Street Talk: Episode 131 - Bank boards capitulating, pushing for scale to combat challenges

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Nathan Stovall

Welcome to Street Talk, S&P Global Market Intelligence podcast that offers listeners a deep dive into issues facing financial institutions and the investment community.

I'm Nathan Stovall, -- and on this episode, we're talking about the consumer, the mortgage market, the state of CRE and what all this means for banks as well as how it will impact their strategic decisions, future capital raising activity and M&A activity going forward. All of those topics were discussed thoroughly at the second Annual Raymond James Whole Loan Conference in Nashville last week. And I'm delighted to not only have been there but have three of the firm's senior leaders join me on this episode to talk about some of the takeaways from that event. First with me is John Toohig, the Head of Whole Loan Trading at Raymond James. John, thanks for being here.

 

John Toohig

Thanks so much for having us, Nate.

Nathan Stovall

Next, we have Bill Sammon, the Head of Financial Services Capital Markets at Raymond James. Bill, thanks for being here.

Bill Sammon

It's great to be here, Nathan. Thank you.

 

Nathan Stovall

Last, certainly not least, one of the firm's most active bankers who has helped the firm have one of the strongest years they've had in some time, one of the strongest years of any of the depository advisers in the space, Bob Toma, a Managing Director on the investment banking team. Bob, thanks for being here.

Bob Toma

Thanks, Nate.

 

Nathan Stovall

So John, I want to start with you. We kicked things off at the event. You started things off and were gracious enough that to have me share some of my views of the space afterward. And the first session, though, after the 2 of us was on the mortgage market. And I'm curious what you thought about it. We've seen much slower originations in mortgage. But on the flip side, credit has been absolutely the gold standard, I think, as you said, is the opening. What do we hear in the mortgage space at the event?

 

John Toohig

It was, I think, resoundingly, at least 2024 has not been 2023. 2023 was such a down year for originations, loan officers looking for any signs of green shoots. And if you remember, 2023, we were floating with an 8% residential mortgage, and that was that was really challenging. Now we've seen a pretty significant relief in rates, we're flirting with a very low 6 handle mortgage today. And it's not 2021. I mean I don't want to say break out the steaks and put away the hot dogs, but it is definitely improving and you can feel that. You can feel that energy coming from mortgage originators, loan officers that a little bit of the refi boom is coming back, rates down, helping affordability and origination volumes are up and not at record-breaking paces, but it's certainly not 2023.

Nathan Stovall

Yes. So not necessarily sort of a good news, bad news situation of good news on credit. We're not worried about it, but we're not necessarily going to get a big tailwind in terms of fee income coming from a big refi boom like we saw, but maybe a little bit better with lower rates.

John Toohig

Credit has been good. I want to touch on that for a second. I mean the 3% mortgage has really been, I think, one of the largest reasons the economy has been as strong and the consumer has been as strong as it is tremendous purchasing power really reduces that debt load on the consumer. There is -- I mean, the 8% mortgage and affordability has not exactly been wonderful, right? And you have seen slightly higher delinquencies and maybe a little bit of a worsening trend on that $1 trillion portion of the market on a $14 trillion market. So that's just the last 12 months' worth of originations, but that number coming down and lower payment should help. by and large, across all of the consumer assets, yes, I do agree with the opening comment that mortgages have been a clear winner.

 

Nathan Stovall  

You had several sessions on the consumer there as well. And I felt like it built on what I tried to put out in my session, and that is that the consumer is stretched, but perhaps not broken. And I felt like we heard that from a variety of sessions and a variety of presenters that you brought together at the event. One thing we had heard, though, is that, yes, you're kind of seeing a little bit of break between the haves and have-nots, where it's the lower income cohorts driving problems and delinquencies. What were your takeaways there? Any real surprises, anything that you thought was alarming or maybe even sort of good news in terms of where the consumer is this late in the cycle?

 

John Toohig

Melinda Zabritsky is amazing at Experian. She's got just incredible knowledge on the auto market. looking at FICO scores and trends. And she's been saying for a while that, to your point, the bottom end of credit, younger borrowers didn't have as much savings, the economic morphine from the stimulus solved a lot of problems. But as that has started to fade and rates now for auto loans, 9%, 10%, 11%, almost 20% of new vehicles these days have $1,000 a month auto payment. I mean, that hurts, right? So there is some stress in the auto space, and we're starting to see that in delinquencies, but it's not -- what you hear analysts call normalization. It's not cataclysmic. So yes, there's some signs of weakening, but largely has held. Then we had our friends from KBRA, Eric and Brian talking more about unsecured lending. solar lending, personal lending, credit card lending. And again, a similar story at the bottom end of credit, younger borrowers, lower incomes. Maybe on credit cards, a bit more alarming that charge-offs are higher and that borrowers are stretched and balances are growing. It's more of a normalization. It's more of a gradualization. It hasn't been a shock yet. So a consistent bend, not break kind of theme is, I think, what we heard on the consumer for credit.

 

Nathan Stovall

And I tried to share some of those results. You mentioned on card, you see -- one of the things that I keep pointing out to people is that, yes, you talk about card being at record levels, you talk about delinquencies jumping, they absolutely are off the trough of late summer of '21, but we're still below pre-pandemic levels in a lot of places. And we're still -- we saw sequential improvement across the banking space in terms of delinquencies. That's not the kind of thing that I feel like screams recession to me. So I thought that was pretty encouraging. And I think the thing that really stuck out the most to me when you think about credit and what we heard at the 1.5 days then was around CRE. You put together a great panel of participants in the CRE market. And it was kind of -- depending on your view, maybe glass half full in my mind of -- if your starting point is how negative some of the views have been out there. I think they were very open about sharing the concerns, but I thought their tone was pretty optimistic. And if I remember correctly, you even said I expected more gloom and doom out of this. Were you surprised from what we heard from the CRE folks that you had at the event?

 

John Toohig

You're absolutely right. I went into that panel and created that panel to be almost an us versus them. I had a gentleman from Sabal, I had gentlemen from Peachtree, which are a little bit more on the distressed, a little bit more opportunistic in their buy box, if you will, and we had folks from the MBA more on an origination standpoint and then Freddie Mac having them on kind of talking about multifamily in case. So it was an interesting kind of 2 sides of the coin, those originating loans today and then maybe those looking and purchasing loans today. And I fully expected it to be one of the more entertaining panels that was out there, and I did expect there to be a slight negative bent. And I came away optimistic. I color me shocked, I was. All parties, even those more opportunistic buyers are saying, listen, we're just not seeing the deal volume that we thought we were. We aren't seeing capitulation. We aren't seeing forced sellers. We're seeing strategic sellers finding value and finding someone who is with a gun to their head required to transact at deep, deep, deep discounts. It's just not happening. Now there are certain strategic sales on specific properties that are losers that are making the headlines but most of the community banks and credit unions, institutions in the room we're seeing an increase in delinquencies, but not the end of the world. So I was very surprised by an optimistic tone.

 

Nathan Stovall

Yes. And they definitely said some deals were broken. They were clear about it.

 

John Toohig

For sure. And...Clear Class C office being a really big problem, even Class B. Urban Manhattan, San Francisco office, those are the ones that are catching the headlines.

 

Nathan Stovall

Right, right. And -- but importantly, something that I try to talk about here is that 2 things that I got from there. There needs to be a lot of nuance in discussion, and I felt like they shared that not only in office, but you need to look at the different subcategories here. And secondly, something that I thought that they put out there that isn't talked about enough is this idea that you just said that there's not exactly guns to people's head to blow this stuff out, that this is going to take some time, I feel like.

 

John Toohig

Extended pretend has worked, right? The modification systems that are out there, I mean, there are losers. There are certain institutions that are going to take their loss and move on and put capital to work elsewhere. But by and large, depositories are not owners of dirt. They're not owners of property, right? They're owners of loans, they're makers of loans, and they don't want to have to deal with owning dirt. So in that regard, trying to keep the borrower float, putting them into an interest-only payment, modifying something, allowing them to have a workout by putting more capital or equity into the property has allowed them to endure. And maybe falling rates will help here in the near future. And that I think is a real factor. And it's likely going to be a good segue also into Bob as he's talking about kind of the mergers and how that CRE overhang has impacted stock prices, has impacted someone's ability to merge if they have an overconcentration of CRE. That, I think, has certainly been a talking point at the boardroom for time. But from a performance standpoint, yes, delinquencies and charge-offs are worsening. Yes, there have been a handful of headline type risk sales, but better, I think, than most expected.

 

Nathan Stovall

I definitely want to talk about that further in terms of CRE with Bob. But you mentioned the boardroom, and I actually want to go to Bill because I think it kind of starts off the piece of what we're seeing in transaction activity. One thing that CRE panel said was that the capital markets has not broken like it was post-GFC, and we're actually seeing more capital coming to the bank space, too, but also more deal activity. And Bill, you had said last year at the first annual event, I love the description you gave of the boardrooms looked like a duck on a pond that didn't appear to be moving that much. But underneath the water, their feet were paddling like crazy. And you referenced that again this year as sort of a lead-up as to maybe why we're kind of seeing a rebound that conversations were happening a lot in the background. And then so coming into this year, we start to see more deal activity. Has that been the experience you've seen, Bill, that these have been ongoing. It's not as if we just had a switch flip, and that's why we're starting to see a pickup this year in '24.

 

Bill Sammon

Yes. I think many of the banks have been having these discussions, and Bob should jump in here. But the math, the investors, the environment didn't really allow it to work and not that things got significantly better at the beginning of 2024. But I think a lot of management teams, I think a lot of boards came into this year saying, I'm just not going to have another year like this. I'm not -- I don't want to answer the same questions. I don't want to be on the back foot. I don't want to be playing defense. I need to find a way to get back to playing offense. And I'm going to get creative to do that. I'm going to go out and tell the story, and we started to see activity pick up. I think those conversations, again, have been happening for a long time. But I think what we saw at the beginning of 2024 was just this mentality of enough is enough. And it's really interesting to hear you guys talk about sentiment around commercial because if we just use that same sentiment conversation and applied it to the investors in the banking space, it's almost the same discussion, where folks are certainly still somewhat conservative. They're nowhere near sounding the all-clear bell, but we've had this shift to kind of a positive stance and a belief that now is the time to start dipping their toe back in the water and the belief that at least from a credit standpoint, there's a good chance that everything is going to be all right and now is a pretty attractive time to start investing.

 

Nathan Stovall

Yes. Bob, and definitely jump in there. I'd love to get your thoughts, similar question with the add-on that not only have we seen a rebound and you've worked on many deals and one of the more active bankers in the space this year. Well, we've seen a lot of those deals require capital, but importantly, capital has been there, and you've seen investors support those transactions. How have investors gotten comfort with those deals? And maybe just talk generally how a lot of those transactions have come together?

 

Bob Toma

I'll echo what Bill said. Coming out of the failures in early 2023, we had industry-wide pause on even M&A discussions. And if you rewind back around Thanksgiving of last year, we saw a brief rally that lost steam in February with the New York Community Bank news. But those conversations coming off of strategic planning and looking at earnings forecast on a stand-alone basis, those weren't -- those were tough conversations. Folks are struggling to maintain or grow profitability on a stand-alone basis and began to really position themselves with other partners in early January. And even though the stock market rally had several starts and stops and really didn't begin to see steam gaining into July. Those conversations were ongoing. And it was really less of a focus on necessarily nominal pricing at announcement and really earnings accretion driven by a stock-for-stock swap. And so capital has been there. It's been -- it's had stops and starts of coming into stocks on their own, but investors have kept capital on the sidelines to fund these deals. And the interest rate marks that are attributed to them are driving capital lower and necessitate in some cases, particularly in larger deals capital to come in to fund the balance sheet at closing, but they're driving significant earnings accretion moving forward, not just with regular way cost savings, but also the mark-to-market of the target's balance sheet is producing improvements in margin moving forward. And investors are eager to fund transactions that are going to generate earnings per share growth. And I think that's been a big lag in the PEs that you've seen for banks trading at this historic discount to the S&P. It's because of a lack of earnings growth. And as we see M&A activity return, you're going to see earnings per share increase for both buyers and sellers, and that's what's driving the capital investment.

 

Nathan Stovall

You mentioned the marks. The biggest marks there are rate marks and a lot of it is on the bond portfolio, 15%, 20% of our asset base, down 10% to 12% in a lot of cases. It's not really credit so much. How much is credit coming up in those conversations, both from the buy side of the bank buyer or investors you've seen looking to support a deal. We know that's weighed on the group, and we have seen a little bit of a rebound there, particularly those CRE heavy banks. But how much is that coming up, credit concerns? And if it is, how do they get comfort over it?

 

Bob Toma

It's been less on the due diligence side, less on credit more broadly speaking, but buyers are taking a conservative view and making sure the credit culture of the target meets theirs and that they're able to continue to grow the portfolios together. There's deep dive due diligence. I think there are a lot of lessons learned coming out of the financial crisis and folks are penetrating a stronger piece of the portfolio. stock-for-stock deals, the sellers are doing reverse due diligence on the buyer's portfolio. So it's been less actual credit concerns as far as the deals that we've worked on and more the fear that there's credit problems looming around the corner and making sure that the customers that you're acquiring through the acquisition are customers that you'd be happy to have on your own and the underwriting is solid. So I would say in terms of deal activity, the rate conversation has been much more a driver of a capital need and a driver of banks wanting to get together because margin pressures aren't going away, even with the relief in rates, we're going to struggle to see NIMs rebound in a significant way and most community and regional banks have 75% or more of their revenue driven by spread. And so the need to get scale hasn't gone away. In fact, it's probably increased in urgency. And that's really what's been driving the activity. And in terms of the deal math, overcoming some of the capital challenges that come from fully mark-to-marking the target balance sheet, which is a combination of credit and rate. But so far, credit has remained clean, broadly speaking, outside of a few of the sectors that John had touched on, but most of the banks aren't exposed there. So there's a conservative and a detailed review on -- from a due diligence standpoint to make sure you're not acquiring tomorrow's problems in a deal today. But so far, that hasn't really been an impediment to activity. Now if we do see a more broad credit deterioration, that will slow down M&A. Folks will become more internally focused, focused on shoring up their own balance sheets. And so looking forward, we expect the activity to continue to pick up steam, particularly if valuations hold. But if credit deteriorates more broadly, that will put a pause on things and folks will return to their neutral corners until that concern is alleviated.

 

Nathan Stovall

Bill, Bob just mentioned scale, and I remember one of the slides you had up during the session, the 2 of you did together, you talked about scale. And I don't remember the exact numbers, but I thought it was interesting where I feel like you laid out that investors are paying up for scale in a more material way. Can you talk about that, how much that is coming up in deal conversations and the dispersion we kind of see in terms of valuation by size?

 

Bill Sammon

Yes. I think it's being driven by the fundamentals. And that -- and the idea that scale is incredibly important has been the main theme since the Great Financial Recession. A number of years ago, if you looked at the curve on the valuation side, the most highly valued bank was somewhere between $8 billion and $9 billion in total assets. And today, that curve is no longer a curve. It's a line straight up and to the right, meaning the larger you are, typically, the higher the ROA and the higher of the valuation that the market provides for the organization. We all know the regulatory environment is very difficult. We've kind of rung all the costs out of the industry that were the low-hanging fruit. And so many banks -- and certainly, the investors believe that the path to higher returns to shareholders is by building scale. And that's why Mr. Toma and all of our bankers have been so busy over the last 6 months and will likely be very busy as we go forward. If you are a community bank in the United States and somebody asks you or if you're an investor in those companies, somebody asks you, what's the right size today? In almost every case, the answer is bigger. And there's not a number that you are ultimately working for. It's just getting larger. And I really don't think that, that theme is likely to go away, certainly for the foreseeable future.

 

Nathan Stovall

And you kind of -- you spoke to this earlier, but that point and some of the others you made, they've been around a little bit. They've been around a while. That's been true for a bit. but we're starting to see some change in behavior. And this is my word, but I'm curious if you agree with it, Bill, and I'd be curious to hear your view here, Bob, that maybe what's changing a little bit on the sell side is kind of acceptance of this fact that earnings are challenging, that regulation is challenging, that we have to be bigger. Do you think there's more kind of acceptance of the operating environment we're in, in the boardroom, Bill?

 

Bill Sammon

I think, listen, if you look at save this summer, where we've seen some rebound in valuations, I mean, in general, if you're an investor in the banking space, for the last 5 years, looking at what the KRE has done, it's been very hard to make money. And that's just a reality of where we are. And if you look at depressed returns on tangible common equity, I do think there is an understanding in the boardrooms and in the C-suites that given the current state of fundamental performance, it's awfully hard to keep your shareholders happy. And I think that's why management teams, Boards of Directors, certainly, we've seen an uptick in some activism around shareholder activity. I think that's what's pressing this is we need to find a way to provide reasonable returns given the balance sheet risks we have. And a lot of that is going to come through getting bigger and trying to drive more returns by having a larger balance sheet to spread out those costs. And I know that Bob is probably hearing that theme in those conversations on a very, very regular basis.

 

Nathan Stovall

Bob, what's your view on that? And added similar question, but with this comment as well, the idea of 1 plus 1 equals more than 2, you take my stock at a modest premium, we ride the wave up. Like I said earlier, that kind of idea has been out there, but it feels like more people are buying into and seeing the value there. Do you agree with that?

 

Bob Toma

Yes. And look, we've been in this environment now for a long period of time and reality sets in for different folks at different time intervals. Public institutions that have actively traded stocks realize the prospects of them being a buyer and what they can pay for certain targets in their markets varies directionally with their stock price. Private institutions may take a little bit longer for these rapid shifts in valuation expectations to adjust. But I go back to when this all started, and it is probably towards the end of last year, looking at strategic planning for '24 and '25. And with the pressure on margins and the pressure on the ability to grow in certain markets, it's really tough to drive earnings per share growth. And that's what's going to drive your stock price higher over time. So if you have access to capital, if you have a strong currency, you can generate earnings per share growth through the buy side. If you do not, you can generate earnings per share growth by partnering with a stronger partner. And really, the activity we've seen year-to-date has been driven by the ability to put 2 companies together and grow earnings per share at a rate that neither company would necessarily be able to achieve on their own. So the recent pickup in valuations could certainly bring some folks sitting on the sidelines back to the market because we're starting to see premiums rise with the stock market. But even if we don't, if we see a correction in bank stock prices and a return to valuations where they were at the beginning of the year, absent of credit, I think you're going to see these transactions continue because it's really about the ability to generate earnings per share growth to combat the stock challenges that Bill alluded to when you look at bank stock performance over a 3-, 5-, 10-year type of period, especially relative to the broader market.

 

Nathan Stovall

In closing, I want to talk a little bit just about capital markets kind of transactions and picking up with you, Bob, on capital raising and the idea, you and Bill alluded to this some in your discussion at the event. But not only are we seeing capital come and support deals, but one of the things that we're looking at in '25 is a bunch of the sub debt that was issued in '20 will move from fixed to floating. And so there could be a refinancing need given the cost of those. Sure, we don't know where SOFR is going to be necessarily then, but some of those deals are pretty expensive. Do you think you'll see more banks go to market and look to refinance some of that sub debt outstanding? And what do you think the investor appetite and support will be for paper like that?

 

Bob Toma

Yes. Certainly, when you go back, the 5-year reset date from the large increase of issuance that we saw in 2020 is going to come starting -- mostly starting mid next year. And the biggest challenge for recent transactions in the sub debt space has been just lack of liquidity from the buyers, a lot, particularly on the smaller community bank side, a lot of that paper were bought by other banks. And with balance sheets and liquidity where they're at today, that buying universe has dried up quite a bit, and you're left pricing the transactions with more price-sensitive purchasers. Now as that paper refis and liquidity returns to the system, I think you're going to see the buying universe come back a bit. You're also -- right now, we're seeing activity pick up, but spreads are still kind of staying wide relative to where rates dropped. I think we're at the beginning stages of seeing the investors really come back into the space, but it's price sensitive. So issuers in the absence of needing to refi haven't come to the market in necessarily a big way, particularly for sub-$50 billion banks where the spreads are wider and the buyer universe is more narrow. But as we see those maturities come up and liquidity returns to the system, it's going to free up some capital for investors to deploy.

 

Nathan Stovall

Sure. Bill, a separate question, but also capital markets related. You talked about securitization a little bit at the event and how it's largely been a larger bank thing. But you thought that, that was going to eventually come down to smaller and regional banks and become part of their toolbox. What's your view there? What kind of transactions do you think we could see? I know it's early days, but curious your thoughts there.

 

Bill Sammon

Yes. I think going back to this idea of trying to find ways to be creative around the balance sheet and play offense, we had our bank conference in Chicago at the beginning of September, about 140 banks there. And what was interesting when we look back on the conversations we were able to have with the institutions. One of the things or one of the people -- the groups that were in most demand were our securitization team, talking about the ability to transfer risk, release some capital through that -- through those transactions. And to your point, Nathan, while we have seen mostly the larger banks do this, there is a very much a growing interest in CRT and SRT and other ways to move things around on the balance sheet. So while we really haven't seen that wave come, we're pretty confident that it is going to make its way to banks under $100 billion and certainly under $50 billion in assets. And over time, I think that you could see many, many banks in this country, regardless of size, use the risk transfer as a way to, again, speak to the regulators and some of their concerns that they have around concentration risk on the balance sheet, but also use it as a capital management tool given what you can do with some of the risk ratings on the asset buckets that can be affected by this. So we've spent a lot of time and effort preparing for this and building our team, and we think they have a likelihood to be very busy over the coming years. So we think this is going to be a real theme, and it's certainly something everybody is talking about right now.

 

Nathan Stovall

And then closing with John, what is your view for just the whole loan market broadly, but looking at banks trying to derisk their balance sheet from that standpoint. You mentioned we haven't really seen much of that. We haven't seen much pruning, particularly in CRE. But one of the things I put out there is the idea if we do see more M&A activity, if you've taken marks on those credits, it might provide you the opportunity to get rid of some of that if you don't want it. What is your view there? Do you think we'll see more distressed trades or even modestly distressed trades later this year or into next year if we see a continued pickup in M&A activity?

 

John Toohig

I think we heard that in the CRE panel. There still is a bit of a gap on the bid and the ask between a buyer and a seller today. And that's some of the reason that we're not noticing as many transactions as sellers aren't quite willing to take as much pain and buyers are maybe a little too aggressive in their valuations. Understandingly, it's difficult to evaluate certain loans in the commercial real estate market today. Falling rates help a lot of things, right? It's going to erase some of those losses. It's going to allow sponsors and borrowers to potentially refinance out at more attractive levels. there's an element of falling rates will erase some of those problems, but it also might tighten in those spreads as institutions may become closer and closer to truly recognizing when a loan is a loser, and it's just not coming back and it's time to redeploy those assets elsewhere. That's just on your one-off loan trading. And then yes, I mean, not obviously revealing any specific names, but having had some of those boardroom discussions and having looked at a number of those portfolios and valued a number of those portfolios and when the event itself happens and not wanting to own certain assets and liquidating those certain assets as a result of a merger or a capital raise, I would expect to see an uptick in those strategic transactions as part of an event as opposed to just kind of the day-to-day balance sheet management that you might have seen. So with M&A activity and with falling rates, I would expect to see an increase in those kind of transactions.

 

Nathan Stovall

Well, terrific. I think it's a great place to leave it. Thank you, John, Bill and Bob for coming on. We certainly appreciate the insight.

 

John Toohig

Thank you, Nathan. We really enjoyed the opportunity to present and chat with you today.