, the “TARP” program, the capital infusion program, and related efforts will bring a return to relative stability in the markets and the banking business. As the dust clears over the next year, those institutions that didn’t forget the essentials of sound banking will be sitting pretty. And they will see opportunities.
Not that things won’t be challenging for all. “We’ve got a lot of wood to chop here,” says Dunne, head of his firm’s executive committee and one of the founders of the 20-year-old company, which specializes in financial institutions.
Sheltering under a TARP
“The bailout will have a positive effect,” says Dunne, who actually hates the term, “bailout,” because it’s a bad representation of what the program does. Dunne expects a positive result “because it will be the beginnings of a lubricant for financial institutions.” He sees TARP—the Troubled Asset Relief Program—as a good idea, and a necessary one. He expects it will chiefly be larger institutions that will benefit directly from the asset-purchase program. But this doesn’t mean that midsized and smaller banking companies—where, he adds, problems aren’t as severe—won’t benefit.
Now, says Dunne, “there will be a buyer in the market who is willing to put a price on highly complicated toxic types of investments.” Many of those assets are still paying, Dunne points out, “which will have greater relevance once there is a return to stability in the markets.”
For now, TARP and other elements of the Emergency Economic Stabilization Act of 2008 hold the promise of slowing and reducing the destruction of capital wreaked this autumn. Dunne says the effort will bring some credit back into the market, and add some certainty about the value of many of the nation’s financial institutions. Bound-up capital will be freed, banks will lend to each other again, in time, and this will affect the mindset of many players.
So, too, Dunne believes that the mid-October announcement that the government would infuse a group of large banks with capital, and make it available to additional institutions, will improve perceptions of the financial sector. Many mid-size and smaller banks can still raise capital, he notes, but the government program brightens the picture. “This crisis is all about confidence,” says Dunne, a 30-year veteran of investment banking, most of it centered on financial institutions. “It’s all about securities we can’t sell and that we can’t find a floor for what they are worth. The government is going to provide that floor.”
One wrinkle of the rescue package as originally passed is the federal government’s acquiring ownership interests in the course of buying assets from the large players. That provision “is candidly political in nature,” says Dunne. Yet it is a price he sees those players being quite willing to pay for critical aid. The newer plan, which draws on TARP’s planned $700 billion, is yet another wrinkle.
Dunne never saw passage of the aid package as the final solution nor the end of the story. The country faces a period of economic pain and deleveraging.
“The most we can hope for is for the economy to suffer for [only] nine months. Maybe it will even be for a couple of years,” says Dunne, interviewed in October a few days after President Bush signed the new law (and again in the wake of the capital infusion announcement). “That is the overriding problem for all financial institutions.”
Finding capital for change
Going into this period, Dunne’s advice to banks is simple: Get capital. To which he adds the proviso, if you can. Though his company arranged plenty of trust preferred in recent years, he doesn’t see that instrument being terribly attractive to investors in the current environment, nor debt. Instead, there will be a return to simplicity. So those who can raise capital should be looking at fresh common.
The banking business is going to come down to two categories of institution, Dunne warns: “Those that can and those that can’t” raise common. [The mid-October government capital program announcement indicated that $250 billion of the TARP funds would be made available for capital infusions in the form of nonvoting senior preferred stock. The large banks initially brought into the capital program account for $125 billion of that. ABA made the point in a statement addressing the program that it did not expect most banks to tap the new effort, as 95% of the industry is well capitalized.]
How can a bank raise common in today’s markets? Dunne puts it down to three key factors.
First is having a respected management team that is realistic regarding where their organization stands, and what its future holds.
Second is having a business plan in place, and communicated to investors, that is simple and straightforward. Today the market wants to see successful, basic blocking and tackling.
Regarding this point, Dunne says that mid-sized and smaller institutions with such strategic plans will have to demonstrate that they know credit—demonstrated by decent portfolios—and know their clients. Investors will want to see that these institutions know how to risk-weight credit appropriately, because more borrowers will be coming to them.
Investors will look to such institutions because “there will be higher rates to the borrowers, but also much higher spreads to those banks.”
The third factor will be the ability to demonstrate that the bank enjoys a solid core funding base—plus the ability to build that base over time. In this context, says Dunne, he is referring to true core funding—strong retail and small business deposits. Institutions that rely too much on Federal Home Loan Bank advances and similar funding will not be perceived as having a reliable base.
Dunne says the markets have already underscored this aspect of investor preference. Back in 2006, he says, two banks with equally strong performance records might have relied on completely different funding strategies—one based on core funding, the other on nontraditional, capital markets funding—and still have been traded at roughly the same price-earnings multiples. But that’s changed, now, he says. Investors favor companies with strong core. Such institutions will enjoy an advantage.
“It’s going to be that important,” says Dunne.
M&A wave coming
Institutions featuring these three factors will be able to raise capital. Those that can’t, he says, must hope that the recession doesn’t last too long.
If that isn’t the case, continues Dunne, such institutions will find themselves vulnerable to acquisition by those who can raise capital. The latter “will be in an extremely strong position over the next several years,” Dunne says. (At the same time that Bank of America was pushing a large common-stock offering, some community banks had successfully gone to market for secondary offerings.)
Dunne suspects that in about 18 months, there will be a major consolidation wave among the roughly 2,000 banking companies that are actively publicly held. The many private banks won’t feel the same pressures to consolidate and will move more slowly in this regard, he continues. But among the active players, there will be many smaller deals, that will nevertheless lead to a 30% shrinkage in institutions among those 2,000, he predicts.
Shifts in investment banking
Many institutions that seek more capital will tap the talents of investment banks. Investment banking has seen its own share of trouble and change in the current crisis. Lehman Brothers filed for bankruptcy in September, Bear Stearns became part of JP Morgan Chase last spring, Merrill Lynch became part of Bank of America, Goldman Sachs and Morgan Stanley converted themselves into bank holding companies in late September.
For its part, Sandler O’Neill and its rival, Keefe, Bruyette & Woods, continue as investment banks and still concentrate on financial services companies.
Dunne says that while his firm intends to go after every bit of the banking industry’s capital building business that it can, he has no illusions that the misfortunes of the big houses will bring much long-term competitive advantage for his firm.
“The competitive environment never grows less competitive next year,” says Dunne. “It will still be very brisk.” He expects that financial institutions specialists will migrate from the large firms mentioned earlier, and find new posts.
One advantage he sees for firms like Sandler O’Neill is a preference for public equity, rather than private equity. Even though regulators have eased certain restrictions on private equity minority investments in bank holding companies, Dunne doubts that private equity deals for entire institutions will dominate.
“I think that the regulators would really prefer that well-capitalized, well-known institutions acquire other institutions,” says Dunne.
Tax law change supports M&A
A factor favoring his thinking, says Dunne, is an early October action taken by the Internal Revenue Service. In Notice 2008-83, IRS announced that when a bank undergoes an ownership change, tax code limits on deductions arising from loan losses and bad debts will not be applied to the acquiring organization. Thus, if a bank is acquired and sells off a portfolio at a loss, or is taken over with bad debt, the acquirer will be able to deduct the losses or bad debt against income. There will be additional help for banks raising large amounts of capital, through this notice, as well. (And this comes on top of another recent IRS shift, in Notice 2008-78, relating to capital-raising plans. At press time ABA was pursuing changes in related accounting requirements.)
The shift seen in Notice 2008-03 “makes the M&A business a much stronger reality sooner,” says Dunne, “because you’ll see strong companies acquiring weaker companies, because they’ll be able to get a lot of favorable tax treatment, much more than they would have been able to get prior to the change.” BJ
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