Large Regional Banks: Lower Risk, Higher Returns?
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PNC Financial (NYSE: PNC) has long been one of the largest and most profitable of the regional banks. At the end of the first quarter it was the nation's sixth largest commercial bank by assets, with about $282 billion, and has a footprint covering most of the eastern half of the country. After a smart recovery from the recession last decade, the bank is looking at some substantial headwinds, so I wanted to take a look to see if there is light at the end of this tunnel.
As recently as the first quarter of this year, things were smooth sailing for PNC, which had digested two substantial acquisitions in the previous twelve months. First, PNC bought the Tampa area assets of troubled BankAtlantic with the deal closing in the second quarter of 2011. Then, in March of this year, PNC made a game changing acquisition, winning a bidding war with BB&T to spend nearly $3.5 billion to acquire the domestic assets of Royal Bank of Canada (NYSE: RY). Royal Bank apparently never could get the hang of running an American operation. The deal included some 400 branches across the high growth, southeastern part of the country.
The formula for regional bank success has been lower credit costs, expanding loan portfolios, lower loan loss provisions, and expense controls. In the first quarter of 2012, PNC's credit costs were down by $101 million, or 25% from the first quarter of 2011. The bank's loan portfolio grew $27 billion, or 19%, on the backs of the aforementioned acquisitions. As a result, PNC's net interest income rose by $115 million. Non interest income was essentially flat, as a big boost from mortgage fee income was offset by the Durbin Amendment's restrictions on check card fee income. The provision for credit losses fell from $421 million in the first quarter of 2011 to $185 million in the first quarter of 2012. And finally, big increases in personnel and marketing, largely on account of the acquisitions, drove up non-interest expense by nearly $400 million. Summing all these together, earnings in the quarter came to $766 million, or $1.44 per share, compared to $833 million, or $1.57 per share a year ago. Obviously, expenses have gotten out of control, and the bank's efficiency ratio fell from 57% a year ago to 66% in the first quarter of 2012.
The current problem, other than expenses, is demand for mortgage repurchases from government sponsored entities, such as Fannie Mae. In recent quarters, these agencies have demanded billions of dollars across the banking and savings and loan universes. Perhaps the worst hit has been Bank of America (NYSE: BAC), which so tired of the agency's demands that its spats became public. Bank of America no longer provides liquidity to small mortgage banks and brokers as it will no longer accept third party underwriting. PNC disclosed it would add $350 million to second quarter loan loss provisions due to a surge in demands due to soured mortgages in the 2005 to 2008 period. The total demands made of PNC thus far from government agencies are near $1.6 billion, and there are no signs of abatement.
PNC has an eye on the future in many different ways. At the June 12 Morgan Stanley Financials Conference, it discussed its initiatives to cross sell, a la Wells Fargo (NYSE: WFC), and improve its balance sheet to comply with Basal III protocols. It, as many banks are doing, is in the process of dumping its Trust Preferred Securities, as these will no longer be considered part of capital for Basal III purposes. In PNC's case, two different series, summing to nearly $1 billion, were recalled. While these high yielding securities are redeemable at par value, it will save PNC substantial interest dollars in the long run to have redeemed these securities. PNC also recently paid $90 million to settle civil charges that its overdraft fees were illegally high. The same suit is still pending against more than two dozen banks.
Despite the reversal in provision expenses, I do not look for PNC earnings to fall much from its record second quarter result of 2011. Analysts are looking at $1.26 per share, and I am looking at something closer to $1.32 per share. Last year the company earned $1.67 per share in the second quarter. For this year, earnings are expected to be about $5.80 per share, compared with $6.04 per share last year. But as the bank integrates its recent purchases and costs come down, 2013 should be a banner year for this bank. Financial investors should take a look before that happens.
It used to be that all large regional banks competed with Bank of America, at least in the mortgage arena. Bank of America's decision to no longer be a correspondent bank for smaller lenders has opened the door for mortgage business from banks like PNC and BB&T, but also has provided an opportunity for Wells Fargo to strengthen its grasp as the number one mortgage originator and servicer. Despite the surge in Wells Fargo's mortgage loans, overall its loan portfolio has been stable, and its larger peers Bank of America and Citigroup have actually been shrinking their loan portfolios, in part to raise capital to meet future Basal III provisions. This has opened the gates for firms like PNC, which already have strong capital levels, to gain market share organically as well as by acquisition.
I believe over the next three to five years that large regional banks will have better returns than their larger counterparts. Large banks have become so complex that it is impossible to really control the business from one place (see, for instance JPMorgan's London trading loss). The regional banks usually are not involved in derivative trades or international trading desks. Their earnings reports are far more transparent than their larger peers, and their earnings are generally more consistent.
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