The Financial Services Industry - Banks, Thrifts, Insurance Companies,and Securities Firms

Foreword The Financial Services Industry-Banks, Thrifts, Insurance Companies, and Securities Firms is the second in a se...

Author: Alfred C. Morley

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Foreword The Financial Services Industry-Banks, Thrifts, Insurance Companies, and Securities Firms is the second in a series of AIMR Industry Analysis seminars and proceedings. The series was conceived by Charles D. Ellis, CFA, to provide educational material on the nuances of individual industries from the perspective of security analysis. In most cases, the specific technical information that must be the backbone of any sound industry analysis is available only through personal experience with a particular industry. This series of seminars makes the fruits of that experience available to all. Each seminar is built around an analytical framework that identifies the key factors to consider in conducting an effective analysis of the industry and that highlights the specific interrelationships that underlie sound valuation decisions. The key topics in all of these seminars are understanding industry basics, analyzing the internal and external factors that affect the industry, interpreting the industry numbers, and valuing the industry's securities. Many of the presentations also address the problem of selecting individual stocks within an industry. This approach is especially appropriate for the financial services industry because of its diverse nature: In banking, analysts must pay special attention to the cyclical drivers of bank stocks, the limitations imposed by both state regulation and federallegislation, and the consolidation the industry is facing; analyzing thrifts requires an understanding of the sources and consequences of the industry's legacy of excess capacity; valuing insurance stocks means tak-

Katrina F. Sherrerd, CFA Vice President Publications and Research AIMR

ing note of a company's loss reserves policies and management of surplus and return; and analysts must examine securities firms to determine their book value per share as well as their "propensity to compensate." The speakers at the seminar, whose presentations this proceedings reproduces in full, are among the leading specialists in financial services industry analysis. AIMR wishes to thank them for sharing their research and practical experience in their respective fields of expertise and for assisting in the preparation of these proceedings. The speakers contributing to the seminar were: Robert B. Albertson, Goldman, Sachs & Company; Gavin R. Arton, CIGNA Corporation; Anthony T. Cope, CFA, Wellington Management Company; Donald K. Crowley, Keefe, Bruyette, & Woods, Inc.; Amy W. de Rham, Massachusetts Financial Services; A. Michael Frinquelli, CFA, Salomon Brothers, Inc.; Robert G. Hottensen, Jr., Goldman, Sachs & Company; John E. Keefe, Lipper Securities Industry Financial Analysis Service; Samuel G. Liss, Salomon Brothers, Inc.; Martin Mayer, author; Reid Nagle, SNL Securities; John B. Neff, CFA, Wellington Management Company; Myron M. Picoult, Oppenheimer & Company; David N. Pringle, Furman Selz Mager Dietz & Birney, Inc.; James K. Schmidt, CFA, Freedom Capital Management; David Seifer, CFA, Donaldson, Lufkin & Jenrette; Wilson H. Taylor, CIGNA Corporation; and Donald G. Zerbarini, Lord, Abbett & Company.

Financial services Industry Analysis~ An Overview Alfred C. Morley, CFA Senior Director Old Dominion Capital Management, Inc. The second of AIMR's Industry Analysis series of seminars focused on the financial services industry, specifically on banks, thrifts, insurance companies, and securities firms. The presentations on each of these industry segments were structured around four basic topics: understanding industry basics, analyzing the market's internal and external factors, interpreting the numbers, and valuing the securities. To many observers, capital is the key to survival for financial intermediaries. The well-financed and efficient survivors will be fewer in number and eventually will face a less severe competitive climate. These survivors will provide the grease to lubricate the growth machinery for the U.s. economy in the 1990s. These thoughts, in different forms and thrust, are prevalent in all of the presentations.

Banking Industry Basics

cover from a recession faster and thus gain in loan market share; ample capital is an absolute prerequisite to acquisitions; and sufficient capital will be a requirement for success in a more liberal environment, which might permit banks to offer new products and services. On occasion, changes in interest rates are highly correlated with movements in the prices of bank stocks. Albertson's research, however, clearly shows that, over time, when bank stocks outperformed the market, interest rates were either rising, falling, or indifferent. Albertson concludes his presentation by discussing what he holds are the primary cyclical drivers within the banking industry, namely credit demand, interest rates, and loss cycles. He points out that on the consumer side, loan demand and disposable personal income are highly correlated. For the corporate market, the driving force behind credit demand relates to the sum of inventories plus spending minus cash flow. With respect to interest rates, evidence suggests that, over time, banks move their rates in line with the true cost of funds, thus providing for a generally stable net interest margin. As might be expected, consumer loan losses are not very cyclical, but commercial losses are much more volatile. Earnings do count in bank stock evaluations, and when negative changes in loan loss cycles affect profits, bank stock prices predictably suffer.

Albertson begins his presentation by listing a number of generally accepted propositions about banking: III Bank capital ratios have deteriorated. III Banks largely have been displaced from corporate lending by other forms of finance. III Consumer debt is increasing and threatening bank profitability because of large loan losses. III Consolidation is the new wave, but successful mergers require considerable Analyzing the Banking Market branch overlap. III Bank earnings are not a good forecaster of In his initial comments, Crowley indicates that banks bank stock prices. during the past 40 years have consistently lost marIII Bank stocks are interest rate sensitive. ket share to competitors, first to thrifts, insurance These are all reasonable-sounding suppositions, but companies, pension funds, and finance firms and Albertson argues that they are largely wrong. Other more recently to the securities industry, including factors, such as capital, loom much more important money market and other types of mutual funds, in understanding industry basics. broker-dealers, and securitized credit obligation isAlbertson says capital probably is the most sigsuers. Moreover, the heat of this competitive battle nificant factor explaining valuation differences is on both the liability and the asset sides of the among bank stocks. Expanding on this belief, he balance sheet. explains that capital is a risk buffer, particularly in Attracting deposits (the liability side) is the heart bad times; a high capital ratio allows a bank to reof the banking industry's franchise, and the key to

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the deposit franchise is the convenience factor, pri- Interpreting the Banking Numbers marily via the branch banking network. Although Nagle claims that investing in bank stocks is full of banks have done reasonably well in the battle for pitfalls for those who do not understand the fundadeposits, Crowley points out, on average, servicing mentals of profitable opportunities but can be rea customer costs a bank about $400 a year. In conwarding for those who do. In support of this statetrast, a telephone-based competitor, such as a money he points out that no other industry has as ment, market mutual fund, incurs servicing costs of only many participants-about 1,200 companies-each about $25 annually. Profits in the banking industry one of which at any point in time might have a currently are primarily from the liability side of the market value well above or well below its economic balance sheet, and those profits appear to be sizable. value. The outliers in the market value/economic If costs are properly allocated, however, the concluvalue relationship offer tremendous investment opsion is that benefits the banks are getting on the portunities-a galaxy of possibly mispriced securiliability side are overstated. Banks now may be apties. Published financial statements often are misproaching the limit of lowering interest rates paid to leading, and investors who look behind the pubdepositors and raising service fees charged to them. lished numbers and discover the truth may well find The major classifications on the asset side of the a wealth of opportunities. balance sheet are mortgages, in which the banks The banking industry traditionally has recorded generally are maintaining their competitive position; financial assets and liabilities at cost, which may be business credit, historically a mainstay of the bankfar different from their market value. It follows that ing industry but one in which market share is slipa sharp change in interest rates can affect market ping; and consumer installment debt, again a relavalues dramatically. Because appropriate reserve tively weakening market for banks. In sum, Crowley levels have not been established, reserve practices states that competition on the asset side is considervary extensively across the industry. True economic able, with banks having particular market share value is defined as a function of a bank's marked-toproblems in business lending and commercial real market net worth (liquidation value) plus its proestate. jected earnings as a going concern. Forward earnHow best to contend with competitive forces? ings will be a function of many factors, including As one answer to this question, Crowley developed starting economic value of the balance sheet; the an "excellence index" for banking companies and strategic direction the company has adopted; and the found that those with the highest ratings focus on components of income-net interest income on a asset quality, cost control, limited-fee income niches, risk-adjusted basis, operating efficiency, and fee inprocessing technology, and deposit-gathering stratcome. egies. The strategies that have not worked as well Nagle's definition of going-concern value is the include aggressive expansion via acquisitions and extent to which a bank's franchise can generate a lending in unfamiliar fields. return above a risk-free rate, given its starting The banking industry is burdened with many marked-to-market net worth. Like other speakers, layers of regulation, far more than its direct competNagle identifies a number of competitive trends aditors. Crowley says he hopes that this burden can be verse to the banking industry. He also cites some alleviated to some degree, and he adds that some opportunities for the industry, including lending to relief is necessary as a catalyst to improve economic small- and medium-sized businesses, which account growth. One possible solution is to combine all regfor about 50 percent of gross national product. These ulatory activities into a single agency, as is common loans are not easily securitized. In Nagle's opinion, in many foreign countries. This structure should if the best-managed companies can acquire less-effiresult in more efficient and less costly supervision, cient banks, they could achieve important cost savbut the multitude of vested interests will make such ings in the consolidation process. a move quite difficult. Once usable and appropriate data are generated, Two key regulatory limitations Crowley identivalid peer comparisons are possible, and Nagle says fies are product offerings and geographical location, the most useful peer group comparisons are market indicators, profitability measures, net interest marboth of which affect the ability of the banking indusgin, operating efficiency, noninterest revenue, capitry to compete not only domestically but also on a talization, asset quality, and asset composition. He global scale. He anticipates changes in the regulaapplies this concept by comparing the relative attractory and economic climate that may reduce these tiveness of a regional bank not only with its peers in limitations in due course.

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the area but also with all banks of like size and with the median for all national banks.

Valuing Bank Securities Schmidt says commercial bank stocks are relatively inexpensive and should benefit in coming years from consolidation, among other actions. The main challenge facing analysts is to avoid banks with financial statements that do not reflect true underlying value. Banking assets rarely are worth significantly more than face value and may be worth much less. This presentation highlights the fact that, in reality, banks are a small-capitalization industry. No bank is among the top 50 stocks in market capitalization, and relative performance of a broad-based bank stock index tends to approximate what small stocks in general do relative to the S&P 500. In selecting bank stocks to structure a portfolio, Schmidt uses a process that first evaluates the national economy and then looks into regional factors, including business growth prospects and the regulatory environment. Within the national overview, emphasis is on the economic growth outlook and on the interest rate forecast. Schmidt argues that banks are related to the economy, but only in one direction-down. A healthy economy can mean higher bank earnings, but a bad economy, or a weak segment within the economy, will cause poor profits. Comparisons indicate that absolute bank stock performance is inversely related to interest rates, but taken relative to the S&P 500, the correlation between bank stock prices and interest rates disappears. This suggests that the correlation is a market effect. Important regional factors in the valuation model are growth prospects, asset values and credit quality, and the banking environment. Schmidt presents a number of charts and graphs to illustrate how these factors can be assembled and used in arriving at investment judgments.

Analyzing the Thrift Industry Banks and thrifts basically are in the same business, and after a long period of parallel evolution, the two industries are converging. In time, the two industries could be united from a regulatory standpoint. Pringle and Hottensen both address the similarities and differences between banking and thrift industry analysis. Pringle identifies the many similar characteristics of banks and thrifts. In comparing a large commercial bank, the leading thrift organization, and a regional thrift, he found that their earning assets were of virtually the same type; each made loans and

invested in Treasuries and mortgage-backed securities. The only difference is that the thrifts, by law, must purchase Federal Home Loan Bank stock. Loans as a percentage of assets tend to be lower at banks than at thrifts, primarily because banks have other sources of income besides loans. Also, banks require liquidity for interest rate management, for correspondent banking activities, and as a cushion in times of distress. Banks also typically have a lower level of total earning assets as a percent of aggregate assets than do thrifts. This difference is because of the banks' very large cash-and-due-from-banks position related to correspondent activity. In analyzing loan portfolios for banks and thrifts, Pringle suggests examining category definitions and exactly what types of loans are included in each category, geographical and industry exposures, and the 10 largest credits. He then discusses analytical approaches in evaluating the loan portfolio. As on the asset side, the liability structure of banks and thrifts is quite similar. Primary differences are that commercial banks have demand deposits, thrifts do not, and unlike the banks, the thrifts can use Federal Home Loan Bank advances for capital needs. Pringle observes that an analysis of nonperforming assets is applicable both to banks and to thrifts. This analysis should focus on nonaccrual loans, renegotiated loans, 90-day past due and accruing loans, and other real estate owned. Hottensen, the second speaker on thrift industry analysis, identifies excess capacity and the burden of additional regulation/legislation as primary causes for some of the problems the thrifts have encountered in recent years. He sees a growing trend toward consolidation, with the stronger, capital-rich banks and thrifts continuing to expand their market share. A second consequence of excess capacity is that the marketplace will not continue to support or tolerate inefficient competitors. As an illustration of this point, the thrifts' share of the mortgage market has slipped sharply in the past several years, a period when mortgage securitization has evolved rapidly with support from a sophisticated network of organizations. Hottensen goes on to describe the changing structure of the thrift industry; for example, of the 10 largest thrifts in 1983, only 3 remain in the top 10 in 1991. The determinants of growth for a thrift, in the final analysis, are asset expansion, which is controlled by growth in the relevant market and the company's share of that growth; profitability and especially the trend in interest rate spreads; and the entrance of new competitors into the marketplace. He explains that a new class of thrift characterized 3

by large market capitalization relative to assets and generous capital ratios offers opportunities to create investor value.

Insurance Industry Basics Seifer identifies a number of issues that are basic to understanding past trends and possible future developments in the insurance business. Evaluation of the investment portfolio and cash flow provides an important financial health measure of the organization. Companies are attempting to emphasize portfolio liquidity and quality for the benefit of policyholders and stockholders, and those firms with positive cash flow are in a position to reduce problem assets as a percentage of total assets. One of the problems the life insurance industry encountered in the mid-1980s was replacement of high-margin cash value programs with interest-sensitive products. This switch eliminated low-cost cash flow and investment income resources and placed on the books minimal-margin products with high acquisition costs. The result was to transfer the spread benefit to the policyholder and away from the stockholder. The demand for annuities as an added source of retirement income is substantial. Annuities are a cash drain on the capital of the insurers, however, and because the market is quite competitive, margins are thin. Seifer says disability income and longer term care policies are growth areas for the life insurance industry. In both areas, however, adequate profitability is still to come. The property/casualty business underwriting cycle has been on a down-curve for more than five years. Nevertheless, Seifer expects some recovery in pricing and margins in the personal automobile insurance market, and some improvement is evident in marine and aviation lines. On the reinsurance market, Seifer observes that the primary underwriters are retaining more business on their own books. Because of more favorable pricing on the part of the reinsurers, however, this now is changing. Foreign competition is not a threat in the insurance industry; because of the ongoing tort and legal liability issue, few foreign companies want to enter the U.S. market. Of no small significance, however, with the final demise of Glass-Steagall in due course, banks will become strong competitors in the insurance field. Seifer says reserves are the most important factor in the analysis of an insurance company and pleads

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with the companies for more complete data on their reserve status.

Factors Affecting the Insurance Market The internal and external elements that affect the business of life and nonlife insurance companies are many and varied. Initial comments by Frinquelli summarize the size of the life and property/ casualty segments of the industry as measured by premium income, assets, capital, and market capitalization. Insurance stocks account for only 3 percent of the S&P 500, which in part reflects the large number of mutual, rather than publicly owned, companies-especially in the life segment of the industry. The insurance industry is fairly concentrated. Although the competitors are numerous, several account for a large share of the business. With few exceptions, the underwriters conduct virtually all of their activities in the domestic market. Frinquelli states that the primary internal factors affecting valuation of insurance stocks are competition, volume, surplus and return management, and loss reserve policies. For property/ casualty companies, product, geography, and distribution also are important considerations. FTinquelli provides a full explanation of the impact of each of these factors. A highlight of that discussion is the comments applicable to reserves. Managements have considerable apparent flexibility in creating and maintaining reserves, and changes in reserves can have a significant impact on the true value of a company. The common belief is that all an analyst needs to know about the external factors that affect insurance stock prices is this: premium rates up, stock price up; interest rates down, stock price up. Frinquelli explains that there is much more to know, including the effect of changing interest rates on the balance sheet, the income statement, and ultimately on the trend in book value. Also, inflation must be considered, because liabilities are cost-based, not dollar-based. Inflation also is a vital element to be considered in analyzing medical care lines. Additional external factors Frinquelli considers are catastrophes, particularly their size, number, and type; regulation, including the possibility of an eventual federal layer of supervision; the extent of product diversification; the matter of asset quality; changes in demographics; and the impact of consumerism, as evidenced by the passage of California's Proposition 103 in 1988.

Interpreting Property/Casualty Insurance Numbers Cope is of the opinion that analysis of a property/ casualty company's operations has two key elementsa loss-development analysis and an analysis of investment income. Much of his presentation is devoted to application of various analytical tools to an actual case, with use of a number of supporting charts and graphs. Among the pertinent points developed during the discussion are when paid losses rise faster than earned premiums, the fundamental profitability of the company is under pressure; in some cases, substantial increases in reserves are signals of potential problems; and as in other financial businesses, cost control is getting increased attention. Three factors are cited as determinants of investment results, namely cash flow, interest rates, and investment policy. Cope adds that many people believe cash flow is the key in trying to time the underwriting cycle: When cash flow turns negative for enough companies or for the industry as a whole, better pricing is in the offing. In fact, however, many companies now are experiencing cash flow squeezes or even negative cash flow, thus far without any effect on industry pricing.

Interpreting Life Insurance Company Numbers What caused the demise of First Executive, Mutual Benefit, and First Capital as ongoing entities, and how did these events affect the public? Picoult's response is that in all three cases, problem investments were a major part of the story, but once the problems became known publicly, a policy-surrender surge added to the adverse situation. Expanding on this point, he states that owning mortgages and junk bonds is not what creates an insolvent insurance company. The assets of an insurance company embody two types of risks: interest rate risk and credit risk. Although most companies limit their interest rate risk through duration matching, credit risk cannot be hedged. Although credit risk generally is not a problem if the insurer can hold the asset long enough for the credit to improve, policy surrenders and lapses will cause the insurer quickly to exhaust its supply of liquid assets, forcing it to liquidate credit-impaired assets, usually at deep discounts to book value. The obvious conclusion from this analysis is that the most dangerous exposure of a life insurance company is policy withdrawals and surrenders. A "run on the bank" tends to be irrational, but it happens. Picoult poses the question, "Will

more insolvencies occur?" The response is that such events would not be a surprise to him. The presentation then focuses on analytical tools and approaches a research analyst can use to determine the financial health of life insurance companies. _

Valuing Insurance Company securities In his opening comments, Zerbarini reviews performance of the various segments of the insurance industry relative to the S&P 500 during the past 10 years, identifying periods of superior and negative trends and the primary reasons therefor. The key ratios most analysts use in evaluating insurance stocks are price-earnings ratios, pricebook-value ratios, and dividend yield. Zerbarini warns that the components of these ratios and thus the quality of both must be carefully appraised to avoid wrong conclusions about value. Zerbarini reviews a number of financial data sets and measures that are helpful in evaluating insurance stocks.

Insurance Industry Dynamics Taylor explains the CIGNA Corporation's strategy in contending with the changing dynamics of the insurance business. His concluding comments are of particular interest: "1 expect a significant degree of turbulence to be generated by issues surrounding state and federal regulation, various tax and industry-specific legislation, and what I call the hyperlitigation problem in the United States. The industry itself remains intensively competitive, which has clear implications for margins and profit. What that suggests is selectivity in terms of an investment focus. Whether property/ casualty, life, health, pension, or reinsurance, there are leaders and followers." In the question and answer session, Taylor was asked what it will take to end the downturn in the property / casualty underwriting cycle, which has persisted for more than five years. His response was not too positive. Although conditions are ripe for an upturn in that prices are poor, no magic indicator exists. The hope is that collective action in time will develop to the benefit of the industry. _

The Art of the Insurance Company Interview To demonstrate how to elicit from insurance company managers the kinds of information an analyst needs to form a judgment about investing in those companies, de Rham and Arton enact a mock company interview. As interviewer, de Rham begins 5

with fundamentals or current trends for the busi- Valuation of securities Finn Stocks ness-a decline in premiums written, for example. According to Liss, industry fundamentals may not This beginning is followed by questions about key make brokerage stocks particularly attractive investindustry issues such as loss reserves for environmenments over the long term, but in the short run, they tal hazards and pricing trends. Finally, de Rham present significant moneymaking opportunities. He addresses new ventures the company is undertaking, offers five key elements to consider in the valuation which in the case of CIGNA, Arton's firm, is manof brokerage stocks: fundamentals; technical factors; aged group health care insurance. With judicious emotional factors; business segment appraisal; and questioning and straightforward answers on the part retail, discount, and institutional considerations. of the interviewee, the analyst should be able to make Detailed discussion of these elements, supported by an informed decision about the short- and mediumthe necessary analytical tools, clearly shows great term prospects for the company's stocks. volatility, however measured, in earnings results of securities firms. Asset management and development of financial account executives to service and expand the asset management business are growing sources of Understanding the Securities Industry income for the brokerage industry. Although not without its pitfalls, this strategy promises to create a Keefe briefly reviews the historical development and more stable source of revenues and at the same time current status of the securities industry, noting that generate additional income from the transaction side 20 years ago, most firms were privately owned, but of the business. today-with few exceptions-they are publicly owned. Currently, the business is composed of - - - - - - - - - - - - - - - - - - - - - about 400 firms, the top 10 of which account for about Financial Institutions and Market Value 60 percent of total revenues. In good years, the inAccounting dustry records a pretax margin of about 15 percent Mayer maintains that market value accounting for and return on equity of 20 percent or better, but in financial intermediaries eventually will be the norm, bad years, profits disappear. As a result, the prices and he strongly favors such a move. He cites a of brokerage stocks tend to be highly volatile, both in number of reasons why this change will not take absolute terms and relative to the overall market. place overnight, however, including resistance from This volatility provides investment opportunities on regulators. Mayer details several instances in which a trading basis. problems could have been avoided if more realistic Keefe explains that because many sources ofbroaccounting and management practices had been in kerage firm income are off balance sheet, as is much place. of a typical firm's net worth, calculating the value of Despite the opposition to market value accounta brokerage firm is difficult. He discusses in detail ing, Mayer says it is on the horizon for three reasons: how to analyze the financial statements, concluding the merger and acquisition boom among financial with the comment that book value per share probaintermediaries, the need for techniques to value bank bly is the most important statistic because growth in portfolios for oversight purposes, and the desire of accountants to avoid litigation stemming from finanbook value is really the only systematic measure of cial institution failures. what the company is earning for the stockholder.

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Understanding Banking Industry Basics Robert B. Albertson Vice President, u.s. Banking Research Goldman, Sachs & Company

Decisions about investing in banking stocks should be made in the context of the recent history of bank performance, the cyclical drivers of bank stocks, and the structural challenges-including consolidation-the industry faces.

People have a great many misconceptions about banks and banking. For example, consider the following simple, reasonable-sounding propositions: III Bank capital ratios have deteriorated during the past decade. III Banks have been displaced from corporate lending by other forms of finance. III Consumer debt is increasing and is threatening profitability in banking because of high loan losses. III Consolidation is the new wave, but mergers must be done primarily in a market with a lot of branch overlap to make them work well. III Bank earnings do not foretell what stock prices are really going to do. III Bank stocks are interest rate sensitive. At the risk of oversimplification, all of these beliefs are largely wrong! I will discuss some of them and present a broader view of three topics in the banking industry: the recent history of bank performance; the cyclical drivers of bank stocks; and the structural challenges the industry faces-basically consolidation.

Recent History of Banking The recent history of banking is rather straightforward. There are only three dates to remember: In 1978, interest rate deregulation got under way; in 1985, the Supreme Court said mergers were all right but states had to approve them; and in 1990, the famous BIS (Basle) ratio came together, leading everyone to decide they knew how to legislate the correct capital ratio for banking. I will go through these dates in order of importance, beginning with the most recent.

Capital Ratios The banking industry is probably the most leveraged industry in the country. Figure 1 traces almost 60 years of the equity-asset ratio for insured commercial banks. The history of capital has been quite dramatic. It has fallen a long way, but most of the fall took place a long time ago. In the mid-1930s, the equity-asset ratio exceeded 13 percent. Walter Wriston was right: High capital ratios did not prevent carnage and failure. The ratio was even higher before the Great Depression. It hit its recent nadir in 1979, and it has been in a slow but steady recovery ever since. The world conclave in 1990 that produced the Basle Accord decided to look at assets in a more sophisticated way. The assembled conferees provided guidelines that say the minimum capital ratio should be 4 percent "Tier I," which is a euphemism for common equity and some preferred. Most banks in the United States are well above 4 percent, and those that are not are very close to that level. Five and one-half percent is actually the practical limit on capital-that is to say, what is necessary to try to do acquisitions. Capital is probably the most important factor explaining valuation differences in banking. Capital is timeless. Capital collects the past, the present, and the future. It cumulates past sins, reflects them in the current condition of the bank, and tells what the future opportunities are going to be for that bank. It is more important than growth and profitability. Figure 2 shows how value correlates with capital levels in 1990 and October 1991. Although the R2 was 0 in 1980, and 0.38 in October 1991, it was as high as 75 prior to the 1987 market crash. In recent years, it has been the single most influential variable in explaining price--earnings and price-book differ7

Figure 1. History of capital-Equity-Asset Ratio, Insured Commercial Bank 14

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ences. Capital is the most powerful influence for four simple reasons: III Capital is a risk buffer, particularly in bad times. III A high capital ratio allows a bank to recover from a recession faster and gain in loan market share. III Capital is an absolute prerequisite to doing acquisitions. With increased consolidation in the industry, capital is going to be more important. III Capital will be a requirement for success in a more liberal environment. It will be the entry ticket to new products and ventures if banks ever get enabling, rather than punitive, legislation.

Interest Rate Deregulation Interest rates are often thought to be an important factor in the valuation of bank stocks. Figure 3 compares movements in interest rates and bank stock prices from 1972 to 1991. Interest rate deregulation began in 1978, causing quite a change in the banking industry. At that point, money market deposits began to appear and consumer deposits began to show significant interest rate sensitivity. Up until then, interest rates on consumer deposits were fixed; they were the anchor to windward for the banks. If anything, banks did better in high-rate environments, as some asset yields were rate sensitive while deposits were not, although they never went too far out on that curve. In the late 1970s, interest rates on consumer deposits became variable, causing the liability structure to change. In fact, to some people, the liability structure was the tail wagging the dog. In 1981 came the big interest rate spike, and banks got creamed on margin. They had to learn that lesson 8

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the hard way. Banks have always tried not to have too much gap in their margins; they have always tried not to be too interest rate sensitive. Interest rates are not as powerful a predictor of bank stock performance as some analysts think, however. The shaded areas in Figure 3 are the periods in which our lOa-bank index outperformed the market. During the periods where bank stocks outperformed the market, interest rates were either rising, falling, or indifferent. Table 1 shows the results of a regression analysis of the relationship between bank stock prices and interest rates during the past two decades. The upper portion is based on relative price performance of bank stocks, and the lower portion is absolute price performance. The independent variables are short-term rates (the Federal funds rate), change in short-term rates, long-term rates (la-year Treasuries), change in long-term rates, the yield curve proxy (the yield on lO-year Treasury securities versus the Federal funds rate), and the spread proxy (the prime lending rate versus the cost of funds, or yield on three-month certificates of deposit). The regressions

Figure 3. Stocks versus Rates--Relative Price Index, January 1972 January 1972 = 100 120

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Shaded areas represent periods of bank stock outperformance.

- - Relative Bank Price Index - - - Federal Funds . - - - - - 10-Year Treasuries Source: Goldman, Sachs & Company

were estimated on a coincident, six-month lead and six-month lag basis. In all cases, the R2s are virtually zero. These stocks have very little consistent interest rate sensitivity; although there are periodic relationships with short-term rates on an absolute basis, none persevere.

Industry Structure Banking has been the most discriminatedagainst industry in the United States. For the past 50 years, banks have been unable to modernize their existing product, unable to broaden into other financial services, and unable to sell their archaic wares except in very tight geographical areas. They have been burdened with all sorts of community responsibilities. What banks have achieved in this environment is amazing. Think about any other industry or stock and apply the same rules. For example, suppose Apple Computer could only sell its computers in California. Suppose it could only sell its first-generation computer, one with a black and white screen

and less than 10 megabytes of memory. Suppose it had to offer a discount to anyone over the age of 55. What do you think would happen to Apple Computer? Three kinds of diversity are important. Geography was a limitation for banks until the mid-1980s. Then, some regional compacts were created, and a lot of merger action took place in the Northeast and Southeast. The first big one was Sun Trust, which was a merger of equals. These regional compacts were a step in the right direction, but more than anything, they intensified concentration, albeit in somewhat broader geography. Nevertheless, it still kept most banks concentrated in one place; they could not cross the country. The reason banks in New England have been failing is because they were only in New England, rather than in several regions. Without this geographical restriction, the industry could have avoided most of the Texas and New England disasters, because the larger banks would have diversified out of those regions. 9

Table 1. Regression Results, Bank Stock Prices on Interest Rates, 1972~1

Item

Change in Treasuries at Constant Maturity ofIO Years

Federal Funds Rate

Change in Federal Funds Rate

Treasuries at Constant Maturity of 10 Years

0.00 -0.03 -0.11

0.01 1.39 1.39

0.00 0.38 1.00

0.00 -1.72 -0.79

0.01 5.14 1.50

0.05 -3.14 -3.56

0.00 -0.03 -0.13

0.00 0.20 0.20

0.00 -0.29 -0.76

0.01 -2.76 -1.27

0.01 -4.64 -1.36

0.07 -3.67 -4.29

0.00 0.08 0.32

0.00 0.31 0.34

0.02 -0.69 -1.94

0.00 -1.59 -0.79

0.08 -13.66 -4.28

0.13 -4.49 -5.80

0.01 -2.59 -1.83

0.00 -1.83 -0.34

0.00 1.00 0.49

0.02 -24.60 -2.10

0.01 20.79 1.12

0.04 15.23 3.19

0.02 -3.27 -2.37

0.00 -2.39 -0.45

0.00 -1.93 -0.95

0.01 -15.49 -1.33

0.00 8.21 0.45

0.03 13.52 2.89

0.03 -3.45 -2.42

0.00 -1.91 -0.35

0.01 -3.37 -1.62

0.00 -9.72 -0.83

0.00 -1.24 -0.06

0.01 8.22 1.72

Yield Curve Proxt

Spread proxl

Relative bank stock index

R2 6-month lag

Coefficient t-statistic

Coincident

Coefficient t-statistic

R2

R2 6-month lead

Coefficient t-statistic

Absolute bank stock index

R2 6-month lag

Coefficient t-statistic

Coincident

Coefficient t-statistic

R2

R2 6-month lead

Coefficient t-statistic

Source: Goldman, Sachs & Company. Note: R2 measures the success of the regression in predicting the values of the dependent variable. An R2 is 1.00 if the regression fits perfectly, and 0.00 if it fits no better than the simple mean of the dependent variable. The coefficient measures the contribution of its independent variable to the prediction. If the coefficient is zero or very small, the regression indicates the variable is not helping the forecast. The t-statistic is the ratio of the regression coefficient to its standard error. If the t-statistic is large, it is unlikely that the true value of the coefficient is actually zero. More specifically, if this value is greater than 2, it is more than 95 percent likely that the coefficient is not zero. A t-statistic below 2 (in absolute terms) indicates the variable is not considered significant and should be disregarded. aRatio: yield on Treasuries at constant maturity of 10 years to Federal funds rate. bSpread between prime lending rate and yield on three-month certificates of deposits.

The types of products offered by financial institutions in the 1980s is presented in Figure 4. Commercial banks competed in five products. In contrast, Sears, Transamerica, RCA, Gulf & Western, and some of the others offered considerably more products. This provides a clear picture of the competition, and it has been tough on bank product. Fleet Financial, one of the earliest to seriously diversify, said, "We are the largest bank in the smallest state, so we better do something." They got into nonbank subsidiaries that were near-banking, allowing them to get a little bit outside of the product and geographic restriction mold. Subsidiaries that are in mortgage banking, asset-based commercial finance, and consumer finance are good ways around geographical 10

restrictions and should get some of the credit for saving banks like Fleet and Norwest. When banks finally hit on a solid earner, politicians invariably get upset: The credit card is an amazing product. Everyone thinks banks are paying off their losses on loans to less developed countries with usurious rates to the consumer on their credit cards. The average return on the credit card business is 300 basis points pretax. The average yield is 18.9 percent per card. On an aftertax basis, this might be 150 basis point return, which I do not think is sinful for the banks, but it makes banks into vulnerable targets. Loan portfolios. also pose diversification problems, although progress has been made, and banks

Figure 4. Product Possibilities Through the 1980s

••••• • •••• •• ••••••

•• •••••• • •• • ••••• ••• • •••••• ••• • • • •••••••••• •••••••• • • • • • •••••• • • • • • • • • ••• • •• • • • • • • •••• • • • • • • • ••• • • •• • • •• • • • ••• ••• • • • •• • • • •• • •• • • • • • • • • • Source: Citicorp.

have been much more disciplined. Actually, the highly leveraged transaction business helped reduce credit concentrations. In the mid-1970s, there was a constant stream of big credits with problems, and the banks seemed to always have big pieces of these problems. Legal lending limits do not mean much anymore; banks usually do not even get close to them. In fact, loans retained on highly leveraged transactions are typically about 0.5 percent of the legal lending limit in many banks. This is one place where lending limits have worked. Lending limits have not worked in commercial real estate. Unfortunately, that is the basic fundamental driver of the U.s. economy. Banks went from 18 to 22 percent of their assets in real estate. I find that, in and of itself, not a bizarre number for an entire loan category. I am stunned that we read little in the newspapers about the real estate developers who did the bad deals, compared to the banks that lent to them. This is an industry that attracts an enormous amount of criticism, which becomes progressively more unfair and unbalanced.

Cyclical Drivers Banks have three cyclical drivers: credit demand,

interest rates, and loss cycles. These drivers are deceptively simple in theory but sometimes complex to assemble.

Credit Demand Credit demand is of two major types-eonsumer and corporate. Banks always have a much sharper loss cycle on the corporate side than on the consumer side, primarily because consumers are debt maximizers and corporations are debt minimizers. For debt maximizers, it is the Los Angeles freeway phenomenon: being so scared you drive carefully. The minimizers-akin to "Sunday drivers"-only go into debt when they have to, which is probably when they should not: at the end of a recession or coming into a recession. They get into trouble. Consumer lending is very simple: Consumers borrow based on strength of income. The appropriate debt level according to the average consumer is as much as he can carry as long as he can service it. Figure 5 shows consumer credit and disposable personal income growth during the past 15 years. They track pretty well. In 1980, however, consumer credit growth dropped like a rock. That was when President Carter was in office, and credit controls were imposed. In 1984 and 1985, consumer credit took off 11

Figure 5. Consumer Credit OUtstanding versus Disposable Personal Income

~ £ ;::

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22 20 18 16 14 12 10 8 6 4 2 0 -2 '76

\

Interest Rates

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'90 '91

Just as bank stock prices do not relate much to interest rates, bank net interest margins are surprisingly stable as well. The upper panel in Figure 8 shows two mega-interest rate cycles, and the lower panel shows bank margins. I do not see any powerful correlation between the interest rate cycle and the bank margin cycle here, either. This is not an industry that bounces around from net interest margin. The lower panel of Figure 8 also shows two spreads: the prime rate versus money market account rates, and the prime rate versus the threemonth wholesale certificate of deposit rates. Basically, the prime to retail fund spread is coming down; the other has been going up. Thus, we are basically neutral on our margin outlook; the primary forces should largely offset each other. You hear about the Federal funds rate and the discount rate going down a lot, while banks have not dropped their lending rates. Banks do not use Fed funds as a source of funds unless they have a serious problem. Most of them are net placers, and the discount rate is a dirty word. Figure 9 shows that the spread between the prime rate and the Fed funds rate has been going up during the past couple of years. The spread between the prime rate and the true cost of funds has been flat, however. Banks really just move their rates in line with their true costs of funds. This is the proverbial orange cart: They were paying whatever it costs to buy the orange, and then selling it at a spread.

- - Consumer Credit Source: Goldman, Sachs & Company.

like a rocket again as it became decontrolled. Basically, consumer borrowers will be back as soon as their incomes come back. Corporations borrow according to a simple algorithm that sums inventories plus spending minus cash flow. This financing requirements "proxy" in Figure 6 tracks very tightly with the growth in business loans. The statistics get treacherous in corporate lending because we tend to focus business credit on the Federal Reserve statistics on how much is outstanding in the banks. Banks are more arrangers of credit than holders of credit. (Many people still believe banks have been replaced by commercial paper.) Figure 7 shows the sum of all of the outstanding bank loans in all of the corporate sectors in the United States-their liability side-as a percent of total long-term debt. The percentage has actually gone up. If anything, I am concerned about the deleveraging phase we are facing on the corporate side. 12

Loss Cycles The loss cycle is the third cyclical driver. Figure 10 shows consumer loan losses for the past 60 years

Figure 6. Loans at Banks versus Financing Requirements Proxy 30,-------------------, 25

~

~

20 15

2 CJ 10 '; ;:l

c c

-<

5 0 -5 -10 '76

'78

'80

'82

'84

'86

'88

- - Business Loans - - - Financing Requirements Proxy Source: Goldman, Sachs & Company.

'90 '91

Figure 7. Long-Tenn Bank Debt as a Percent of Total Long-Tenn Debt

'i:: <J)

u >-< <J)

0...

33 32 31 30 29 28 27 26 25 24 23 22 21 73

75

77

'81

79

'83

'85

'87

'89

'91

Source: Goldman, Sachs & Company; Commerce Department, Quarterly Financial Report.

FlQure 8. Average Rate Data Through OCtober 1991 Interest Rate Cycles 13r---,.,--------------------, 12 I~

11 10

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using a consumer finance compact as proxy, and Figure 11 shows all losses (consumer and corporate) for the past 40 years. For consumers alone, the 1975 recession produced only a minor blip. During the mid-1980s, the loss rates were actually declining mostly because the mix changed; homeowner equity loans and second mortgages replaced unsecured lines. Consumer credit is also continuing to increase in the overall mix, so the combination graph has an upward bias. If that were removed, the corporate loss cycle would show some pretty big swings. Commercial losses are more volatile. The charge-off ratio doubled in 1974 and again in 1982. Commercial charge-offs bounce around. Consumer losses are higher, but tamer. I believe for consumers you do not need a loan loss reserve. Reserves are for the unexpected; consumer losses are predictable. I am frequently told that bank earnings do not mean anything because no one trusts them. Figure 12 contradicts this belief, however. It shows earnings-per-share growth relative to the market against bank stock price changes relative to the market. We used core earnings, which are quarterly results adjusted to exclude nonrecurring events, such as the big developing country provisions during 1987-89, and other irregular items such as asset sales. The two series have a much tighter fit than you might have expected. Earnings do count, and when they are interrupted by loss loan cycles, the stocks predictably suffer.

Structural Challenges

'91

The banking industry is trying to solve some problems by cutting costs-alone and through consolida-

- - Prime Rate - - - Three-Month CD Rate - - - - - Money Market Rate Bank Margins/Spreads 6,----------------------,

Figure 9. Spreads on True Costs 800,-------------------, 700 600 '" 500

.5

~ 400 .~

~

300

100 O'----...L-----'-------'-_ _L-_--'----_---L_----.l_----l

'84

'85

'86

'87

'88

'89

'90

'91

- - - Regional Bank Margin Prime--Money Market Spread - -Money Center Bank Margin Prime--Three-Month CD Spread

Source: Goldman, Sachs & Company.

O'------'----"'-------'-_.L......---'--_-'-----'-_-'-----'-_--'------'---.J '80 '81

'82 '83 '84 '85 '86 '87 '88 '89 '90 '91

- - Prime--Discount Rate - - - Prime--Cost-of-Funds Proxy - - - - - Prime--Federal Funds

Source: Goldman, Sachs & Company.

13

tions and mergers. The capacity issue in banking is schizophrenic. Is the problem over- or undercapacity? If you look functionally at the industry, capital is still short; it is certainly not in excess. So functionally, lending capacity is a problem because the system lacks capital. That may not be as apparent at the low point in the credit demand cycle, but it is there. Even if all the banks were merged into one, we would still have that problem. Structurally, that is a different matter. Because of its history, the US. banking system is the most fractionated industry in the world. There are too many banks and too many branches. That is a different kind of capacity-delivery capacity. This is a natural offshoot of all of the restrictions the industry has lived under. As a result, the game is going to be delivery inefficiencies. Branch reduction is important, but the back office is the true key. Table 2 lists five recently announced mergers in order of branch overlap-Society/ Ameritrust (high overlap) through Fleet Norstar /Bank of New England (limited overlap). If you look at the savings in expenses as a percent of the target bank in all of these deals, the opportunity for savings is curiously a consistent number whether it is an in-market or an outof-market merger. In showing the sources of savings, the table lists local items, such as retail branches, on the left and fixed-cost items, such as overhead, toward the right. At least half of the expense savings are available regardless of market. I do not think geography is going to matter as much as people think. Cost savings will be the most important thing banks can achieve over the next five years, and that is how we are focusing our bank stock investments.

Figure 10. Household International Consumer Net Charge-Offs to Average Receivables 6,-----------------------,

5 4

3 2

o'--_---'---_----'-'"'--_--'-_-----.J'--_--'-_-----.J_ _--'-----' '29

Source: Federal Deposit Insurance Corporation.

14

'61

'69

'77

-----,

Figure 12. Price Change Differential versus Core Earnings Growth Differential--Money center Banks versus S&P 500 60 , - - - - - - - - - - - - - - - - - - - - - - - ,

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'80

'84

'85 '89

Try to understand banks, and then select among them. This is a people business, and the key is to meet the managements and get comfortable with them. If you cannot, or if they cannot meet you, look somewhere else. After the fundamental analysis is done, there are two questions an analyst should ask bank managements about their banks. First, ask the CEO, "Do you know what a TIline is?" A TI communication line is a digital line that allows the bank to deliver a back office systems capability from Denver to Dusseldorf. Digital communication was invented decades ago and became commonly available by 1980. A few banks figured it out in 1985. It removes one of the shackles of geography from consolidation and delivering back office support. With

ca :0

1.3 1.2 1.1 1.0 0.9 ~ 0.8 ~ 0.7 P-. 0.6 0.5 0.4 0.3 0.2 0.1 0'48

'53

Conclusion

Figure 11. Net Charge-Off Ratio FDIC Insured Commercial Banks 1.4,----

'45

Source: Household International.

'88'90

- - - Earning per Share Growth Differential

Sources: Goldman, Sachs & Company; company reports.

Table 2. Out-of·Market Merger Potential Expense Reduction Mix Spectrum In-Market (Branch Overlay)/Out-Of-Market (Systems and Operations) Society/Ameritrusta

$millions mix Percent mix

Retail Branches

Commercial Banking

47.5 37

10.1 8

Trust 8.6 7

Corporate Overhead

EDP& Operations

37.2 29

25.3 20

Systems

Operations

BankAmerica/Security Pacificb Consumer Delivery $millions mix Percent mix

350 35

Wholesale Delivery

Other

150 15

100 10

200 20

200 20

Chemical/Manufacturers Hanover c Branches & Real Estate $millions mix Percent mix

100 15

Staff

Technology & Operations

350

200 31

54

NCNB/C&S Sovran d In-Market Branches $millions mix Percent mix

Marketing

Business Lines

25 7

47 13

Branch Banking

Other Line

Staff! Support

20 8

55 21

108 31

Corporate Overhead 44 13

Support Services & Operations 126 36

Fleet Norstar/Bank of New Englande

$millions mix Percent mix

100 38

Systems & Operations 90 34

Sources: Goldman, Sachs & Company; company reports. Note: Mergers listed in order of high-branch overlay. a30 percent of target: $129 million run-rate save. percent of target: $1,000 million run-rate save. c33 percent of target: $650 million run-rate save. d 21 percent of target: $350 million run-rate save. e41 percent of target: $350 million run-rate save. Ex-Special asset pool cost save 34 percent of target: $265 million run-rate save. Close 50 of 323 BNE branches. b 32

one simple exception-that you must have checks delivered locally to clear the Fed-everything else can be done remote. Other than that, geography is not a limit.

The next question is, "00 you have common products and systems across your existing geography?" These two questions will tell you whether the bank is really "cooking" in the consolidation phase.

15

Question and Answer Session Robert B. Albertson Question: If capital requirements as a percentage of total assets are expanded to 5 or 6 percent, and a bank can get a 0.8 percent return on assets, its return on equity is 16 percent at 5, but at 6, it is only about 13.6. That starts to go from okay to pedestrian. Can we be overreacting on the capital side? Albertson: No. When a bank increases its capital and reduces its return on equity, investors pay more for the stock. Bank stock prices do not go down one-forone when they do common offerings because of dilution. There is something special about capital in banks. I think the real question is this: Should a bank be able to earn 80 or 100 basis points return on assets, or are we just kidding ourselves? We applaud all of these banks that finally get there, and we forget that they have been living in an industry in which efficiency has never really been a focus. I think we will see decent return on equity numbers for banks when the return on assets rises well over 100 basis points. Question: Will banks tough it out on the efficiency side to close the gap? Albertson: All banks are focusing on efficiency. Even those that are not merging can somehow eliminate up to 10 percent of costs in a year. Question: The credit card challenge is in the public domain. Somebody asked how much subsidization of bad credit debt are consumers paying for at 18.9 percent. Obviously, a good bit if the losses range around 5 percent.

16

On the other hand, all the major issuers have had better rates for better creditors. How do you see the credit card business evolving? Albertson: Maybe the only time to invest in bank stocks is the two months in which Congress is out of session. This issue is very visible, and everyone seems eager to hop on a populist bandwagon. A little global perspective would help. Even if you are the best customer at Harrod's, the rate on its card is 32 percent; a Barclay's card is also 32 percent. The problem is that the credit card's functional purpose has been misperceived. It is not intended as a primary financing vehicle. If a consumer is using it accordingly, they are misusing it. The average consumer borrows $800 on the card. The card is really two products, and maybe they should unbundle it and price it as such to get away from this risk. If I borrow $800 at 19 or 20 percent, I am spending close to $150 a year on interest, which is foolish. On the other hand, I receive with the card a free checking account that works everywhere I go. That is worth something each month. If you ask for a simple checking account, it would cost you more than $4 a month if you do not keep minimum balances. So after deducting a fee for checking, the average bank card user is really paying $90 a year in interest, or 10 to 12 percent. The card is subsidizing between functions, and banks have to learn how to reprice that, unbundle it, and delineate the transaction device from the rate paid on the borrowings. Currently, people who use the card purely as a transaction

device are being subsidized by the higher rate paid on outstanding balances. I mentioned that the industry earns 300 basis points pretax. If they all went down to 14 percent, half of that could be completely recaptured by charging interest the day of purchase instead of after a 30-day grace period. Banks have a lot left that they can work with to keep this business profitable. Question: Banks have seemingly had an infinite capacity to dig their own holes. It was obvious with the lesser developed country debt, when Wriston said, "No country shall go broke." We have seen the carnage in real estate loans. Then there were the highly leveraged transactions. What new holes are they going to dig, or are they going to learn their lesson somewhere along the way? Albertson: Banking is a cyclical business. Part of the cycle is that a recession should produce losses and make bank earnings go down. Where we messed up is not in the actual business banks get into but in their tendency to forget that the government can make them a lot worse in times of distress. The lesser developed country exposure and losses would have been far less had the government not encouraged such lending in the first place, then pushed so hard for debt forgiveness. If the government had not interfered, we would not have had this problem. We would have had a cycle, banks would have lost some money, but it would have become better. Commercial real estate is very much the same thing. We

had overbuilding in 1975, but we came out of it. The difference is partly that we had inflation to help then and different demographics. What we have now is the Financial Institutions Reform, Recovery and Enforcement Act, which has basically made it a felony to misappraise property. Now, if you are an appraiser, you would be trying, with fear as your motivator, to lowball your appraisal. That results in making the downside on these properties unrealistically low. Now, the regulators are asking banks to mark real estate to market, even when loans are performing. Banks are supposed to lend to borrowers who need the money and cannot directly tap public markets at favorable rates. By definition, this is an "illiquid" instrument in most cases. This is their real function. They are not supposed to be securities firms. When regulatory distortions add to the effects of the cycle, they are in trouble. I do not see any new problem credit areas at this juncture, partly because banks do not want to lend. They have pulled back. In 1975, there was the same question. When are the banks going to dig the next hole, and what is it going to be? We had an oil industry problem then. The answer was proposed to be tankers and nuclear utility loans, and neither hit. So I think it is a cycle. We are almost through this one. We will have another period like this again-probably in the late 1990s. Question: If regulation gets more severe and limiting, do you think we will see any denouncement of bank charters? Albertson: Yes. If you are a banker, and you have been watching all of this happen, you know what you do not like. The reason

you accept regulation now is simple-you are insured. If you can find a way to stop using consumer deposits, you do not need that bank charter. If you can find a way to fund yourself otherwise, you are going to get out of this business. Several banks, such as Morgan, have looked at this possibility in the past. If one or two of them actually try it, I think that will reverse the regulatory process. The reason the government has its hooks in banks is because it is insuring them. That is only fair. The regulators want to know where the money goes, they want control over it, and they want banks to pay when it goes bad. But it has gotten to an extreme. Question: Some banks, Morgan for example, can do underwritings. Obviously, a bank must qualify for this on some kind of prudent basis. Will we see more of that, and will that rattle the traditional underwriters? Albertson: I think investment bankers have a big problem here. For underwriting to help banks, it will have to be a pretty big business. If you add up all of the profits made on Wall Street and divide it among 10 large banks and 20 smaller banks, it is a "good living" for very few. If all of the big banks and some medium-sized regional banks went into that business, there will probably be serious price competition. Question: One of the things you do is try to get some perspective on future corporate lending. That Goldman, Sachs & Company survey of chief financial officers looked positive recently, which is unusual in this environment. Please comment on this. Albertson:

In April, our survey

of corporate borrowers said we were going to have a borrowing boom because cash flow in the corporate sector was tight. In the latest survey, cash flow for the 1992 period according to corporate treasurers looks much better. This means they are not going to need banks as much, so the credit demand in commercial lending is now coming back down to a low single-digit level. I am happy to see the cash flow of the corporate sector firming up because that will help the economy. I do not care about having loan growth right now, and loan growth will be very sluggish until later in 1992. The banks that will make the money are the service providers that do more than just lending anyway. In this same survey, we asked the CFOs of Fortune 500 companies how much they pay their bankers for things other than lending, and the answer was an astonishingly high 40 percent. Cash management, trust, and derivative products are where the growth will be in the next few years. Question: What predictions do you have for Southeast bank mergers? Albertson: I think the big local mergers are over. North Carolina National Bank is doing something that others do not have the heart to do, which is to take over a big company and say that what they are really acquiring are 500 more branches. I think what you will see in the Southeast are small and medium-sized fill-in deals. That is all you will probably see in the rest of the country, too, with the exception of the Midwest, where a couple of megamergers are due.

17

Analyzing the Banking Market~nternal and External Factors Donald K. Crowley Executive Vice President Keefe, Bruyette, & Woods, Inc.

Banks have consistently lost market share in the past 40 years, partly because of regulatory limitations on their location and activities. The banks that are doing well in this competitive environment are those that focus on asset quality, cost control, fee-income niches, state-of-the-art technology, and efficient deposit gathering.

Because so many internal and external factors affect commercial banking today, I will approach the subject in five basic segments: (l) the competitive environment among banks and between banking and nonbanking companies; (2) the operations and product mix of banking companies, as well as the strategies that seem to work and those that seem to be most flawed; (3) the three key aspects of bank regulationmonetary policy, supervision, and insurance; (4) the geographic and product offering limitations imposed by banking regulation and legislation; and (5) U.S. banking operations in the context of global finance.

Competitive Environment The financial industry has been competitive during the vast 40 years. Table 1 shows the market share of U.s. financial assets by industry segment for 1950, 1960, 1970, 1980, and 1989. During this period, banks have consistently lost market share to their competitors. Who they lost it to and when it was lost varies. The banks' traditional competitors-thrift institutions, insurance companies, pension funds, and finance companies-gained share between 1950 and 1960. The principal gainers were thrift institutions and pension funds. Between 1970 and 1980, market shares were comparatively stable. Then, in the 1980s, banks as well as their traditional competitors began to lose market share to the securities industry, primarily money market mutual funds, other mutual funds, broker-dealers, and securitized credit obligation issuers. The banking industry is fighting a competitive

18

battle on both the liability and the asset fronts. This point has been missed by the regulators, by those setting antitrust policy, and by many people looking at this industry. The liability side is the funds-gathering function; most people think of bank liabilities exclusively as deposits, but they are far broader than that. The asset side of the balance sheet is putting those funds to work profitably, and that has been one of the foibles of this industry.

The Liability Side The liability side, or the deposit-gathering side, is important in today's environment because it is the heart of the franchise. The deposit franchise is the reason, when things got tough, Bank of America survived as an independent entity and Continental Illinois did not. The key to the deposit franchise is the convenience factor, which is difficult for nonbank competitors to overcome. The United States now has about 30,000 banking branch offices, and the number is increasing, even though the number of independent banks is shrinking. The network of branch banks provides convenience; customers know where to take their money and where to get their money. They may want to change banks because of bad service, but as long as the bank is in their neighborhood, they will stick with it. Of the competitors, the toughest ones for banks are money market funds and brokerage houses. These competitors have significantly different cost structures and approaches to getting deposits; they are also operating under different and more lenient regulations. Overall, banks have done reasonably well, despite their problems and bad press, in the battle for

Table 1. Market Share of Total U.S. Financial Assets, selected Years, 1950-89 Industry Segment

1950

1960

1970

1980

1989

Total assets ($billions)

$294

$597

$1,340

$4,032

$10,534

Commercial banks Traditional competitors Other depositories Insurance Private pension funds Public pension funds Finance companies Securities industry competition Money market mutual funds Other mutual funds Securities broker I dealers Real estate investment trusts Securitized credit obligation issuers

51.2% 46.3 13.7 25.3 2.4 1.7 3.2 2.5 0.0 1.1

38.2% 57.9 19.8 23.8 6.4 3.3 4.6 4.0 0.0 2.9

1.4 0.0

0.0

38.6% 56.4 20.0 18.7 8.4 4.5 4.8 5.0 0.0 3.5 1.2 0.3

0.0

0.0

0.0

1.1

36.8% 58.5 21.2 15.8 11.6 4.9 5.0 4.6 1.9 1.5 0.1

30.7% 55.8 16.3 16.7 11.0 6.9 4.9 13.5 4.1 5.3 2.2 0.1

0.0

1.8

1.1

Source: Federal Reserve Flow of Funds.

deposits. Using the Federal Reserve's definition of liquid assets-which includes bank checking accounts, savings accounts, and large CDs, as well as nonbank liquid investments such as brokerage accounts, sweep accounts, and the direct holdings of these kinds of obligations-liquid assets are estimated to be about $5 trillion. Banks have about one-third of that market, thrifts have 20 percent, money market funds and brokerage firms have about 10 percent, and the broad group of primarily direct holdings of near money-T-bills, bankers acceptances, commercial paper-are about 37 percent of that total. Four or five years ago, banks had about 29 percent of the market, so they have increased their share of the total liquid market. Some of the gain was at the expense of thrifts, whose share declined from about 25 percent. Brokerage and money market funds picked up market share from about 7 percent to 10 percent. The broad holdings dropped a little from 39 percent, perhaps due to the convenience of brokerage firms. Right now, banks are flush with funds. They are reducing the amounts of their largedenomination CDs. Nevertheless, in this unusual environment, a credit crunch exists in the midst of ample equity. Banks have some obvious advantages, but they also have some major impediments to attracting deposits. On the negative side, handling customers costs the banks a lot of money because of their investment in bricks and mortar. Servicing a customer costs a bank about $400 a year and a telephone-based competitor only $25. On the positive side, banks have a franchise in the depositor markets. They also have convenience and Federal Deposit Insurance

Corporation (FDIC) insurance-which is a mixed blessing. Some of their competitors also have insurance; for example, brokerage accounts have the Securities Investor Protection Corporation. Insurance is an important consideration for many depositors, and banks could get additional policies to offer customers even better protection. The profits in the banking industry today are primarily on the liability side of the balance sheet, and they are sizable. On a fully loaded basis, however, the benefits on the liability side are not as good as you might expect. This is fertile territory when looking at what the fully loaded costs are for serving depositors, as opposed to the fully loaded cost on the lending side. I would suggest that the costs are higher on the deposit-gathering side, and therefore the benefits banks are getting on the liability side are overstated. However, the profitability of the deposit base appears higher today than it has been in recent history. Many banks are pressing the limits by lowering the rates they pay depositors and raising the fees they charge them.

The Asset Side The asset side of the banking market is about $10.5 trillion, and banks have about 30 percent of that market. The market can be disaggregated into a variety of distinct businesses, as shown in Table 2. Approximately 35 percent of total credit is in mortgages. Banks have about 21 percent of the mortgage market; five years ago they had about 20 percent, so not much of a shift has taken place. Thrift institutions have about 21 percent of the mortgage market; five years ago, they had 29 percent. Insurance companies are competitors in this area with 7 percent of

19

Table 2. Estimated Market Shares-Business Credit, Mortgage Loans, and Consumer Debt, 1990 and 1985 Credit Holder

1990

1985

Business credit Commercial banks Corporate bonds Commercial paper Trade credit, etc. Total

31%

34%

29

26

3 37 100

3 37

100

Mortgage loans Commercial banks Thrifts Insurance companies Government securitized enterprises Mortgage pools Individual holders Total

21 21 7 7

20 29

29 15 100

25

7 6

13

100

Consumer debt Commercial banks Finance companies Credit unions Retail credit Pooled securities Other Total

46

18 13 5 12 6

100

47 19 13 5 6

10 100

Sources: Federal Reserve Bulletin, Federal Reserve Flow of Funds.

Consumer installment debt, at about $725 billion, is a much smaller market than business credit. Banks' share is about 46 percent; a few years ago, it was 47 percent. The finance companies have about 18 percent of the market, compared with 19 percent a few years ago. Credit unions are a competitor in this area with 13 percent of the consumer credit market. Retailers have 5 percent of the market. Neither of these groups has changed much in share during the past few years. Thrifts have declined from 8 percent to about 5 percent. The pools and securitized part of that market is now 12 percent, up from 6 percent. Gas companies and others provide the remaining credit. The remaining 37 percent of the total, the other forms of credit, include insurance companies' mezzanine financing, commercial mortgages of one sort or another that are not held by the traditional lenders, and trade credit. The competition on the asset side of the balance sheet is considerable. Commercial banks are having their noses bloodied on business lending and particularly on commercial real estate. All the banks want to be single-family residential lenders or consumer lenders, but they have an enormous amount of competition coming from other institutions, including some of the federal agencies.

the market. The Federal National Mortgage Association and the Federal Home Loan Bank Board are Banking Strategies also competitors, with 7 percent of the market, a Banks have followed various strategies, some sucfigure that has been rising slightly; it was 6 percent cessful and some not, in an effort to compete. The five years ago. Mortgage pools and trusts have alstrategies that have worked can be found in the best lowed anybody to have a piece of this mortgage companies. In the 1980s, I developed an "excellence market through securitization. Their share has risen index" for banking companies. The excellent compafrom 25 percent to 29 percent in five years, so they nies had qualities that allowed them to hold their are the biggest factor in servicing the mortgage marheads high through all of the cycles. They have ket. Individual holdings of mortgages approximate stubbed their toes occasionally, but essentially they 15 percent of the total, up from about 13 percent five retain the qualities that brought them through the years ago. worst of times. Of the top 200 banks, I identified The other large segment of the asset market is about 6-J.P. Morgan & Co., Wachovia Corporation, business credit, which is $3.5 trillion, or approxiNational City Corporation of Cleveland, NBD Cormately 30 percent of the total asset market. Business poration of Detroit, Suntrust Banks, and PNC Financredit historically has been one of the two mainstays cial-with an internal cultures that had kept them in of the banking industry. Banks have 31 percent of excellent shape for the prior 30 years. the business credit market today; five years ago, they Asset quality was the heart of the enterprises that had about 34 percent. Corporate bonds-both long did well during this period. A bank's credit culture term and short term-represent 29 percent of the is key to its success. No matter where its growth total business credit market; they were about 26 percomes from in this industry, a bank will still rise or cent five years ago. Clearly businesses have been fall on the strength of its credit quality. A large funding out, which obviously is part of the growth proportion of banks have been reminded of this esin highly leveraged transactions. Commercial paper sential rule recently. Cost controls also have been a consistent factor is a surprisingly small part of the business credit for those banks that have done well. Pressure has market at about 3 percent, which has remained esincreased as more of the competitors they face have sentially unchanged during the past five years. 20

low cost structures. Cost control should be a constant discipline. When looking at fee income, it is essential to emphasize niches of strength. Nobody in this business seems to have the strength to be good in all areas. They have to pick their strengths, whether it is fiduciary, securities processing, credit card and debit card processing, or a variety of smaller specialties. The key is concentration and market share. Technology is important, but it is a moving target, and banks have to keep up with the changes if they are to be successful. Companies without stateof-the-art technology will have trouble competing. This area is coming under siege as well from some of the nonbank competitors. Deposit gathering, of course, is important. It is an inherited role. It is a role of concentration and market share, but increasingly it is going to be a matter of efficiency as well. A number of strategies have not worked. Almost every banking company that has tried a strategy of aggressive expansion through acquisitions has failed. That may not be the case, however, for consolidation acquisitions, the type of transaction we are seeing a lot now. The current transactions are also being done at what we hope will be the trough of a cycle, so they hopefully will be more successful than earlier acquisitions. Another flawed strategy is lending in unfamiliar fields. Many of the failures of the past decade involve banks that went into areas they knew little about-for example, energy lending or buying nonbank financial companies domestically and abroad in unfamiliar fields. When things are going well, banks have a tendency to think they can do everything right, and they end up spreading themselves too thin. The correct strategy, which is evident among the excellent banks, is careful, deliberate, conservative, and timely expansion within their own markets and into nearby or related markets. In short, this industry has a serious problem with what you could only describe as bad management and a kind of "follow the leader" mentality that endlessly gets its members into trouble.

Banking Regulation The banking industry operates under several redundant layers of regulation and supervision. This is in line with the history of an industry that was not set up to be efficient. The United States was not a country that was reindustrializing itself. This was a country that was insulated from foreign competition because of its geographical isolation. Therefore, the objective was to control banks closely and restrain

their powers. This was accomplished by permitting their operations on a states' rights basis. The banking industry is subject to a parliament of special interests. The industry was not set up to be efficient; it was set up to be socially and economically restrained in the sense of avoiding undue concentration of financial power. Now the industry faces layers and layers of supervision and regulation, and each agency has its own agenda. An incredible amount of battling for turf takes place among various agencies at the federal and state levels. Massive redundancies also exist, but dismantling this redundancy is difficult when the 50 states have 50 banking superintendents with their own bureaucracies. To legislators and lobbyists, banking legislation is not a consumer issue; it is a subject that only impacts the consumer when it is a negative. Political "hot buttons" include bank failures and bailout costs; redlining and community reinvestment; and nondiscriminatory hiring, firing, and lending. The banking and thrift industries both are characterized by an array of small independent institutions, many of which survive by virtue of their oligolopolistic powers in small communities where other competitors are not allowed or find entry insufficiently profitable. Supervision today is the big problem, and it is politically charged. I do not envy bank examiners. The banker-bank examiner relationship today is more adversarial than it has been at any time since the Great Depression. The environment now is one of "beggar your banker." Regulators are spending too much time telling good bankers how to do their jobs, and the regulatory process is burdening the industry with tons of paperwork that has marginal utility. I hope that will tum around; I believe it must if the economy is to tum around. The regulation of nonbanks is quite light. Most people would agree that insurance companies have a bigger problem than banks with commercial real estate, because their claims are frequently junior to those of banks-either as owners or mezzanine lenders. Nevertheless, there is not much discussion of large problems emerging in the insurance industry, although it is beginning to surface. Meanwhile, banks have been forced to write down and set aside sizable reserves against their commercial real estate outstandings. Many nonbank institutions are not really regulated at all. For example, finance companies pretty much do as they choose, and brokerage firms are doing quasi-deposit gathering. FDIC insurance is a significant part of the bank and thrift deposit-gathering franchise, but it is not working as anticipated. It was designed to protect 21

small depositors, up to a certain level-not everyone. The "too big to fail" concept, under which deposit insurance has covered almost everything in big bank failures, has dramatically increased potential government liabilities and involvement. By condoning this government involvement, banks are inviting excessive supervision and, thus, are mortgaging their birthright. I hope that new legislation on deposit reform and FDIC funding will limit the FDIC insurance to what it was originally designed to do-protect the small, unsophisticated depositor, not those who want to take advantage of high rates in weak institutions. In my opinion, all of the regulatory functions could easily be combined into a single entity. They are handled this way in foreign countries, and it must be done here. The multitude of vested interests will make this difficult to accomplish, however.

Regulatory Limitations

insurance or securities. The legitimate, as opposed to self-serving, concerns relate to the risks inherent in underwriting either insurance or securities. Again, the key regulatory objective is to protect the integrity of banks. The Federal Reserve Board of Governors has debated this problem and classified it as one of establishing adequate "firewalls" to isolate one banking function from the adverse consequences of other functions. I believe most of the governors believe it can be done. It is done in many other businesses, and it is done in banking right now by separating the fiduciary function from the lending activities. Most of the opposition to broadening the permissible activities for banks comes from the primary vested interests that would prefer not to have competition from banks.

Global Considerations Recent developments should help US. banks become more competitive globally. By most standards, the Basle Accord, which attempts to equalize capital requirements among the banking entities in industrialized countries, was very good. It set standard capital ratios and effectively levels the playing field. French and Japanese banks were operating with 1 to 2 percent capital ratios before the accord, but U.S. banks had to maintain much higher ratios. As U.S. banks are allowed to become more national, they can become a much larger factor in the international environment. Still, to be truly reflective of the mammoth size of the US. economy, these banks would have to be $1 trillion in size to be in scale with the relative size of their Japanese, German, and u.K. competitors.

Two key regulatory limitations-on product offerings and geographical location-affect the banking industry's ability to compete. Compared to banking systems in other countries, the U.S. system is extremely fragmented. The largest banks, as measured by product type, have only 2 or 3 percent market shares. In comparison, Germany, Japan, and the United Kingdom have only a handful of significant banks. This fact is underscored by the history of the US. banking industry. In 1900, none of the top 50 banks was west ofSt. Louis. Today, only four or five of those bank names would be recognizable as survivors, and only one or two might rank in the top 50 today. Only 5 of the 10 largest banks in 1980 are still in existence. While a few were acquired, some failed or were mercifully put out of existence. Geographical concentration continues to hurt Conclusion the banking industry. Because of the concentration, The U.S. banking industry has an excellent basic banks cannot get out of harm's way when their marfranchise. Banks have been doing their best to hold kets are under pressure. Clearly, what is needed is their own competitively on both the asset and the nationwide interstate banking. Without nationwide liability sides, despite various legal and regulatory operations, banks do not have the economies of scale impediments. A principal negative is government necessary to operate efficiently. Consolidation offers hindrance. Because of high cost structures in the enormous potential savings. How many separate past, most of the industry's problems have come boards does a banking company need? How many from the asset side. The banks have sacrificed credit legal counsels? How many regulatory reports does quality to maintain market share and profitability. it need to issue? That trend is reversing now. The focus is on cost With regard to the Glass-Steagall Act, the issue cutting and consolidation. Also, other competitors is more complex. The questions are whether to perare leaving the field. If banks have learned from their mit banks to engage in other pursuits and which mistakes, the history of the next 10 years will be activities to allow them to pursue. Banks should be better than that of the past. able to use their distribution systems to distribute

22

Question and Answer session Donald K. Crowley Question:

If the banking system were to consolidate into a minimum number of banks, what do you think the industry return on equity and growth rate would be?

Crowley: In most industries, the tendency is for the return on equity to gravitate toward the midto low teens-the 12 to 14 percent range. To the extent that consolidation takes place, this trend will have peaks and troughs. Over the long term, high rates of return draw competitors, and low rates of return remove capital from the industry, so the tendency would be to gravitate back toward the norm.

Question: Despite the fact that we need fewer banks, particularly in suburban areas, many banks continue to be chartered and continue to do reasonably well. Please comment. Crowley: The people who form banks do it for one of two reasons: either they are dissatisfied with the existing services and want to start a bank to meet unmet needs, or they figure they can start a bank, get it going, and sell it later to somebody else. In that sense, it is a little like cable television franchises. As a practical matter, about five years ago, most banks hit the wall, like marathon runners do. They have tapped all their friends and their business connections, and their growth stabilized at that point. Obviously, we do not need more banks; we need absorption, but the history has been otherwise. Perhaps we should only allow existing charters to persist.

Question: How do you see bank insurance changing, particularly as the cost increases to 30 basis points? What cost pressures will that cause? Is there any possibility of a Warren Buffett/Charlie Munger-style private bank insurance plan? Crowley: I remember one meeting in which senior bank management discussed umbrella insurance for banks, and they were intrigued by the idea. As the costs go up, they will and should look for a private alternative of one sort or the other. The problem right now is the integrity of the insurance industry. An appropriate underwriter or group of underwriters would be hard to find. My own feeling is that insurance is a great problem for banks. It is an invitation for the kind of pervasive government intervention that is taking place right now. I have not run into a bank that has not had to increase its staff to deal with regulatory supervision. Most people do not have the slightest idea of what banks are paying in supervisory costs right now. Essentially, bank insurance should be minimal. It must cover the unsophisticated depositor, which is its original purpose. Bailouts, if absolutely necessary, should have to be done by the Treasury Department or some other government agency. They should somehow be taken out of the realm of basic insurance.

Question:

Is there any chance of a big problem on the money market side?

Crowley: The chance of a problem with a money market bank is

always there, but I do not think it is a serious threat at present. In looking at the U.S. market in particular, banks are more flush with funds now and are funding much more of their assets with core deposits that are very slow to leave. Funding stability is an important anchor to the windward, regardless of what might happen on the economic scene.

Question: How should increased reliance on trading profits be factored into the evaluation of price-earnings ratios? Crowley: Depending on the breadth of a bank's involvement with trading, a certain actuarial pattern is assumed to exist over time. As analysts, we take averages spread over a number of quarters. However, the market does not pay much for these earnings. Bankers Trust, for example, even with its good return on equity and the comparative stability of its volatile earning sources, has a discounted price-earnings ratio. That is a company that typically has a 25 percent return on equity, but it has not been treated that well in the marketplace.

Question: Obviously, banks have not been rushing to lend to countries in Eastern Europe. With a backdrop of previous problems in lending to lesser developed countries, is some kind of insurance necessary to encourage such lending? If so, who should provide it, and how should it be funded? Crowley: My concern with banks right now is not that they will lend too much but that they 23

will be chastised by the experience of the past 10 years and act in a way that damages the economy. I think they are scared. I see no interest from most banks in lending to Eastern Europe, regardless of the terms.

Question: Do you think what has happened to credit cards this fall is going to have any impact

24

on potential new entrants into the credit card business?

Crowley: My guess is that the outcome will be a moderately reduced average rate on credit cards. I hope it will not be done by legislation but by banks themselves. Banks can probably maintain the profitability of their credit card business through fees

or absence of grace periods, but some modest diminution of profitability is probable. The big competitors are the low-cost entrants, the ones for whom consumer credit is a corollary product; AT&T is the most obvious example. Because credit cards are a profitable business, banks will continue to look at it.

Interpreting the Banking Numbers Reid Nagle President SNL Securities

Investment analysts evaluate the financial strength of a bank and relate that to its market pricing. To do so requires assessing liquidation value and going-concern value; making use of such peer group comparisons as market indicators, profitability, net interest margin, operating efficiency, capitalization, asset quality, and asset composition; and identifying market misvaluations.

For financial institutions, unlike companies operating in other industries, the process of analyzing and interpreting financial condition is similar both from the credit and the investment standpoint. In fact, because the market has come to realize that in highly leveraged financial institutions the safety and soundness of an institution is paramount, the interest of credit analysts and investment analysts are frequently the same. An investment analyst needs to evaluate the financial strength and well-being of the company and relate that to its market pricing. The analyst needs to examine both the economic value of a company and its market value. A buy signal occurs when the market value falls substantially below the economic value. A sell signal occurs when it is substantially above the economic value. No other industry that I am aware of has greater investment potential, both for profit and for loss. Investing in banks is full of pitfalls for those who do not understand the fundamentals of profitable opportunities. The reasons for this are many. One is that no other industry has as many companies: about 1,200, including 400 publicly traded banks, 400 publicly traded thrifts, and about 400 pink sheet companies. There is a wide array of companies to choose from, and each one of them at any point in time has a different ratio of market value to economic value. Those ratios are changing constantly, and the outliers in the market value/economic value relationship create phenomenal opportunities. One of the reasons those opportunities exist is that no one investment firm follows all of the companies; in most other industries, with a limited number of companies to follow, one security analyst or a group of industry security analysts within a firm can

cover the industry. In contrast, a firm might cover only 10 percent of the financial companies at most; more typically, a firm might cover 20 or 30 companies. The likelihood that, by covering 20 or 30 companies, someone can find the extremities of market versus economic value within a 1,200-company universe is very slim. Another reason investment opportunities exist in the banking industry is that the information disseminated on banks and thrifts is often misleading and sometimes incorrect. People who accept the published financial statements at face value as an indication of value will be misled and may suffer serious financial consequences. Those who know how to look behind published numbers and discover the truth will find a wealth of opportunities. The Securities and Exchange Commission and Financial Accounting Standards Board are working furiously to correct the problems in financial disclosure. Investors who are not restricted to the long side and can sell short also have opportunities in banking stocks. At any point in time, such an investor could identify a basket of undervalued securities relative to the norm and a basket of securities that are overvalued. By going long on the undervalued securities and shorting the overvalued securities, the investor can capture the value that lies in between. Of course, many money managers are prohibited from going short, but during the past few years, the short side has presented enormous opportunities. Only on a few occasions and only to a few people is it crystal clear that the industry is undervalued or overvalued to a substantial extent. Last fall, for example, a few security analysts realized the banking industry had been oversold. Prices were extremely low, particu25

larly for companies that had bright futures, which provided a tremendous opportunity for those who invested at that time.

Assessing liquidation Value Much of the opportunity in bank investing arises because financial statements often do not accurately reflect financial reality. One reason for this is the use of historical cost accounting. Traditionally, the banking industry has recorded its financial assets and liabilities at cost, regardless of how the market may value those instruments. As a result, a sharp movement in interest rates that dramatically affects the market value of fixed-income portfolios and long-term liabilities does not show up in the income statement or balance sheet. In the past four or five years, bank managers and auditors have had tremendous flexibility in determining the appropriate reserve levels for banking institutions. Across the spectrum of 1,200 institutions, the difference in reserving practices between conservative banking managers and those trying to hold onto the last vestiges of prosperity is a mile wide. For example, in a highly leveraged institution-say, at 20:1-equity can be overstated by 20 percent if management is given the ability to value assets even 1 percent off their true value. The Bank of New England is an extreme example. Only months before it failed, it had equity capital of $800 million. Ultimately, the Federal Deposit Insurance Corporation needed more than $3 billion to resolve the institution after it failed. That is a tremendous gulf between reality and perception. The marketplace is getting smarter. Table 1 shows all banks and thrifts with $10 billion or more in assets. The companies are ranked by their ratio of price to book value as of November 13, 1991. At the end of November 1991, this ratio ranged from a high of 276 percent for State Street Boston to a low of 4.7 percent for CaiFed. CalFed's management and accountants presented what they perceived to be the equity level of CalFed in their financial statements, but the marketplace suggested this value was 96 percent in error. So even using contemporaneous financials, the disparity between management and market valuations is tremendous. In 1987, the range of price-book-value ratios was much tighter than it is today. The lowest ratio among banking institutions at that time was 45 percent for Bank of America and the highest was 167 percent for Northern Trust. At that time, Bank of America was teetering, and the institution's long-term viability was in substantial doubt. Since then, the way the marketplace understands, evaluates, and assigns

26

value to publicly traded banks and thrifts has been dramatically transformed. Analysts have learned to look beyond the accounting numbers and to understand the business and economic fundamentals of these companies. The market value they assign to a company is appropriately based on the long-term expected value that company will generate. Bank profitability and creation of value come from two places. One is an economic balance sheetnot the accounting balance sheet, which typically records assets and liabilities at cost. The economic balance sheet reveals the true equity position of a company when its assets and liabilities are fairly marked to market. Not all parts of the balance sheet are created equal. For banks having a market value significantly below book value, the difference can usually be found on the asset side of the ledger. Table 2 compares the five best-performing banks and the five worst-performing banks in market value appreciation and depreciation during the past four years. The types of loans cited in Table 2 are frequently the culprits responsible for market value depreciation. Several interesting points can be made about these companies. Four of the five top-performing companies are from the Midwest, which has fared much better than other parts of the United States through the current recession. Certain kinds of assets, mainly those I euphemistically call "high risk," form a much smaller percentage of the balance sheets for companies that have succeeded than of those for poor performers during the past four years. In fact, the only one of the five good companies to have any highly leveraged transaction (HLT) loans and lesserdeveloped country (LDC) loans was Bank of America, and its percentages of those were very small. The LDC crisis for all intents and purposes is over in U.S. banking. The significant differentiation between the five best and five worst market value performers is in high-risk real estate loans. Most of the five worst have a substantial proportion of assets concentrated in all three categories of this group; this is not the case for most of the top five performers. In fact, for the five top market value performers, the average for high-risk loans amounted to 8.8 percent of assets compared with 22.8 percent for the worst group. These numbers show that banks facing a lack of lending opportunities-those that tried to fill in the void by acquiring types of credits and loans that were in vogue at the moment-fared poorly, and the marketplace rewarded them appropriately for their indiscretions. With the exception of Banker's Trust and J.P. Morgan, which are not traditional banks, the kinds of activities that are appropriate for the bank-

Table 1. Financial Statistics--Banks and Thrifts with $10 Billion or More in Assets, 1987 and 1991 Price Change Between Price-Book Value 12/31/87 and 12/31/87 11 /13/91 11 /13/91

State

Typea

State Street Boston Corp. Northern Trust Corp. Banc One Corp. J.P. Morgan & Co., Inc. NorwestCorp. Bankers Trust New York Corp. Wachovia Corp. SunTrust Banks, Inc. Ameritrust Corp. Bancorp Hawaii, Inc.

MA IL OH NY MN NY NC GA OH HI

B B B B B B B B B B

155.0% 166.8 156.8 136.4 96.3 84.9 139.9 141.3 89.4 127.7

275.6% 244.6 241.4 233.3 200.7 197.6 185.3 182.2 182.1 180.8

195.6% 165.3 138.2 83.4 172.6 113.8 97.0 94.5 77.3 142.2

CoreStates Financial Corp. First Bank System, Inc. Golden West Financial KeyCorp Comerica, Inc. NBD Bancorp, Inc. Manufacturers National Corp. Firstar Corp. PNC Financial Cort Republic New Yor Corp.

PA MN CA NY MI MI MI WI PA NY

B B T B B B B B B B

152.8 99.5 102.4 109.8 115.8 115.3 111.2 124.0 151.4 131.8

172.3 171.3 168.0 164.8 164.7 163.8 162.0 160.4 155.8 152.9

39.8 17.4 194.0 107.6 101.8 105.2 125.0 114.5 20.5 47.0

C&S/Sovran Corp. Society Corp. Huntington Bancshares, Inc. First Union Corp. US. Banco~ Boatmen's ancshares, Inc. First Fidelity Bancorporation Fleet/Norstar Financial Group National City Corp. BankAmerica Corp.

VA OH OH NC OR MO NJ RI OH CA

B B B B B B B B B B

NA 114.1 120.4 120.0 97.7 106.6 116.3 143.7 148.3 45.5

152.1 144.2 142.9 134.9 134.6 134.1 131.3 129.4 129.4 129.1

NA 47.3 63.4 50.6 101.3 49.6 5.0 2.7 24.5 461.8

Meridian Bancorp, Inc. Barnett Banks, Inc. NCNBCorp. Mellon Bank CorK' First of America ank Corp. Security Pacific Corp. Valley National Corp. Wells Fargo & Co. UJB Financial Corp. Bank of New York Co.

PA FL NC PA MI CA AZ CA NJ NY

B B B B B B B B B B

108.5 132.9 96.5 88.4 105.1 90.7 91.4 123.1 143.8 76.5

124.9 121.9 121.9 121.7 114.3 111.9 109.7 106.8 99.9 97.6

31.4 15.9 126.1 37.5 38.9 23.6 0.9 47.1 (23.6) 32.5

Great Western Financial First Interstate Bancorp Crestar Financial Corp. Mich~an National Corp. First hicago Corp. H.P. Ahmanson & Co. Chemical Banking Corp. Shawmut National Corp. Bank of Boston Corp. Manufacturers Hanover Corp.

CA CA VA MI IL CA NY MA MA NY

T B B B B T B B B B

106.7 92.4 115.2 120.2 78.0 92.0 52.0 102.3 95.3 51.2

94.3 88.1 82.8 77.1 75.4 74.7 71.9 71.6 71.4 71.1

3.3 (24.2) (13.0) (5.2) 43.0 (4.5) 16.4 (53.3) (44.4) 29.7

Signet Banking Corp. Union Bank Chase Manhattan Corp. Citicorp Continental Bank Corp. MNC Financial, Inc. Midlantic Corp. HomeFed Corp. Dime Savings Bank of New York CalFed, Inc.

VA CA NY NY IL MD NJ CA NY CA

B B B B B B B T T T

115.2 114.8 57.8 84.2 67.6 125.6 106.5 51.5 56.8 42.9

71.0 67.6 59.4 53.1 49.6 41.7 28.9 24.6 20.4 4.7

(15.3) (35.3) 08.I) (38.3) (16.7) (73.7) (82.8) (97.3) (75.4) (90.8)

Company

Source: SNL Securities. aB = bank; T = thrift.

27

Table 2. High-Risk Lending Statistics, selected Banks with $1 Billion or More in Assets

Asset

Five Biggest Price Gainers between Five Biggest Price Decliners between 12/31/87 and 11/13/91 12/31/87 and 11/13/91 BAC MCOR HWKB BRBK RFBC Avg. CFB NBIC HIE MIDL CSTLa Avg.

Total assets ($millions)

118,108

Percent of total assets: 1.57% Highly leveraged transaction loans Term lesser-developed countries loans 1.68 High-risk real estate loans 3.40 Construction & development loansa Multifamily loansa 0.45 4.38 Nonresidentialloansa Subtotal (other high-risk loans) 11.20 2.58

Nonaccrualloans

1,202

1,336

1,235

1,339

2,538

3,542

6,213 21,234

2,976

0.00% 0.00% 0.00% 0.00% 0.31% 0.00% 0.00% 5.15% 2.91% 0.00% 1.61% 0.00 0.00 0.00 0.00 0.34 0.00 0.00 0.00 0.01 0.00 0.00 1.01 1.86 10.82 12.99

0.32 0.24 4.81 1.47

1.38 0.17 6.92 6.92

0.27 4.36 6.81 11.43

1.27 1.42 6.75 8.80

6.46 0.53 18.55 25.53

6.30 1.27 10.66 18.14

1.33 2.05 15.87 24.25

10.37 0.57 10.75 24.58

3.66 0.52 17.56 21.74

5.62 0.99 14.68 22.85

0.37

0.30

0.26

0.50

0.80

5.77

5.36

3.60

6.36

6.20

5.46

Restructured loans

0.05

0.03

0.28

0.04

0.00

0.08

0.34

0.71

0.00

0.12

0.02

0.24

Other real estate owned

0.32

0.16

0.04

0.16

0.27

0.19

3.16

1.18

1.79

2.64

3.19

2.39

Loans 90+ days past due & accruing Subtotal (other high-risk assets)

0.27 3.22

0.11 0.68

0.08 0.69

0.18 0.65

0.63 1.40

0.25 1.33

0.91 10.18

1.51 8.76

0.23 5.63

0.7 9.85

41.16 10.57

0.91 9.00

14.42

13.66

2.16

7.57

12.83

10.13

35.71

26.90

29.88

34.43

32.31

31.85

Total (high risk assets) Price change between 12/31/87 and 11/13/91

461.82 307.79 229.17 226.53 225.00

(77.62) (79.88) (81.95) (82.77) (87.88)

Source: SNL Securities. Note: Financial data as of September 30, 1991, unless otherwise noted. aAsofJune30, 1991.

Key: BAC MCOR HWKB BRBK RFBC

= = = = =

BankAmerica Corp. Marine Corp. Hawkeye Bancorporation Brenton Banks, Inc. River Forest Bancorp

CFB NBIC HIE MIDL= CSTL =

Citizens First Bancorp Northeast Bancorp Hibernia Corp. Midlantic Corp. Constellation Bancorp

ing community are the ones that have traditionally proven themselves to be both profitable and relatively risk-free. High-risk ventures typically disappoint shareholders and managements by failing to generate the returns that traditional banking activities do.

Measuring Going-COncern Value The economic value of a balance sheet can be estimated by adjusting each component of the balance sheet to reflect market value rather than accounting value. Determining the appropriate reserves is an important part of this process. With some degree of judgment applied to each financial institution, one can generally apply standards of reserves appropriate for different asset types, and these more accurately portray the financial realities of the company than the picture managements and auditors present. True economic value is a function of a bank's mark-to-market net worth (liquidation value) plus its projected earnings as a going concern. Going for28

ward, those earnings will be a function of a number of different factors. These include the starting value of the balance sheet; the strategic direction of the company in relation to the evolving role of banking; and the components of income-net interest income on a risk-adjusted basis, operating efficiency, and fee income. Going-concern value means the extent to which a bank's franchise can generate a return over and above a risk-free rate of return, given its starting marked-to-market net worth. A bank with a starting net worth of $100, with a risk-free rate of return of 8 percent, should generate $8 a year on a risk-free basis. To the extent a bank has franchised its customer relationships, its position in the community or region enables it to generate returns substantially above 8 percent. That reflects the returns attributable to going-concern value. Before 1990, banks paid a substantial franchise premium to acquire branches and deposits of other banks, believing there was a valuable franchise imbedded in the branches and deposits being pur-

Rgure 1. Merger and Branch sale Pricing, Quarter1y chased. The ratio of deal value premium to tangible Median Premium, 1989-S1 book value is probably the best conventional mea7,---------------------------, sure of the economic value of a bank, because it includes both its liquidation and going-concern val6 \ ues. The deposit premium paid in branch sales\ , which is calculated as the excess of liabilities assumed over assets acquired-is the best measure of the franchise value of deposit relationships. Buying branches and deposits does not necessarily capture 2 the full franchise value of a bank, however, because it does not capture the inherent customer relationO'----'-_...L----'_---'-_.L..-----'-_...L----'_---'-_.L..----l ships on the asset side of the ledger. 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q As shown in Figure 1, the deposit premium was '89 '89 '89 '89 '90 '90 '90 '90 '91 '91 '91 '91 approximately 6 percent in the first quarter of 1989. - - Branch Deposit Premium The banker's valuation of the franchise inherent in - - - Dealers Tangible Book Premium banking has diminished, however. In fact, in the Source: SNL Securities. most recent period, the premium declined to 1 percent. The premium to tangible book value has not changed too much during the past three years, al- Industry Trends though it has shown some volatility. The decline in Several developments in the financial sector may branch sale premia indicates bankers have a dimmer explain what is happening to banks. Figure 2 comview of the franchise value of banking than they did pares the shares of the nation's financial assets held a couple of years ago. In particular, deposit relationby depository institutions and by other sectors. The ships are seen to have little value, independent of other less price sensitive banking relationships. share for depository institutions has been on a secuFigure 2. Rnancial Assets Held by Depository Institutions as a Percentage of Total Rnancial sector Assets,

1900-2000 (projected) 100 90 80 70 60

C

50

P-.

1950 General Moturs Pension Fund

40

'1

f

,~

30

~·i~·_f"·

1940 !nv
20 10 0 1900

'10

'20

'30

'40

'50

'60

'70

'80

'90

2000

- - Depository Institutions - - - Nondepository Institutions

Sources: Federal Reserve Board Annual Statistical Digest; Goldsmith, Financial Intennediaries in the American Economy, 1958.

29

lar decline throughout the century, with a few shortterm exceptions. In the 1970s and 1980s, traditional lending opportunities for the banking industry diminished, and banks rushed to replace those with loans to LDCs, energy companies, HLTs, and real estate credits. The result was a brief bubble. The banks are now in a period of liquification of many of the excess credits that were created during that period, a process that accelerates the reduction in their share of total assets. The depository sector accounted for 85 percent of financial assets in 1900; today its share is 40 percent, and it is likely to be close to 30 percent by the end of this decade. Several different types of financial institutions have picked up the slack. Figure 3 shows the total assets of different types of financial institutions from 1940 through 1990, with projections to 2000. Since 1980, the fastest growing financial asset category has been pension funds. This growth is largely a function of public policy and individual preferences. Public policy has now established pension funds as the major tax-advantaged vehicle for individual savings. Pension funds do not require any capital for their existence, so pension fund assets offer infinite leverage possibilities. This should lead to continued growth in pension funds. Mutual funds, because of technology and the absence of any meaningful capital constraint, have also experienced a rapid growth rate. Figure 3. Total Assets of Different Types of Financial Institutions, 1~2000 (projected) 5,500 r - - - - 5,000 L ..... 4,500 4,000 <Jl

§ S i:E ~ <Jl Q) ~

~

3,500 3,000 2,500 2,000 1,500 1,000 500

oL=:~~ '40

'60

'50

'70

'80

'90

2000

Commercial Banks Pension Funds -

--

Mutual Funds Money Market Funds Thrifts

Sources: Richard D. Crawford and William W. Silher, The Troubled Money Business (New York: Harper Business, 1991): 9.

30

The growth of commercial bank assets has slowed in recent years, and thrifts' assets have dropped off precipitously. These trends are likely to continue in the future. Unfortunately, government policy was not designed to accommodate the declining role of banks and thrifts in the financial sector. In fact, during much of the 1970s and 1980s, government policy encouraged expansion of depository institution balance sheets. The process of contraction and failure evident today is a natural consequence of a sector that will ultimately represent less and less of the total financial assets of our economy. These trends have several implications for the banking industry. It might be tempting to say that banking is not a growth industry, that it does not provide many investment opportunities. That is not the case, however. Banking will be around for a long time, although in a diminished role compared to other forms of savings and intermediation. Many of the traditional banking activities have been stripped away from banks. For example, blue-chip companies in the 1970s began bypassing the banking system by issuing commercial paper and medium-term notes. That meant the largest banks, which had traditionally supplied credit to these firms, lost a big part of their asset base. Many of them rushed into high-risk, aggressive credits to fill the void. In the past 10 or 15 years, we have seen more than just large corporations sucked away from the banking system. We have seen the mortgage sector and the consumer-lending sector diminish as well. The prominence of Fannie Mae and Freddie Mac, which are involved in a majority of the mortgages being written in the United States, has rendered depository institutions inefficient holders of mortgage assets. In fact, financial institutions, which traditionally were both the originators and holders of financial assets, now find those functions are being split. Banks and thrifts may still be the most efficient originators of certain financial assets, but they may not be the most efficient holders of financial assets. This is certainly true with mortgage products. Similar, though less dramatic, changes have occurred in consumer lending. Over time, federal policy has had a large influence on what form consumer lending takes. As a result of the period of debt disgorgement resulting from the excesses of the 1980s and also the fact that nonmortgage interest expense for consumer credit is no longer tax-deductible, consumer loans will undergo a very slow rate of growth in the years to come. Moreover, many forms of consumer credit are increasingly being integrated into the capital markets. Equity (second-mortgage) loans are being integrated into the capital markets to the point that the opportunity for banks to hold equity

loans as a profitable component of the balance sheet will diminish. Automobile lending has become an intensely competitive business. Auto buyers do not need to go to a bank to get a loan. They simply go to a car dealership, pick out a car, and a half-hour later leave with the financing. Unlike the role of banks in originating equity loans, the role of banks in automobile lending is diminishing. Prevailing auto loans are no longer profitable for most bank portfolios. The credit card business is moving away from the banking industry as well. Recently, two nondepository institutions have become major players in this business-AT&T and Sears. A number of other entrants are expected soon. The secondary market for credit card loans, which is very active, has undergone significant changes in recent years. The premiums paid in the secondary market have declined from 20 or 25 percent a couple of years ago to 10 percent today. As a result, the profit margins and the premiums banks will be able to extract on the consumer credit card loan balances they generate will continue to decline. Although these trends sound negative, a number of opportunities exist. One area of opportunity is lending to small- and medium-size businesses. These loans are not easily securitized and integrated into the capital markets. Furthermore, small business accounts for more than 50 percent of gross national product. To serve this market, banks will need to change their underwriting processes. They will need to retrain themselves in evaluating businesses, because the nature of businesses that exist today is very different and much less physical-capital intensive than the businesses of 20 years ago. They are much more human-capital intensive and require a different degree of sophistication and underwriting skill to evaluate. The other opportunity is cost savings. The bestmanaged companies have an opportunity to acquire companies that are not so well managed and then achieve cost efficiencies. Even though that does not sound as alluring as making loans, consolidation that produces net efficiencies is a very profitable activity. The major realignment of bank market values during the past several years has given those banks that have demonstrated the technological and management skills to undertake profitable consolidation the opportunity to buy less successful banks.

Peer Group Comparisons Peer group comparisons are very important to the valuation of banks. By comparing financial and operating performance, investors can assess the perfor-

mance and trend line for a given institution. To illustrate the elements of a peer group comparison, I will use the Worthen Banking Corporation, a bank that epitomizes the kind of institution that has been able to make many of the changes necessary to generate value for shareholders. Investors who buy based on standard ratios, such as price-book, would probably not buy this company. In the mid-1980s, Worthen had some severe problems. It had some significant loan-quality problems, including about $60 million in loans to a securities firm that went bankrupt. Management was replaced, and now it is difficult to recognize the company because of the changes that have been made. This is a compelling company that has demonstrated the ability to generate value for shareholders. The most useful peer group comparisons are market indicators, profitability measures, net interest margin, operating efficiency, noninterest revenue, capitalization, asset quality, and asset composition. III Market indicators. Table 3 shows comparative market information for Worthen, four regional peers, and the median for all banks nationally, all southwest banks, and all banks of Worthen's size. In some categories, Worthen looks different from its peers. For example, Worthen does not pay a dividend. It realized in the mid-1980s that it was capital deficient and needed to build its equity base. Worthen has been able to generate better returns on equity every year for each of the past five years, and its return on equity is close to 16 percent now. That rate of return exceeds the implied cost of capital for a company with its risk profile. Any time a company generates a return on its equity base in excess of its cost of capital, it should retain that capital and continue to build. This company has done exactly that. Second, Worthen's price-tangible-book ratio of 147.5 percent is well above the median for all banks110 percent-and above the median for regional and asset-size peer groups. Based on this ratio, an analyst might conclude that Worthen is fully priced now, but that may not be the correct conclusion. In this case, the price-earnings ratio is a more meaningful measure because these are true earnings. Worthen's price-earnings ratio is considerably lower than that of its peers-8.6 compared with 12.4 for all banks. This suggests that Worthen's underlying earnings power comes from a variety of factors. III Profitability. Figure 4 shows Worthen's financial performance compared to its peers. Over this period, Worthen showed continual improvement in its return on average equity. Another measure of profitability is the ratio of adjusted earnings to average assets. As Figure 5 shows, Worthen's adjusted 31

Table 3. Worthen Banking Corporation: Comparative Market Infonnation, November 11, 1991 Peer Group Characteristic

WOR

AFBK

BNKS

BOMA

COLC

All Banks

2.23% 2.41 1.72

2.38% 1.89 1.11

0.23% 0.32 0.30

2.45% 2.53 2.26

0.35% 0.40 0.41

Median Southwest

Size Group

0.70% 0.98 0.73

0.37% 0.45 0.45

Liquidity' Past month Past quarter Past year

0.29% 0.43 0.33

Price change -2.2 9.1 36.1

Past month Past quarter Past year

8.0 18.7 174.3

-6.0 -11.3 38.2

1.9 31.0 71.9

6.6 9.9 154.3

1.1 0.0 32.1

5.1 6.3 71.9

2.1 1.2 44.4

Dividends Dividend yield LTM payout ratio

0.00 0.00

1.58 7.50

2.13 18.40

0.00 0.00

0.72 34.00

3.08 34.70

0.00 7.50

3.04 36.00

Market Ratios Price-earnings (fourth quarter) Price--core earnings (fourth quarter) Price-book Price-tangible book

8.6 8.8 137.0 147.5

23.7 22.3 136.8 156.5

8.6 8.3 86.3 116.3

29.3 16.8 76.7 79.8

47.3 53.0 123.1 140.5

12.4 12.7 103.1 110.7

14.4 16.8 86.3 103.0

12.2 12.6 116.5 125.0

Ownership profile Inside ownership Institutional ownership Shares outstanding Market value of common ($millions) Price as of 11 /11 /91 52-week high 52-week low

4.89 12.61

12.05 43.39

10,931,399 $180.37 $16.500 $18.000 $10.375

Source: SNL Securities. a Average

weekly volume as percent of shares outstanding.

Key:

WOR AFBK BNKS BOMA COLC

32

= Worthen = Affiliated Bankshares of Colorado = United New Mexico = Banks of Mid-America, Inc. = Colorado National Bankshares

41.55 9.34

43.47 43.89

8.36 36.24

13.83 11.52

13.95 13.89

11.83 13.90

Figure 4. Worthen Banking CorporatiollProfitability: Return on Average Equity Latest 4 Years and Past 12 Months 20,-------------------:;::=====l 15

~ -

:.-=:-----

10

o -5 L -

L-

---'

--'-_----'

'90

'89

'88

'87

6/'91

Most Recent 5 Quarters

201========:::::----------1

~ 15

c

------- -------

B

~ 10

------------_ ---'--...

5L-

...l-

9/'90

6/'90

12/'90

---'L--_ _----'

3/'91

6/'91

Worthen Banking Corporation

-

--

All Banks Banks in the Southwest Banks with Assets of $1 Billion to $5 Billion

penses required to support low-cost deposits. Together they provide a good measure of operating efficiency. Figure 7 shows that Worthen's ratio was higher than all of the peer groups in 1987 but has declined since 1988 and has been lower than that of its peers since 1989. Typically, the bigger banks have a smaller net interest margin than smaller banks. Regional banks tend to have larger net interest margins, but they also have larger operating expenses. Attracting demand deposits, which have a very low cost of funds associated with them, frequently requires a much higher level of accompanying operating expense. In this category, Worthen has traditionally outpaced its peers. III Capitalization. Figure 8 shows capitalization ratios for Worthen and its peers. In 1987, Worthen's equity-asset ratio was significantly below those of the other banks. By June 1991, it had increased its capitalization ratio so that it is close to those of its size peers. III Asset quality. Sound asset quality is one of Worthen's strongest characteristics. Figure 9 shows the ratio of nonperforming assets to total assets. Worthen has made phenomenal progress in bringing its nonperforming asset ratios down since 1987. Figure 5. Worthen Banking Corporatioll-Adjusted Earnings as a Percent of Average Assets

Source: SNL Securities.

earnings-assets ratio has increased dramatically, particularly relative to its peers, since 1987. The adjustment removes extraneous nonrecurring earnings and expenses. III Net interest margin. Figure 6 shows Worthen's net interest margin relative to its peers. Worthen's net interest margin was severely deficient relative to its peers in 1987, improved materially in 1988 and 1989, and since then has largely paralleled-though remaining below-that of its peer group. Worthen is taking steps that will ultimately lead to a resumption of growth in its net interest margin. III Operating efficiency. A good measure of relative efficiency is the ratio of net noninterest expense to net interest income, where the net noninterest expense is defined as operating expense less noninterest income divided by net interest income on a fully taxable equivalent basis. The numerator of this ratio captures operating efficiency, which is how much was spent on operating expenses less how much was earned in fee income. The denominator captures the ability to produce net interest income. It is important to relate operating efficiency to net interest income because of the higher operating ex-

Latest 4 Years and Past 12 Months 1.0,-------~--------____:::_-==:_l

---

-0.5<-'87

--''88

-''89

-'-_---'

'90 6/'91 Most Recent 5 Quarters 1.2,-----------------------,

-

1.0f~

.:-=-:.-:::-:::.-----'-::-:0.81-

-----------

l::

P':

0.6 f0.4 f-

0.2 '--

-'-_ _-_--_-_--:-'L-_--

6/'90

9/'90

12/'90

-l..-

3/'91

---l

6/'91

Worthen Banking Corporation All Banks Banks in the Southwest -

--

Banks with Assets of $1 Billion to $5 Billion

Source: SNL Securities.

33

Rgure 6. Worthen Banking Corporation-Net

Figure 7. Worthen Banking Corporation-Net Noninterest Expense as a Percent of Net

Interest Margin

Interest Income

Latest 4 Years and Past 12 Months 4.75.--------------------,

Latest 4 Years and Past 12 Months 80

75 l::

'@> 4.25

~

~

---

70

~ 65 -----------------

4.0

60

3.75 " - - - - - - - ' - - - - - - - - ' - - -_ _--'-_---' '87 '88 '89 '90 6/'91 Most Recent 5 Quarters

-=-

4.6r-------------------",

§

4.4

---

--- -- -- -- -- -- - . . -,#--::.~_:. ~_-_----~=:.-:::-:-~--2=---------

-=--=.::--

-=-=- ~ 55 :- -= ~-- - - - --~-'------'--------'-------"------' '87 '88 '89 '90 6/'91

=-=-

Most Recent 5 Quarters 70 r - - - - - - - - - - - - - - - - - - - - - ,

l::

'@> 4.2 t"
:::E 4.0

60

-------3.8 L6/'90

-

l.-

9/'90

--

l.-_-====t:::::=---_---..J

12/'90

3/'91

6/'91

Worthen Banking Corporation All Banks Banks in the Southwest Banks with Assets of $1 Billion to $5 Billion

55

--------

6/'90

-

Source: SNL Securities.

9/'90

--

------------12/'90

3/'91

6/'91

Worthen Banking Corporation All Banks Banks in the Southwest Banks with Assets of $1 Billion to $5 Billion

Source: SNL Securities.

Management indicated in 1986 and 1987 that it was going to dedicate itself to this task, and indeed it did exactly what it promised. Whereas Worthen's ratio in 1987 was substantially in excess of that of its peers,

Rgure 8. Worthen Banking Corporationcapitalization: Equity as a Percent of Assets Latest 4 Years and Latest Quarter

-_:--=-~ -=-=-=-= ---=--:

7

1::Cli

6

-=--: -=--= -- - --~

-

...u Cli

p...

5 4 '87

'88

-

--

'90

6/'91

Worthen Banking Corporation All Banks Banks in the Southwest Banks with Assets of $1 Billion to $5 Billion

Source: SNL Securities.

34

'89

it is now below those of its peers. This is characteristic of a number of successful bank investment stories during the past few years. Figure 10 shows reserves as a percent of nonperforming assets. This is another indication of Worthen's progress in improving its asset quality. One of the things that always identifies a sure winner, from an investment standpoint, is bank management that wants to hide income rather than manufacture it. Historically, when reported profits were thin at year end, banks did the reverse of what most individuals would do at year end. Most individuals with a mix of gains and losses would sell the stocks with losses to minimize their aftertax cash outflows and maximize their economic positions. This approach leads to accounting losses, and many bank managers are loathe to show losses because they are afraid of how the marketplace will interpret the loss. Whether it is realizing losses from a portfolio or making conservative additions to reserves, those are all signs of a management willing to build long-term value. Taking voluntary steps that reduce reported income today in favor of building long term eco-

nomic value will always reward the patient, longterm investor. Periodically, managers will do the "right" thing, providing a real opportunity for investors to get in on the ground floor. Ultimately, economics always prevails over accounting. Figure 11 shows loans as a percent of deposits. The company has significantly reduced its risk exposure and deleveraged its balance sheet. For credit analysts and investors, this is an indication that the company is close to being rock solid; it has done everything it can to clean up its balance sheet. During the mid-1980s, the state of Arkansas went through substantial problems with the failure of a number of large savings institutions, attributable both to mismanagement and to fraud. Worthen has been a very active acquirer of these franchises. These acquisitions will provide Worthen with a dominant market position, which will allow it to influence the pricing of deposits (which are not securitized like mortgages and consumer loans) and to influence the pricing of loans to businesses in the markets it serves. Asset Composition. Figure 12 shows the ratio of domestic commercial and industrial loans to assets for Worthen and its peers. While the company

Figure 10. Worthen Banking Corporation--Reserves as a Percent of Nonperforming Assets Latest 4 Years and Latest Quarter 100 r - - - - - - - - - - - - - - - - - - - - ,

c '"

~

60

40 35

=_'-_-_._-._-_- --------- ---------._...l-

'88

'87

---L

---L_----l

'89

'90

6/'91

Most Recent 5 Quarters 100 1

-----------=:::=========1

c '"

~

I----------~

80"-

~---

60 - - - - -=:-":-=-::'-::--....---

40L--

-:--------

----------------------------...l....L. .....J

.L-

9/'90

6/'90

3/'91

12/'90

6/'91

Worthen Banking Corporation

Figure 9. Worthen Banking Corporatio~ Nonperfonning Assets as a Percent of Total Assets

-

.-

All Banks Banks in the Southwest Banks with Assets of $1 Billion to $5 Billion

Source: SNL Securities.

Latest 4 Years and Latest Quarter 5r------------------,

has been deleveraging its balance sheet and shedding risk, it has concentrated its energies and built up its expertise in commercial banking, which is destined to be the most profitable balance sheet activity for the years to come. This company has honed

4

2 I

C-

-~ ~~- -=--- --l.-

- - ~_.----==--==----L

---L_~

'89

'90

'88

'87

6/'91

Figure 11. Worthen Banking Corporation--l.oans as a Percent of Deposits Latest 4 Years and Latest Quarter

Most Recent 5 Quarters 3.5r-----------------

-------

3.0

~ 2.5

------

J

i::

~ 2.0

-

---

------------

.......

...... 70

.-_::--=-----

1.5 1.0 L -

--'-

9/'90

6/'90

-

--

-----'--

12/'90

--'-

3/'91

----'

6/'91

65 L -

.L-

'87

'88

----'L-

'89

--L_--'"

'90

6/'91

Worthen Banking Corporation

Worthen Banking Corporation

All Banks Banks in the Southwest Banks with Assets of $1 Billion to $5 Billion

All Banks Banks in the Southwest Banks with Assets of $1 Billion to $5 Billion

Source: SNL Securities.

-

--

Source: SNL Securities.

35

Rgure 12. Worthen Banking Corporation--Domestic Identifying Marketplace Misvaluations Commercial and Industrial Loans as a Percent of Assets An investor who knows what signals to look for can target obvious misvaluations in the marketplace. Latest 4 Years and Latest Quarter 20,------------------0 These misvaluations are egregious, despite the significant progress the marketplace has made in the past few years in understanding the value, or lack of 15 fC:::-=-=-==-:';-=:;-;;;":"-.::.,------ ,;,-~-~-~-~~ value, that underlies banking companies relative to what their accounting statements show. The way our company analyzes these companies is an example of one methodology for identifying 5 misvaluations. Our method of analysis will proba0 ' - - - - - - - ' - - - -_ _--'----1.----1 bly not work in a few years, because the marketplace '87 '88 '89 '90 3/'91 will be that much more savvy then; but it does work now. Worthen Banking Corporation All Banks

Banks in the Southwest -

--

Banks with Assets of $1 Billion to $5 Billion

Figure 14. Worthen Banking CorporationConsumer Loans as a Percent of Assets Latest 4 Years and Latest Quarter

Source: SNL Securities.

------........

13

its business lending skills even while reducing loans overall as a percent of the balance sheet. Two categories ofloans Worthen has reduced are high-risk real estate loans and consumer loans, as shown in Figure 13 and Figure 14, respectively. Increasingly, banks are becoming originators of loans but not holders of assets that are easily securitized and integrated into the capital markets. That is exactly what Worthen has done. It has diminished its reliance on what is becoming an increasingly less profitable part of the balance sheet. Figure 13. Worthen Banking CorporationHigh-Risk Real Estate Loans as a Percent of Assets Latest 4 Years and Latest Quarter 16 14

..........

10 8L-

l.-

'88

'87

--'---

-L-----'

'89

'90 3/'91

Worthen Banking Corporation

-

--

All Banks Banks in the Southwest Banks with Assets of $1 Billion to $5 Billion

Source: SNL Securities.

36

~

12

-

~ 11 10 ' - - - - - - - ' - - - - - - - - ' - - '87

'88

'89

--1.----1

'90 3/'91

Worthen Banking Corporation All Banks -

--

Banks in the Southwest Banks with Assets of $1 Billion to $5 Billion

Source: SNL Securities.

By looking at the composition of the balance sheet and the makeup of the income, it is possible to mark the balance sheet to market. Our process is quite simple. 1 For each company, we approximate the liquidation value by applying the appropriate level of reserves for different categories of assets. For example, high-risk activities-eonstruction lending, commercial real estate lending, HLTs-would get significant levels of reserves. From the liquidation value, we approximate the going-concern value, remembering that economic value is the sum of liquidation value and going-concern value. We tried to approximate the going-concern value by making gross generalizations and setting franchise value equal to the greater of 5 percent of core deposits to capture the franchise premium or to five times net income to reflect the value that companies like State 1Por a description of our process, see Rhonda Brammer, "Good Banks, Bad Banks," Barron's (September 9, 1991):14.

Street and Northern Trust generate largely off balance sheet. Admittedly, this method may capture only 80 percent of the truth, but in investing in a field that is so grossly misvalued, 80 percent of the truth tends to work out very well. This type of analysis provides a ranking of companies. Table 4 lists the best and the worst banks as of November 15, 1991. We suggested buying nine companies and selling eight short. Despite a fall in bank stock prices since then, six of the nine long positions are up in price and six of the eight short positions are down in price, and the average appreciation is 10 percent. Of the companies listed on the short side, Michigan National is a poorly managed company; had it been operating on the East Coast or the West Coast, it probably would have met the same fate as Bank of New England or City Trust. Because it was in the Midwest, however, it survived. Wells Fargo has been the subject of considerable conjecture. I believe the preponderance of risk in Wells Fargo's balance sheet and its rapid growth are causes for concern. In high-growth institutions, 99 times out of 100, even the best management cannot defy the odds. When a bank grows that rapidly in a nontraditional activity, it is going to get singed. On the other hand, Wells Fargo is immensely well managed, if the risk concentration issue is overlooked. Figure 15 shows an operating efficiency chart comparing Wells Fargo to its various peer groups. Normally, banks are well managed or poorly managed in all aspects. Most often, the companies that have rushed into high-risk kinds of lending activities are also the most inefficient. Those are the companies that do not maximize fee income. In this case, management is bifurcated. They seem deficient at risk analysis (although they are probably very good underwriters) yet operate very efficiently. So that has to weigh on one's mind. Table 5 is a counterpart of Table 4, but for thrift stocks. Investing long in the thrift industry requires great patience and a lot of hope. You must be willing to hedge so that you really do not care what happens-you simply want to capture the misevaluation. The calculations shown in Table 5 were done at the end of October, and by mid-November, the 14 long positions had not changed much. For the four

Figure 15. Wells Fargo &Compan~ Noninterest Expense as a Percent of Net Interest

Income Latest 4 Years and Last 12 Months

---

60

1:: (l)

~

50

----------------

'88

'87

'89

'90

6/'91

Most Recent 5 Quarters

65,---------------------, 60 +'

~~

55

---------------~-~

.... 50

45 401=:=======r::==~-..L.-------I...--~ 6/'91 3/'91 12/'90 9/'90 6/'90

-

--

Wells Fargo & Company All Banks Banks in the Southwest Banks with Assets of $10 Billion or More

Source: SNL Securities.

short positions we recommended, the decline was 28 percent and even more since the ending date shown in the table. _

Conclusion Tremendous misvaluations exist among 800 publicly traded banks and thrifts, but you must be willing to examine the full range of companies to identify value opportunities. I guarantee that at least for the next five years, until the marketplace reaches full throttle and until enough participants understand the valuation process, these misvaluations will continue.

37

Table 4. Portfolio Results of Long and Short Bank candidates

Company

State

As of 09/04/91 Price/ Economic Value Price

Price as of 11/15/91

Percent Change in Price

Return on Investment

Annualized Retumon Investment

Long candidates Commerce Bancshares, Inc. First American Corp. United Missouri Bancshares Inc. Worthen Banking Corp. United Counties Bancorporation Hawkeye Bancorporation Chemical Financial Corp. USBANCORP, Inc. First Merchants Corp.

MO TN MO AR NJ IA MI PA IN

$95.7 70.9 89.1 89.9 74.5 60.1 71.6 54.8 86.4

$32.750 14.625 34.500 15.125 62.500 10.000 32.000 16.500 29.500

$32.625 17.250 36.250 16.750 59.000 9.750 32.500 18.125 30.750

(0.38)% 17.95 5.07 10.74 (5.60) (2.50) 1.56 9.85 4.24 4.55

Total for longs

(1.43)% 34.32 9.48 19.91 01.39) (5.39) 2.83 19.55 8.55

(7.23)% 173.98 48.07 100.93 (57.74) (27.35) 14.34 99.13 43.37

8.49

43.06

28.86

143.31

Short candidates Citicorp Chase Manhattan Corp. Wells Fargo & Co. Fleet/Norstar Financial Group Barnett Banks, Inc. Michigan National Corp. City National Corp. Mark Twain Bancshares, Inc.

NY NY CA RI FL MI CA MO

901.1 335.2 239.2 230.4 180.2 152.8 174.7 165.3

Total for shorts Total for long & short portfolio·

14.625 19.875 74.000 24.125 33.000 36.000 12.500 22.625

10.750 16.875 59.625 22.250 32.000 37.250 10.875 22.750

(26.50) 05.09) 09.43) (7.77) (3.03) 3.47 03.00) 0.55 00.10)

Source: SNL Securities. Notes: Economic value of common equity = tangible equity + reserves - preferred equity - 80% of LDC loans - 40% of non-LDC nonperforming loans + 90+ day delinquent loans-3.3% of nonrisk performing loans - (highly leveraged transactions + high-risk real estate) + 5% of core deposits (or 5 x adjusted income). Nonrisk performing loans = total loans - LDC loans - high-risk real estate - non-LDC nonperforming assets + 90+ day delinquent loans. Core deposits = total deposits - deposits> $100,000. •Assumes an equal dollar amount is invested in basket of longs and basket of shorts; within each basket, an equal dollar amount is spent on each stock.

38

Table 5. Portfolio Results of Long and Short Thrift candidate

Company

State

As of 10/25/91 Price/ Economic Value Price

Price as of 11/15/91

Percent Change in Price

Return on Investment

Annualized Return on Investment

Long candidates Germantown Savings Bank Parkvale Financial Corp. ESB Bancorp, Inc. Charter FSB Bancorp, Inc. Lincoln Savings Bank First Savings Bancorp FedFirst Bancshares First Federal of Lenawee Portsmouth Bank Shares Omni Capital Group Glacier Bancorp, Inc. First Northern Savings Bank ONBANCorp TriState Bancorp

PA PA PA NJ PA OH NC MI NH NC MT WI NY OH

$252.57 210.38 209.57 206.44 189.77 182.38 180.86 177.90 176.09 172.04 166.84 160.74 153.35 151.12

$13.250 13.375 12.875 16.000 17.250 19.250 16.500 16.750 10.750 18.000 10.500 19.000 17.500 16.250

$13.500 13.750 12.875 15.000 16.750 19.250 17.250 16.250 10.750 18.000 10.750 18.500 17.250 16.500

1.89% 2.80 0.00 (6.25) (2.90) 0.00 4.55 (2.99) 0.00 0.00 2.38 (2.63) (1.43) 1.54 (0.22)

Total for longs

3.31% 5.53 0.25 02.41) (5.86) 0.09 8.91 (5.83) 0.05 (0.18) 4.74 (5.29) (3.13) 3.10

57.59% 96.04 4.43 (215.76) 001.80) 1.56 154.86 001.26) 0.93 (3.11) 82.39 (91.90) (54.46) 53.85

(0.48)

(8.33)

Short candidates Old Stone Corp. Citadel Holding Corp. GLENFED, Inc. Coast Savings Financial

RI CA CA CA

058.47) 007.31) (9.16) 43.62

4.000 24.500 6.375 7.750

3.500 15.000 4.375 5.375

Total for shorts

02.50) (38.78) (31.37) (30.65) (28.32)

Total for long & short portfolio·

56.93

989.46

Source: SNL Securities. Note: Economic value = common equity - intangibles + loan loss reserves -40% of nonperforrning assets - 20% of 90+ day delinquent loans - 13.2% of high-risk real estate loans - 2% of (commercial nonreal estate + consumer loans) - 1% of (total loans - nonperforrning assets 90+ - high-risk real estate - commercial nonreal estate - consumer loans) + 30% of I-year gap + 1.5% of loans serviced for others - capitalized cost of servicing + greater of [3% of (deposits - brokered deposits) or 5 x (66% of last 12 months core income)]. Nonperforming assets =nonaccrualloans + restructured loans + other real estate owned. High-risk real estate =total construction loans + total permanent mortgages - 1-4 family mortgages. •Assumes an equal dollar amount is invested in basket of longs and basket of shorts; within each basket, an equal dollar amount is spent on each stock.

39

Question and Answer Session Reid Nagle Question: Banks often get pushed into failure because they lack liquidity. What are the red flags for illiquidity? Nagle: Illiquidity was the main cause of bank failure in the 1930s, when 9,000 banks failed because they were illiquid. This occurred even though the equity-asset ratio of banks before the Great Depression was 13 percent. I do not think liquidity is a big concern now, however. If the liability side is either uninsured or noncollateralized, then liquidity is a real issue. Liquidity is not a big issue now because banks can always raise money if they have collateral and most deposits are insured. There will not be any capital flight unless the creditworthiness of the U.s. government comes into question. As an indicator of potential failure due to illiquidity, look at the liability side and see how much is subject to flight if a panic should occur. Insured deposits, for example, are not subject to flight. If they are, we are all in trouble. If a substantial amount of money is subject to flight, measure that against the liquid resources the institution has to cover it. Question: When marking assets and liabilities to market, how important is monitoring the duration of the assets and liabilities and avoiding duration mismatch? Nagle: Duration mismatch is becoming increasingly important, but right now it is impossible to measure the duration of assets and liabilities. With the disintegration of the thrift industry, 40

much of its balance sheet, particularly the mortgages and mortgage-backed securities, has flowed to bank balance sheets. The proportion of bank balance sheets devoted to long-term fixedrate mortgages and mortgage securities has increased significantly. Traditional analysis using Generally Accepted Accounting Principles, typically available only once a year, provides crude insight into the relationship of a company's market value to changes in interest rates. Duration information, currently unavailable, would represent an improvement. Ultimately, market value accounting would provide the most meaningful information to investors.

value. On a commercial loan, you can lose the whole loan if you make a bad judgment. Is that contrast a meaningful one?

Question:

Nagle: Out-of-market lending is a cause of great concern. That is the first question that should be asked of management. I met with the management of a West Virginia bank a few weeks ago, and it seemed very well run. I liked everything I heard. Then, the managers started telling me about making loans in Texas and about correspondent relationships in a lot of different places other than West Virginia, and that made me very nervous. I would stay away from that.

You made the statement that "commercial and industrial loans are destined to be the most profitable area." Please expand on that. Nagle: Commercial and industrial loans do not lend themselves to securitization, because no common underwriting standards exist that are universally accepted and trusted, which is what allows loans to be packaged and securitized. Ultimately, securitization reduces bank profitability; In smaller, less competitive cities, businesses have only a couple of players they can deal with, and the banks can basically charge whatever rate they want, within reason. They have a local monopoly. That kind of business will be the most attractive for bank balance sheets going forward.

Question:

Losses on real estate portfolios can be severe-say 50, 60, or 70 percent of balance sheet

Nagle: Traditionally, loss experience on noncollateralized commerciallending has been far below the levels currently experienced on real estate lending, which is collateralized. If management has a good track record, the level of prior loss experience can provide a reasonable degree of comfort. Investors can evaluate and speak to management to assess the likely underwriting standard for business lending.

Question:

Is out-of-market lend-

ing wise?

Question:

Do you see more value in equity investments in top-tier banks that are stabilized nonperformers or in more controversially discounted debt or subdebt investments in lower tier banks that have a reasonable interest margin? Nagle: Prior experience, particularly with subdebt of financial institutions, is that it is an all or

Table 6. Real Estate Nonaccruals by Region, December 1990 and June 1991 (percent of type of loan) United States Type of Loan 1-4 family residential 5 or more family residential Construction & development Commercial Total real estate loans

12/90

North

6/91

12/90

1.08% 5.06 11.67 5.50

1.26% 6.77 13.65 6.31

4.24

4.71

South

6/91

12/90

6/91

1.79% 7.31 20.18 9.10

2.21% 9.34 21.84 10.04

0.96% 5.58 8.66 4.97

1.04% 8.72 10.90 6.14

6.95

7.37

3.82

4.43

Midwest 12/90

6/91

West 12/90

0.62% 2.11 5.63 2.19

0.60% 2.91 6.04 2.60

0.39% 1.70 6.35 3.73

1.75

1.91

2.37

6/91 0.46% 1.72 10.09 4.35 3.18

Sources: SNL Securities, W.e. Ferguson & Co.

nothing experience. Tremendous opportunities existed in the thrift industry just a couple of years ago, because investors in subordinated debt did not realize that with financial institutions, you do not get 70 cents back on the dollar. You either get it all or you get nothing. Question: Peer groups for banks always seem to be based on asset size. Is this the best way to select a peer group in today's society, or should we choose some other basis such as business concentration? Nagle: Given the way the economy has behaved in recent years-namely, characterized by rolling recessions-regionality and business line are probably the two most important considerations in peer group comparisons. Asset size can often be a misleading indicator in selected peer group composition.

Question: What have been historicalloss percentages on nonperforming loans, especially in real estate? Do any measures include principal and interest losses, foreclosure costs, and so on? Nagle: No very good measures are available. You would need to get that information from individual banks, because the data typically available from public sources do not combine all of the accrued interest and do not add the net charge-offs back in. Table

6 shows the nonaccruals by region, and Table 7 looks at net charge-offs as a percent of nonaccruals, but they do not show what the cumulative charge-off is. I believe that loss experience on distressed high-risk real estate lending is actually somewhere near 50 percent. On the highest risk real estate, the rate is probably somewhere between 50 percent and 75 percent in severely depressed regions and probably between 40 percent and 60 percent on other types of high-risk real estate.

Table 7. Real Estate Charge-Qffs by Type, 1990-91 (percent of nonacx::ruals) Year to Date June 1991 Annualized

Type of Loan

1990

1-4 family residential 5 or more family residential Construction & development Commercial

12.75% 30.73 25.16 19.63

15.99% 23.20 25.73 21.12

21.59

21.12

Total real estate loans Sources: SNL Securities, W.e. Ferguson & Co.

41

Valuing Banking securities James K. Schmidt, CFA Managing Director and Chief Investment Strategist Freedom Capital Management

Banking assets are rarely worth significantly more than face value, but they may be worth much less. Examining earnings and asset quality must therefore be undertaken with a bias toward finding hidden problems rather than uncovering buried treasure.

Bank stocks have performed well in the past decade, but they have also been quite volatile. Figure 1 shows that, according to the Dow Jones Regional Bank Index-a capitalization-weighted index of 53 regional banks-bank stocks have performed very well since the index was created in 1982. Figure 2 shows the performance of the regional bank index relative to the S&P 500. On a relative basis, performance does not look as strong as it does on an absolute basis. Banks are a small-capitalization stock industry; none is among the top 50 stocks in market capitalization. Therefore, it is not surprising that the relative performance of a broad-based bank index will approximate what small stocks do relative to the S&P 500. Small-capitalization stocks performed well in the 1982-83 bull market and then underperformed until 1989. The summer of 1986 was a peak in bank stock relative performance. Frenetic merger activity was taking place during the first six months, and takeover speculation was built into bank stock prices. "Bank stock hell" began in October 1989. The problems began with the collapse of the United Airlines buyout financing, which in tum generated concern about the amount of leverage in the economy as a whole. Coupled with real estate problems and various regulatory factors, this was the beginning of a disastrous year for bank stocks. Bank stock prices began to improve again in November 1990.

Bank Stock selection We have developed a process we use to select bank stocks and structure a portfolio. The process involves first understanding what is going on in the national economy. Then, we look into regional fac42

tors-economic growth prospects and the competitive and regulatory environment for banking. We then develop and maintain a model portfolio.

National Overview The national overview has two important aspects: the economic growth outlook and the interest rate forecast. The first step is to determine where the economy is going. Banks are related to the economy, but only in one direction-down. A healthy economy can mean bank earnings are up somewhat, perhaps 8 or 10 percent, but a bad economy or a weak segment within the economy can cause disaster. The second macro factor is interest rates, and both the basic direction of interest rates and the spreads are important for banks. Figure 3 and Figure 4 compare bank performance to three-month Treasury bills on an absolute and relative basis, respectively. Absolute bank performance is inversely correlated with interest rates. As interest rates go down, bank stock prices go up. Taken relative to the S&P 500, the correlation between bank stock prices and interest rates disappears, so the apparent correlation is a market effect. The relationship between interest rates and bank stock relative performance is not strong when you look at correlations over different periods and at different points on the yield curve. Bank stock performance is difficult to relate to interest rates. That makes sense because bank earnings are affected by interest rates, but not in a simplistic way. Banks are asset sensitive rather than liability sensitive. On average, they make more money when rates are high than when rates are low. Sometimes funding spreads open up as rates decline, however, so rates in the act of falling are more favorable than those in the act of rising. The celebrated credit card case is a

Figure 1. Dow Jones Regional Bank Stock Price Index

Figure 2. Dow Jones Regional Bank Index versus

S&PSOO

1982 = 100 400 r - - - - - - - - - - - - - - - - - - - - - - - ,

1982 = 100 140r------------------------,

350

120

300 100

250 200

80

150 60 100 50 L----J_----'-_-----'-_----'--_----L_---'-_--'---_...L.-_-'--------' '83 '84 '85 '86 '87 '88 '89 '90 '91

40'----'----L---'-------'-------'-----_-'--_-'--_-'--_-'-----' '83 '84 '85 '86 '87 '88 '89 '90 '91

Source: Freedom Capital Management.

Source: Freedom Capital Management.

good example: As rates have fallen, the spreads on credit cards have skyrocketed. In addition, the maturity structure of a bank is somewhat complicated because there are various imbedded options on the asset side. So no simplistic formula exists to relate bank earnings to interest rates other than to say the correlation is low. Thrifts, in contrast, are typically very liability sensitive.

in an area that provides some growth, earnings can increase even if margins are stable. Asset growth sometimes provides a clue about what is going to happen to asset quality, and changes in growth rates often foreshadow changes in the loan quality or the level of noncurrent loans at a bank. Currently, the most important category to examine for asset quality is real estate. Table 1 shows loans outstanding and the percent that are nonperforming or noncurrent in various real-estate-related categories. Note that construction and development loans are by far the most troublesome, while loans collateralized by residences tend to produce few problems. Figure 5 is a map of the United States showing the percentage of troubled real estate assets by state and region. The map clearly shows differences in states and regions. In Massachusetts, for example, 17 percent of all of the real estate assets are nonperforming, which means they are either repossessed real estate or they are loans that are not being kept current. In contrast, the rates in Idaho and Iowa are only 2 percent. With such wide discrepancies, the poten-

Regional Characteristics Because the banking system is fractionalized, the characteristics of different regions of the country are an important consideration. Three characteristics are particularly important: growth prospects, asset values and credit quality, and the banking environment. The economic growth of a region as measured by growth of employment or payroll is important because it forms a foundation for balance sheet growth. Simplistically, growth in bank earnings is a function of the growth of the earning assets and the interest margin the bank is earning on the assets. If a bank is Figure 3. Bank and 91-Day Treasuries Perfonnance

Figure 4. Relative Bank Perfonnance and Treasuries Perfonnance 1982 = 100

1982 = 100 400,..----------------------,16 350 300 250 200

\ \ \

120

12 /\ \ / - / ./

ISO

1 4 0 , - - - - - - - - - - - - - - - - - - - , 16

14 '"d

\

10 \

/

'

"

"'-

/

,

~

100 80 60

50 L-~~;:;_;_~=--=_~=___:_::!::_~!_:_~:__:.,L___----.J 4 '83 '84 '85 '86 '87 '88 '89 '90 '91

40

"_-"/' \

- - Dow Jones Regional Banks - - - 91-Day Treasuries

Source: Freedom Capital Management.

12

\ \

"\

'/

/ /",/

/'

"0

\ '\,.

,

8 6

100

14 \

10] /

"-

r

'-

/

""

~

-

....... "

I

8

"

I

"

'---.....,_"_,..--~_____,_'_=_---:-:'-----'-::,_____--"----L-.....,-"---'-----J

'83

'84

'85

'86

'87

'88

'89

'90

'91

6 4

- - Dow Jones Regional Banks Relative Performance - - - 91-Day Treasuries Source: Freedom Capital Management.

43

Table 1. Real Estate Loans Outstanding and Percent of Noncurrent Loans as of June 30, 1991

All Banks

Asset Size $100 Million $1 Billion Less Than to to $100 Million $1 Billion $10 Billion

$10 Billion or More

Total Loans Outstanding ($billions! All real estate loans Construction & development Commercial real estate Multifamily residential 1-4 family residential Home equity lines of credit Commercial real estate loans not secured by real estate Highly leveraged transactions Loans to foreign governments and institutions

$847.8 116.9 246.3 22.6 353.1 66.0

$97.4 6.3 25.6 1.9 50.7 3.1

$211.1 19.9 68.6 6.5 96.6 14.2

$265.3 43.4 88.1 7.2 98.0 25.8

$274.1 47.4 64.0 7.0 107.8 23.0

28.3 68.2

2.1 0.0

4.7 0.6

8.7 14.3

12.7 53.3

24.9

0.0

0.2

1.5

23.3

4.89% 14.07 6.16 7.65 1.57 0.73

1.98% 3.35 2.73 2.73 1.42 1.23

2.55% 6.41 3.34 3.45 1.40 0.83

5.02% 13.77 5.70 6.45 1.57 0.61

7.59% 18.99 11.20 14.20 1.81 0.73

Percent of Loans Noncurrent All real estate loans Construction & development Commercial real estate Multifamily residential 1-4 family residential Home equity lines of credit Commercial real estate loans not secured by real estate Highly leveraged transactions Loans to foreign governments and institutions

8.03 11.07

8.42 N/M

8.96 5.59

6.23 10.14

8.86 11.38

16.01

N/M

22.69

13.57

16.11

Source: Federal Deposit Insurance Corporation.

tial for troubled real estate loans at a bank is obviously highly related to geography. The map also shows the importance of inflection points, or changes in direction, in the economy. During the past 5 or 10 years, those states that have grown the most are not necessarily those that have the fewest real estate problems, and those that have grown the least do not necessarily have the most problems. The best correlation of growth with real estate problems is found by examining those states where growth exceeded its prior trend line and the states where growth fell short of the prior trend line. The dislocations in the real estate market occur when growth rates change relative to their trend. For example, during the past 10 years, Iowa went through very slow growth. The state's economy had real problems during the early 1980s with the farm economy in depression and many farms being repossessed. In the late 1980s, the state did not grow, but things stopped getting worse. Farm land bottomed at about $1,000 an acre in 1985, and it is about $1,200 an acre now. Things are not going gangbusters, but they went from being disastrous to being good. That 44

means Iowa has no danger of overbuilt real estate. Banks in Iowa do not have a lot of speculative condominium loans because not a lot of condominiums were built. Banks did not have a chance to get into trouble as they did in other areas, and the nonperforming real estate loan rate is only 2 percent. In contrast, the Northeast states like Massachusetts and Connecticut experienced a huge problem in their real estate markets when their economies declined somewhat after being so strong in the mid- to late 1980s. Massachusetts and Michigan are an interesting contrast. Massachusetts has an unemployment rate a little above 9 percent, which all the politicians are fretting about. Actually, 9 percent is not that high; it has been higher than that in Michigan for years. The nonperforming loan rate in Michigan is fairly low compared to Massachusetts because Michigan has been living with a slow-growth pace for a decade, while for Massachusetts it represents a radical readjustment. So the change from rapid growth to poor growth is what gets people into trouble. The other important point illustrated in Figure 5 is how long it takes to work out of bad real estate

Figure 5. Troubled Real Estate Asset Rates by State, June 30, 1991 Midwest

West

Central

Northeast

MA 7.15

RI

\, "--12.86

---'CT °NJ 16.83 11.76 'DE 4.29

Southwest

~o 'W

HA 0.84 ~p-

()

Less than 4 percent Between 4 percent and 8 percent More than 8 percent Source: Federal Deposit Insurance Corporation.

loans. In 1991, the Southwest region looked bad; several states were posting nonperforming asset ratios of around 10 percent. Those are fairly high numbers, but they disguise the underlying reality. In Texas, the real estate problems have been much more severe than in Massachusetts, but the banks with the really bad ratios have failed, and they are not in the FDIC sample anymore. If the data are adjusted to include the failed institutions, Texas has been a disaster. Texas real estate is still producing nonperformers even though we are several years into the recovery of the economy. To illustrate the magnitude of the problem, I will relay the experiences of a savings bank in Washington state that has a loan out on a commercial building in Houston. It made the loan in 1984. It was originallya $40 million credit, and in 1987, the savings bank wrote it down to the appraised value of $20 million. In 1989, it took a $9 million writedown on this property, from $20 million to $11 million. The timing on this project is insightful. Oil prices peaked in November 1980, and the economy in Texas started rolling over. At the time, the price of a barrel of oil was forecast to be $80 to $90 by the end of the

decade, but it soon became clear that that would not happen. The first big writeoffs on energy loans were taken by Texas banks in spring 1982: InterFirst announced in May that it would lose money due to a big loss provision. Banks in Texas started failing in plentiful numbers in 1985 and 1986. The real estate market bottomed in Texas in 1986, but in 1989, people were still discovering they had to mark their properties down by 45 percent. This seems awfully late in the game to find out you have problems. My view of the real estate valuation cycle is illustrated in Figure 6. This shows the relationship between when a market turns and when it shows up in bank earnings statements and balance sheets. It is not a scientifically produced exhibit; it is a qualitative representation. Assume we are talking about a particular piece of real estate, such as a condominium in downtown Boston. On the time cycle, Year 2 represents the peak in the market. Assume our hypothetical one-bedroom condominium in a nice area had a market value of $250,000 in August 1987, having risen steadily over the prior years. We did not know it then, but 1987 turned out to be the peak in the real estate market. In fact, market values started declin45

Figure 6. Real Estate Valuation Cycle Initial Value = 1.0 2.4r------------------2.2

- -

/'"-

/

-

--,

....

2.0 /

1.8 1.6 1.4 1.2 1.0 0.8 L -_ _- L_ _-----.l

- : -_ _- ' ;_ _- - - :

2

3

4

5

Years - - Market Value - - - Appraised Value ----- Book Value

Source: Freedom Capital Management.

ing from that point forward. A year later that property was worth $200,000; a year and a half later it was worth $175,000. Appraised values lag market values for quite some time. There is a general rule that people have come to rely on in real estate. Any property is worth more this year than it was last year. This is treated as a basic law of physics by a lot of people in the real estate business and certainly in the appraisal business. Into the first year of the bear market in real estate, appraised values keep rising, even though market values are falling. This creates a gap in which the property appraisals are totally out of sync with the market. Another lag occurs before appraisals show up on the bank balance sheet, because not everything is appraised every day. So six months or more go by before the carrying value of nonaccrualloans in bank repossessed real estate reflects what the appraised values are. These themselves lag the tum of the market quite a bit. As a result, a year or two after the real estate market turns, a very large gap exists between what a bank says its real estate is worth and what the true market value is. That is the phenomenon we saw in Texas, we are starting to see in New England, and we will see in California.

Solving the Asset Quality Riddle The health of a bank can be assessed by analyzing various categories of a balance sheet and how loans flow in and out of the various categories. I will use Barnett Banks to illustrate how to solve the asset quality riddle. In the current environment, people are very concerned about trends in nonperforming assets. A non46

performing asset is either a nonperforming loan-a loan that is not current on interest payments-or it is real estate repossessed and owned by the bank. A lot of emphasis has been placed on determining whether a bank's nonperforming assets have peaked. Barnett's nonperforming asset ratios peaked in the second quarter and declined in the third quarter, according to the bank. Five of the six research reports on Barnett banks that I reviewed recently responded positively to the fact that nonperformers would decline in the third quarter. Not everyone was bullish on Barnett, but all analysts agreed that a peak in nonperforming assets was a good sign. Many things influence nonperforming asset ratios, but the effects can be sorted out. Using Barnett Bank's third-quarter report, I will illustrate the relevant cash flows and estimate what happened. The bank stated in its report that "real estate owned rose to $383 million" and that "our sales of foreclosed real estate did increase to more than $30 million." First, look at the $30 million. The real estate owned is supposed to be marked to market, so theoretically all of the $350 million Barnett had in real estate owned in June is sellable at that value and could be moved out without a loss. In fact, the bank was only able to move 8 percent of it. I am not encouraged to know that only 8 percent of Barnett's portfolio can actually be moved at the value at which it is carried. In addition, the bank probably sold its better properties: If it had 800 properties, it probably picked the best 100 to move out. So selling $30 million is not a particularly optimistic note. If its real estate owned went from $350 million to $383 million, even though it sold $30 million, then the bank acquired $63 million of additional real estate during the period. I am assuming that this came from loans previously considered nonperforming. As those loans migrated from nonperforming real estate to real estate owned, the bank foreclosed on them. There are other paths the balances could move in that could make that number over- or understated. For simplicity, however, lets assume that the $63 million migrated from nonperforming loans to other real estate. The nonperforming loans category dropped from $593 million to $558 million during the quarter, but $79 million was written off and $63 million was moved to repossessed real estate. With a little arithmetic, it appears that $107 million was actually added to nonperforming loans during the period ($593-$79-$63 + Y =$558; therefore, Y = $107). This shows continued deterioration in real estate. That certainly makes sense because the economy is not recovering. You would not think you could reverse all of the problems Barnett has in one quarter this

early on in the real estate cycle. Nevertheless, the optimistic tone of its report has been accepted at face value by a few analysts. In looking at the Northeastern banks, I notice that of those with a lot of real estate problems, a fair number also had surprising stabilization or a slight decline in nonperformers. They are placing a lot of emphasis on controlling the nonperforming asset number and being able to record a lower number. I think that is making people a little too sanguine about what is going to happen in the real estate markets generally.

Management Quality

mainly correlated with the size of the bank. The number of options granted is correlated with the size of the bank; the price action matters little because each year more options are granted at current market. As long as the stock price is volatile, the options will be valuable. Another problem with managements that own a lot of stock is that as the percentage of management ownership increases, the ability to trample on the rights of the minority shareholders also increases, as does the ability to plunder the bank for their own ends if things get bad. So I am not happy to see that degree of insider concentration because it allows things to happen that do not always benefit stockholders.

The quality of bank management is an important consideration. A management can be evaluated by looking at its past record. Because we are in a tran- Bank Stock Pricing sition point, particularly in real estate, historical records on some asset quality items are not always Our philosophy is to buy bank stocks that are cheap. indicative of what is happening going forward. A lot When screening banks, many price anomalies can be of the banks in New England that failed in 1990 had discovered because the industry is so fractionalized. impeccable asset quality and very low chargeoffs Figure 7 shows how bank stocks have traded on a through 1988. So the past chargeoff record may not price-earnings ratio (PIE) basis during the past 30 be indicative of the future. years. The bank PIE has varied over time, but it Another thing I look for in management is sharealmost always is below the PIE of the S&P 500. holder orientation. Although a shareholder orientaBanks do not get a lot of respect in the marketplace. tion is important in most industries, the divergence Bank stocks last sold at a premium to the market in between management's payoff matrix and what the mid-1970s, and now they are just above 60 pershareholders want to see seems to be wider in the cent; they still are selling at a steep discount. banking industry. Bank executives' goal in life is not A good regional bank may sell at 9.5 times this necessarily maximizing the value of their stock, beyear's earnings, which is about where a low-quality cause being the head of a large bank or of any bank utility stock would be. This is puzzling because over makes you a prominent figure in a community. It the long term, bank stocks have been big outgives you a certain influence that you cannot put a performers, and many studies show that bank earnmonetary value on. Remaining the head of the bank ings-per-share growth over a 10- or IS-year period is and continuing to make the bank grow is the most very competitive with that of the market, and often important goal for a lot of bankers. better. One explanation is that the market is ineffiTo determine whether banks are shareholder cient and banks are underpriced. This is true to a oriented, analysts have to watch what they do rather point, and I believe that the gap will narrow during than listen to what they say. Their actions must be the next five years. consistent with maximizing shareholder wealth. A Figure 7. Relative PIE Ratios-Keefe, Bruyette, & number of analysts use the amount of stock held by Woods Index versus S&P 500,1961-91 management as a measure of whether management 120 has the interest of the shareholder at heart. I think this yardstick has a number of problems. First, assuming management's sole goal is increasing their own personal wealth, the amount of stock ownership ..... 80 @ would have to be tremendous before their wealth is ~ more correlated to the price movements in the stock 0'::: 60 than it is to their compensation plan. If the bank grows, the compensation packages keep growing 40 and ensures wealth regardless of stock performance. Stock option plans are often cited as incentives 20 L..l..::----,,-l-:-----,,,L------,-,l ----.l...--.....L------.J '61 '66 '71 '76 '81 '86 '90 for improving stock performance. However, in these plans, the wealth accumulated from stock options is Source: Keefe, Bruyette, & Woods, Inc.

47

Bank stocks are not as alarmingly underpriced as they might appear statistically. The reason for this is the method a lot of analysts use to calculate bank statistics. Too often, problem banks are removed from samples because they distort statistics. Because of this practice, banks as a whole appear to have very good earnings progressions. For example, a portfolio of favorite banks in 1980 would have included Texas Commerce, Mcorp, SeaFirst, and a lot of banks that failed or were taken over at distressed prices in the 1980s. Yet most people who do retrospective studies tend to exclude these banks. That is true of loan-loss provisioning, too. Whenever a loan provision is sufficient to produce a quarterly loss, the number is removed from the sample. Severe loan losses cannot be ignored. So I do not think that banks are nearly as undervalued as some of the PIE statistics might show. There are always risks to bank earnings streams that are greater than would be evident from retrospective analysis of "cleansed" data.

The Banking Environment

Figure 8. Bank Acquisitions Announced--Total Assets by Quarter 250

214.9 200 ~ 150

o

§r:o

fFt

1.

lOOt, .

5~t

. . . _.. 3.9

HW

7,1

14.6

3.4

8.9

->~,

4/'89 1/'90 2/'90 3/,90 4/'90 1/'91 2/'91 3/'91

Source: SNL Securities Monthly.

markets. Phenomenal expense savings are one result of this type of merger, which tends to benefit both banks. It also is good for the industry as a whole. In each of the deals pending right now, between 8,000 and 10,000 employees may be cut to achieve the efficiencies that will make the merger work. For all the deals now outstanding, the number of jobs to be lost is between 50,000 and 60,000. That is not good news for those 50,000 or 60,000 people, of course, but for those remaining, it is a tremendous capacity reduction in the industry. Having fewer bankers and fewer banks has some positive implications for the overall competitive structure in the industry.

The banking environment is another important consideration. The United States has about 13,000 banks; in Canada, 10 banks dominate the country. The fractionalization of our banking system is the byproduct of regulation. To a large extent, these rules now have changed. Banks have been deregu- Conclusion lated on the product front and also geographically, state by state. A measure before Congress would Commercial banks represent an inexpensive group allow full nationwide banking. of stocks that should benefit over the upcoming years A great deal of merger activity lies ahead. Figure from consolidation activity. This will provide an opportunity for shareholders of target banks to re8 shows the volume of deals announced during the ceive takeover premiums, and it will reduce compepast eight quarters. You can see this volume has tition and allow the entire industry to operate more exploded this year. Banks were out of the merger efficiently. The main challenge for analysts is to game somewhat when they were under regulatory avoid pitfalls-those banks whose financial statepressure in 1989 and 1990. That has now subsided, ments do not relate the true underlying values. Unso we are seeing a lot of deals. The volume exploded fortunately, banking assets are rarely worth signifiin the third quarter of 1991. In the fourth quarter so cantly more than face value, but they may be worth far, a couple of major deals have already been anmuch less. Examination of earnings and asset qualnounced-Manufacturers National and Comerica, ity must therefore be undertaken with a bias toward and National City and Merchants National. finding hidden problems rather than uncovering A new type of acquisition is more common now: buried treasure. mergers of equals-that is, banks in overlapping

48

Applying Banking Analysis to the Thrift Industry-5imilarities and Differences David N. Pringle Managing Director Furman Selz Mager Dietz & Birney, Inc.

After a period of parallel evolution, banks and thrifts now are converging. The similarities and differences between the two industries are apparent in their balance sheets, disclosure of nonperforming assets, capital requirements, off-balance-sheet exposures, and income statements.

Banks and thrifts are in essentially the same busilowing three institutions: National City, a commerness. They both borrow money from depositors and cial bank with about $24 billion in total assets, headin the capital markets, and they make loans and quartered in Cleveland, Ohio; H.F. Ahmanson, purchase investment securities. Generalizations which I believe is the largest thrift in the country, in about how the two industries differ should be made Los Angeles, California; and Maryland Federal, a with caution, because they tend to move as one. thrift located in Hagerstown, Maryland. Banks usually have more diversity than thrifts in _ their customer bases, loan portfolios, and sources of income. Thrifts usually cater to older and middle- Balance Sheet Comparisons: Assets class depositors. Thrifts also make more loans in the Ignoring the nuances, the asset structures of banks single-family market than banks. At least two historand thrifts are very similar. Table 1 compares balical reasons help explain these differences. One is ance sheet assets of these three institutions. that the large eastern thrifts-Provident Institution for Savings, Philadelphia Savings Fund Society, SeaEarning Assets mans Bank-were originally created as quasi-chariThe earning assets of the three institutions, with table organizations. The wealthy donated to the inone exception, are quite similar. They make loans stitutions, which then paid interest on deposits as an and invest in Treasuries and mortgage-backed secuinducement for the working class to save. Second, rities. The one difference is that thrifts purchase regulation has driven a lot of what banks and thrifts Federal Home Loan Bank (FHLB) stock. (The FHLB do. Before the 1980s, thrifts could not lend on much system was created in the 1930s to provide liquidity more than real estate assets, and banks were largely for the thrift industry. Member institutions buy eqprevented from lending on real estate. uity in the system, on which they receive a dividend. Now, after a long period of parallel evolution, In turn, they may borrow from the FHLB system at the two industries are converging, although banks essentially subsidized rates.) are moving more onto the thrifts' turf than vice versa. Banks are typically less "loaned out" than At some point during the next few years-probably thrifts-that is, loans are usually a smaller percentonce the deposit insurance funds are recapitalizedage of their assets. The loan percentage for banks the two industries will be united from a regulatory may range from 30 percent for a Republic New York standpoint. Corporation to 80 percent for a Wells Fargo. Thrifts The similarities and differences between banks tend to be in the upper end of or above that range. and thrifts are apparent in their balance sheets, disNational City, for example, has 67 percent of its total closure of nonperforming assets, capital requireassets in loans, which is normal for a commercial ments, off-balance-sheet exposures, and income bank; the proportion for Ahmanson is about 74 perstatements. These can be illustrated using the folcent, and for Maryland Federal, 86 percent. 49

Table 1. Balance Sheet Compariso~Assets (millions of dollars, except as noted)

Item

Earning assets Total loans Investment securities Mortgage-backed securities Fed funds sold FHLBstock Other Total earning assets

National H.P. City Ahmanson

$15,947 1,744 2,218 9 0 ------.Z2Q 20,714

Other assets (248) Allowance for loan losses 2,009 Cash and due from banks 338 Properties and equipment Customer acceptances 119 Real estate held for development 0 Other real estate owned 105 250 Intangibles Accrued income and other assets ~ Total other assets 3,029 Total assets

$23,743

Loans as a percent of assets Earning assets as a percent of assets

$37,783 276 5,114 1,888 386 2,283 47,730

(213) 743 688 0 748 229 550

Maryland Federal

$656 17 36 3 7

----.n 741

(l)

10 3 0 0 0 0

~

3,471

7 19

$51,201

$760

67%

74%

86%

87

93

98

Source: Corporate annual reports. Note: Data are as of 12/31 /90, except Maryland Federal, which is as of 2/28/91.

Banks are not as loaned out as thrifts for two reasons. One is that they have other sources of income besides loans, whereas thrifts are fairly dependent on loan volume for their income. Second, banks require liquidity for interest rate management (they are much more active in this than many thrifts), for correspondent banking activities, and as a cushion in times of distress. A surprising number of thrifts depend on the FHLB system for their liquidity. They feel if they ever get in a bind, they can just go to the window and borrow. Banks also typically have a lower level of earning assets as a percent of total assets. The major reason for this is that banks carry a very large cash-and-duefrom-banks position. Most of the large commercial banks run correspondent banking operations. For instance, National City has about 150 downstream correspondent banks for whom it clears checks. In this process, tons of float moves back and forth between institutions. None of that carries interest for anyone, at least from the banking system/s standpoint. Most of this float is offset by noninterest-bearing demand deposits (a liability). If a thrift has less 50

than 90 percent of its assets in earning assets, that is usually a warning signal; a thrift should have 94 to 97 percent of its assets earning money. Although loan portfolios are basically black boxes, analysts can learn a lot about the portfolio by using some common sense and looking at three key areas. First, check on category definitions. Although the industry is moving toward better disclosure, many times a financial statement will list "residential loans outstanding." Banks, but mostly thrifts, will hide construction loans there. They also may hide second equity deeds of trust and home equity lines of credit in the category of residential loans outstanding. Finding out what those loans actually are is very important. Second, look at geographical and industry exposures. Five years ago, I think every thrift in the country had some exposure to Houston garden apartments and Colorado ski condominiums. Third, ask the institutions about their 10 largest credits. I once called a chairman of a Virginia bank at the request of a client and asked him about his largest loan. He did not know what it was. I never called the institution again. Rapid growth in loan portfolios is generally a bad sign. Talk to the managements about their policies and procedures. If you do not understand something/ ask again. The mix of loans differs somewhat between banks and thrifts, as illustrated in Table 2/ but the analysis of the loans is similar. Thrifts usually do not write commercial business loans, known as commercial and industrial loans. They do not write a lot of nontaxable loans, and they have not made a great amount of loans to lesser Table 2. Loan Comparisons (millions of dollars)

Item Commercial business Real estate construction Commercial mortgage Residential mortgage Consumer Equity reserve Credit card Leasing Non-taxable International Total loans

National H.F. Maryland City Ahmanson Federal $6,634 850 1,208 1,984 3,084 541 897 288 411 ~

$15,947

0 0 $ 8,180 29,480 107 0 149 0 0 _ _0 $37,916

0 $18 0 603 10 37 0 0 0 _0 $668

Source: Corporate annual reports. Note: Data are as of 12/31/90, except Maryland Federal, which is as of 2/28/91.

considered part of the investment portfolio. Some developed countries. Beware of thrifts that are growthrifts have set up joint ventures with real estate ing their commercial loan portfolios rapidly. These developers. Typically, the earnings visibility in this companies do not know the business and are likely type of business is low, which has caused trouble for to have a high percentage of nonperforming coma lot of institutions. It is a low price-earnings (PIE) mercialloans. business, and I think thrifts are trying to phase out Both banks and thrifts write commercial mortgage and construction loans. The key risk element the whole thing. for both groups is the degree of owner-occupied as opposed to developer properties. The banks are now disclosing these data. Historically, owner-occupied Balance Sheet Comparisons: Liabilities loans have had better performance than developer The liability structure of banks and thrifts is remarkloans. Norwest did a study going back to 1946 and ably similar except for a couple of variants, which are found that more than 90 percent of its losses were on apparent in Table 3. One is demand deposits: Comdeveloper as opposed to owner-occupied properties. mercial banks have them, thrifts do not. Demand Combined exposure to developer loans should not deposits are essentially noninterest-bearing deposits be more than 15 percent of total loans, or 1.5 times placed with banks by correspondent banks or busiequity. We use these parameters owing to our belief ness customers in lieu of paying fees. Other demand that in the next five years, 50 percent of the total deposits arise from loans that require a 0.5 percent exposure to construction loans plus developer propcompensating balance that does not pay interest. erty loans will be written off. Thrifts are not in this type of business. The percentage of loans in the residential mortThe second difference is the FHLB advances. gage category varies across institutions. The key These represent a large percentage of thrifts' longanalytical issues are: the kind of adjustable rate term funding. Only a few thrifts have ratings from mortgages the institution has-whether it has "teaser rates," some of which are never profitable; Table 3. Balance Sheet Comparison-Liabilities the type of loan-value ratios; whether the loans have (millions of dollars, except as noted) documentation; and whether the loans have cramdowns (court-mandated reductions of principal National H.F. Maryland balance based on a borrower's ability to pay) or a Item City Ahmanson Federal renegotiation of contracts. Cramdowns are happening much more on single-family loans than on comDeposits mercial real estate loans. Demand deposits $3,677 0 0 Consumer loans are the next biggest area. On Savings and NOW 2,412 $ 4,616 $ 51 consumer loans, watch nationally syndicated credits. Money market accounts 3,258 5,383 43 Finance company receivables, credit cards, and Individual time 6,643 28,606 499 Total consumer 15,990 38,605 593 home equity loans will prove interesting. Watch the drawdowns on the home equity loans. Most banks Other time deposits 2,130 0 0 and thrifts are running around 45 percent to 50 per_ _0 Foreign _0 ----.lQl cent. If that increases to 80 percent, delinquencies are Total deposits 18,321 38,605 593 likely to occur.

------------------

Other Assets The other assets category makes up a smaller percentage of total assets for both banks and thrifts. Banks have customer acceptances among their assets, but thrifts usually do not. These are essentially bankers' trade acceptances sold to corporate clients. They remain on the balance sheet because, in association with the trade underwriting, banks write letters of credit, which the accountants require them to keep on the balance sheet. Banks usually do not have real estate held for development as an asset. Although they often do business with real estate developers, they tend to do it through their venture capital portfolios, so it is

Nondeposit liabilities Short-term borrowings 2,158 FHLB advances 0 Other long-term debt 1,172 Acceptances outstanding 119 Other liabilities ~ Total nondeposit liabilities 3,812 Total liabilities Equity

1,438 5,243 2,307 0 1,266 10,214

10 87 0 0 14 111

$22,133

$48,859

$704

$1,609

$2,342

$56

Wholesale funding as a percen t of total

24%

7%

1%

Source: Corporate annual reports. Note: Data are as of 12/31/90, except Maryland Federal, which is as of 2/28/91.

51

the credit agencies, so they are locked out of the long-term capital markets. Although banks now have access to FHLB membership and borrowing, they have not taken advantage of it. Wholesale funding is an issue for both banks and thrifts. Wholesale funding is riskier than retail funding. If a thrift has a very large position in borrowed funds, ask about it and try to determine whether its maturity is mismatched. Are the borrowed funds used to finance hedged-risk arbitrage portfolios? These are situations in which thrifts borrow money in differing maturities, invest in mortgage-backed securities, and hope that the mortgage-backed securities amortize at the same rate that deposits roll off. This is a fairly risky strategy, but it can present an opportunity in thrift investing. A number of thrifts still have very high-cost debt on their balance sheets, which is starting to roll over. As they replace the higher cost debt, margins should improve dramatically. Finally, acceptances are found on bank liability balance sheets, but not on those of the thrifts.

Nonperfonning Assets

lysts must deal with constantly. Regulators tell us we should get more information, and banks tell us that reserves as a percent of nonperforming loans mean nothing. The Federal Reserve has determined that if an institution has more than 1 times its equity in nonreserved, nonperforming loans, it is in real danger. The Fed has never seen a bank come back once its nonreserved, nonperforming assets are greater than twice equity. For comparison between banks and thrifts, I suggest using these ratios: nonaccrual plus renegotiated plus 90-day past due loans plus other real esate owned (OREO), divided by total loans plus OREO. In Ahmanson's case, its stated nonperforming asset ratio is 3.79 percent of assets. The percentage for nonperforming loans works out to 3.78 percent; the nonperforming asset ratio including 90-day past due and still accruing is 4.72 percent. So in a comparison between banks and thrifts, Ahmanson has essentially understated its nonperforming assets by 100 basis points. The range of nonperforming assets is very wide in the financial industry. For example, Fannie Mae's 60-day delinquencies at the end of September in its single-family portfolio were around 60 basis points-0.6 percent. The best large bank is J.P. Morgan; its nonperforming asset percentage is about 1.15 percent. The worst large bank is MNC Financial at 15.9 percent. Thrifts range all over the board. All the savings banks in one town in New England have nonperforming asset percentages well over 10 percent. The median for banks on a nonperforming asset ratio basis is around 4.74 percent. Because thrifts lend much more widely on single-family mortgages, which have a lower risk profile, they should be well under that median.

Asset quality is important because banks' and thrifts' returns are so low that they cannot afford to take losses. Therefore, it is important for analysts to get numbers that conform to these four categories: nonaccrual loans, renegotiated loans, 90-day past due and accruing loans, and other real estate owned. Thrifts do not always disclose these data, and banks have just begun to disclose loans in the renegotiated category. The 90-day past due category will probably include a lot of FHA/VA loans and some student loans, but you will also find some loans that should be on nonaccrual. Although regulation has intensi_ fied and has narrowed discrepancies, a huge amount capital of management discretion remains in disclosure of The investment portfolio is something most analysts nonperforming asset levels. overlook. Due diligence on U.S. Treasury securities A general breakdown of least-risky to most-risky is not necessary, but disclosure elsewhere in the portassets is as follows: single-family mortgages, home folio is not very good-usually one footnote someequity loans, commercial business loans, other conwhere. Among the things to watch out for are matusumer loans, commercial real estate loans, and conrity mismatches, for which thrifts are notorious. struction loans. Institutions with high-risk profiles Banks are less notorious for this problem, although and low nonperforming loans are suspect. Beware they do it as frequently. Another item to watch for of institutions with high levels of nonaccrual real is nongovernment-guaranteed mortgage-backed seestate assets and very low amounts of other real curities (or private issues); they do not have as high estate owned, because these loans will migrate into a credit quality. Third, equity portfolios are seldom "other real estate owned" at a prohibitive cost. Gendivulged in financial statements; nor are venture erally speaking, for banks and thrifts, a level of noncapital portfolios, which both banks and thrifts carry. performing assets less than 2 percent in this environJunk bonds are a fading issue since regulators have ment is knocking the ball out of the park; more than cracked down on them. 8 percent is very risky. The regulators are looking for a minimum tangiReserves are an issue that bank and thrift ana52

ble equity-asset ratio greater than 4 percent. If an banks were very bad about disclosing this data. In institution does not have it, the regulators will be all some of the Virginia banks, the undispersed conover its back. Although the thrift industry is not struction lending commitments were between 50 regulated by the Federal Reserve, in time this will be and 100 percent of their outstanding loans. So that a thrift and bank issue and 4 percent will be the floor. in effect, construction exposure was understated by If an institution wants to participate in the consolida50 percent. tion game as an acquiror, the Feds tacitly require an equity-asset ratio between 5 percent and 6 percent. - - - - - - - - - - - - - - - - - - - - - A severe crackdown on capital is taking place. Income Statements

Off-Balance-Sheet Exposures Off-balance-sheet exposures get almost no recognition from analysts. Table 4 shows the types of offbalance-sheet exposures that National City, Ahmanson, and Maryland Federal have. Typically, banks have futures and forward contracts, interest rate exchange agreements, foreign exchange, commitments to extend credit, standby letters of credit, and recourse liability. Thrifts usually limit themselves to futures, forward contracts, and interest rate exchange agreements for managing the difference in the pricing of assets and liabilities. Table 4. Off-Balance-Sheet Exposures

Item Futures and forward contracts Interest rate exchange agreements Caps and floors Foreign exchange contracts Commitments to extend credit Standby letters of credit Recourse liability

National H.F. Maryland City Ahmanson Federal

Yes

Yes

No

Yes Yes Yes

Yes No No

No No No

Yes Yes No

Yes No No

Yes No No

Source: Corporate annual reports.

Thrift analysts can look at several specific areas to estimate the impact of off-balance-sheet operations. The biggest risks are in mismatched interest rates and maturity schedules. Analysts should find out if a thrift has a huge amount of interest rate exchange agreements coming due in any given period and whether it can refinance them at the same cost. Analysts should also check for deferred gains and losses. If a thrift sets up a position and takes a loss in it, it is allowed to defer its losses over a certain period. This can be an opportunity because if these losses go away, the profitability of an institution can go Up. Analysts should also check for undispersed lending commitments. Until about a year ago, the

The income statements for banks and thrifts also look remarkably similar, although there are some differences that are evident in Table 5. The best way to analyze revenues, regardless of the industry, is to look at price and volume. Margins represent pricing; earning assets represent volume. This approach makes estimating earnings on the basis of historical data much easier. Banks have higher margins than thrifts for three reasons. First, they have noninterest-bearing demand deposits. Second, they tend to make riskier loans, so theoretically they should get paid a higher Table 5. Income Statemen~ Three Months Ended June 1990 (millions of dollars, except as noted)

Item Average earning assets Margin Net interest income Provision for losses Net after provision

Other income Item processing Trust fees Deposit fees Credit card fees Mortgage servicing fees Real estate activities Gains on sale of loans and investments Other Total other income

National City

H.P. Maryland Ahmanson Federal

$20,939 $44,168 $750 4.72% 2.95% 2.45% $247.4 (46.7)

$326.0 (57.4)

$4.9 (0.3)

200.7

268.6

4.6

42.8 23.1 23.3 17.6 9.4 0.0

0.0 0.0 19.0 0.0 19.0 (4.0)

0.0 0.0 0.3 0.0 0.1 0.0

4.0 29.9 150.1

M 51.3

0.5

(258.6)

(203.0)

(2.9)

Pretax income PTE adjustment Taxes

92.3 (11.0) (21.0)

117.0 0.0 (56.2)

2.3 0.0 (0.9)

Net income Preferred dividends

60.2 (4.0)

60.8 0.0

1.3 0.0

Net to common

56.2

60.8

1.3

Operating expenses

11.1

0.1

J1Q

Source: Corporate annual reports.

53

rate of interest. Third, banks traditionally have had a lower cost of fund than thrifts, and this goes back to Regulation Q. Many thrifts have not changed their habits. Within a given market area, the thrifts follow the banks' lead and tend to pay between 25 and 75 basis points more for deposits than banks, although logically it is not clear why. Banks have a myriad of income sources. National City, for example, processes most airline tickets and makes sure the airlines get their money. They have trust businesses, which the thrifts do not. Banks are becoming more involved in mortgage servicing, which thrifts have been involved in for a long time. Banks also tend to charge higher fees for deposits. As a rule, thrifts are more dependent on volume of earning assets and what their margins are doing (Le., net interest income) than are banks. As shown in Table 6, J.P. Morgan receives about 67 percent of its revenues from nonlending sources. For Ahmanson and Maryland Federal, only 11 percent and 8 percent, respectively, of their revenues come from noninterest-income sources. Expense ratios, used to figure out how efficient a financial institution is, must be analyzed differently for banks and thrifts. Thrifts look at interest expense as a percent of earning assets. This number ranges from a low of 99 basis points at Golden West to more than 300 basis points at some unnamed thrifts. For banks, the range is from about 176 basis points for Republic New York, one of the tightest run banks in the industry, to about 526 basis points for Norwest. This difference is probably valid, because thrifts derive most of their income from their balance sheets and banks have considerable income derived from off-balance-sheet activities such as item processing and trust fees. Banks tend to look at what is known as an efficiency ratio. This ratio is derived as follows: The denominator is net interest income before loan loss provision and fully taxable equivalent adjustment plus noninterest income less securities gains; the numerator is operating expenses. Golden West's efficiency ratio is about 33 percent. The best in the banking system exceeds 50 percent, which is everyone's goal at this point, but people have had varying success in getting there. The big trade-off is between a higher margin and a higher level of expenses. Banks are more expensive than thrifts to run. They have more product lines, and they have more

54

Table 6. Revenue Allocation-Noninterest Income As a Percent of Total Revenue

Institution

Noninterest Income

J.P. Morgan Mellon Norwest Fleet/Norstar CoreStates National City BankAmerica NCNB Republic N.Y. First Union Suntrust First Wachovia BancOne C&S/Sovran Barnett Banks Dominion Bancshares Wells Fargo Society Key Corporation First Fidelity H.F. Ahmanson Maryland Federal Median noninterest income percentage

67%

44 39 38

37 35

34 32 31 30

29 29 28 28

26 25 24 24 22 22 11

8 28

Sources: Corporate annual reports; Furman Selz.

people. And they have to keep some of their corporate finance people in Park Avenue co-ops. Whether you want to buy bank or thrift stock mainly depends on return on equity. Some thrifts have returns on equity that exceed what a lot of banks can put out. Just look at the bottom line. Banks with return on equity of more than 12 percent trade over book value. The same is true for thrifts. Many of the thrifts I look at are either takeover or liquidation candidates. One criterion people use is book value. One thing to remember is that several thrifts carry a bad debt reserve in their equity accounts; this is usually only disclosed in the original offering circular. Historically, thrifts were able to take loan loss reserves for tax purposes that they did not take for financial reporting purposes. This went into their equity accounts. If a change of control takes place, or if they pay dividends out in excess and cut into this bad debt reserve, they have to pay the government dollar-for-dollar taxes.

Question and Answer session David N. Pringle Robert G. Hottensen, Jr. Question: Both of you have mentioned that savings and loans could look different in the future. Great Western Financial seems to be an example of the new look, particularly on the liability side. Please expand on the changes you envision. Pringle: One obvious change is that many thrifts have started calling themselves banks. Similarly, in New England, where banks have had some trouble, financial institutions are being called trusts rather than banks. Another change will be the creation of large financial institutions that are umbrellas for smaller institutions. I also believe that smaller community-based financial institutions will continue to serve their customers better. Four or five years down the road, some of these smaller financial institutions could become very profitable. There is something about actually knowing customers' names when they walk in the door. Many people still do not want to go to automatic teller machines. Hottensen: Until now, no one has been successful in transforming a basic thrift franchise into a commercial bank. The best performing S&Ls in the marketplace have been those that have milked the franchise and offered only limited services to consumers. In Great Western's favor is a growing buyer's market for well-capitalized survivors. Great Western is like the underachiever in school. Although this company has tremendous potential, it still has a C- stock performance because investors have not realized

its potential. There is a lot of goodwill among its depositors, the basic structure is growing, and it has good capital ratios, but the outcome is not C;l sure bet. Question: Do you think the industry will move to a 6 percent equity ratio? Isn't that too much equity? Pringle: Yes, because most of the problems in the banking system have been caused by the need to employ excess capital. Going forward, return on assets must create ROE. The only way to improve return on assets in a deleveraging environment, such as we have now, is to make customers pay for the services they use. Right now, the insured depository institutions' deposit rates are falling. Because the banking and thrift industries have no loan growth, their return on assets is declining. The only solution is to raise pricing. Hottensen: S&L and bank managers must have the flexibility to manage their equity and assets to the optimum. Strong institutions, such as Golden West, have three options: Repurchase stock, increase dividends, or make acquisitions in an increasingly buyers' market. If they have that kind of flexibility, in which they can demonstrate strength with respect to the regulators, then they will have a lot more of a shock absorber to the downside in their stock prices; in addition, the upside reflects those opportunities as they present themselves down the road. Question:

Should good finan-

cial institutions have their own examiners? Pringle: Not necessarily. The banks that can do that internally without spending a huge amount of money are going to be much better off, have a much more realistic view of the market, and take fewer risks than institutions that do not. The banks that have been most successful in dealing with the current environment have been in the Midwest. One reason is that they never bounced as high off the 1982 and 1983 lows as the rest of the commercial real estate industry. National City never disbanded its bad asset management team from the early 1980s. Manufacturers National never disbanded its team and has a strong cooperation between the asset quality people at the bank and the lending officers. People have to jump through many hoops to write loans. For outside examination, I believe that the Office of the Comptroller of the Currency standards should be applied not only to banks but also to thrifts. According to several people who run the credit quality side of large commercial banks and who have performed due diligence on several Middle Atlantic and Northeast financial institutions, the Comptroller of the Currency has done a more thorough job than the state regulators and the Federal Deposit Insurance Corporation examiners. State examiners and the FDIC have allowed banks to use two-year-old real estate appraisals. Managements still harbor a huge amount of denial, and I think in some cases that is politically motivated. This is evident 63

in the insurance industry as well. So between having an internal or an external examination process, it is probably better to have consistency within the industry, and that is imposed by the Comptroller of the Currency's office. Question: Will the proliferation of thrift initial public offerings continue? How might this affect future thrift buyouts, and who are the potential acquirees? Hottensen: Weare going to see more initial public offerings in the future. The principal beneficiaries will be depositors. The established formula (stock repurchase, reducing expenses above all else) creates value, and investors will have many opportunities. As far as who is going to buy these things, I think the banks will try to issue common stock. I think they would see these kinds of transactions as capital accretive, where they would build asset and liability mass in selected markets. Question: How will the California real estate market affect the big California thrifts? Pringle: That is hard to say, because real estate is a diverse subject, but I think California is still early in the real estate cycle. In commercial real estate, analysts must look at the mix of office buildings, shopping centers, and apartment buildings; how much of the portfolio is construction; and how much is owner-occupied as opposed to developerowned. The office commercial real estate trends in Southern California look amazingly like the trends in New England in 1986 and 1987 and the Washington, D.C., metropolitan area in 1989 and 1990. I understand that vacancies are going up. The effective rental rates, which is a more

64

important factor than vacancies, are starting to plummet. Question: Does an upward sloping yield curve help S&Ls more than banks? Pringle: I do not know if the yield curve by itself is sufficient to determine which group will outperform. Certain yield curves might favor one group over another. For example, with a steep curve, banks may be able to push deposit rates down faster than S&Ls. The real risk is if long rates come down to 7 percent, you essentially nationalize the singlefamily mortgage markets, because Fannie Mae and Freddie Mac will end up with fixed-rate mortgages refinanced by borrowers locking in low interest rates. Hottensen: Well-managed thrifts are surprising investors because the spread improvement has more than offset the weak residential markets and loss of market share through securitization. A lot of thrifts are rebuilding loan loss reserves and improving the quality of their balance sheets. With mortgage interest rates at 8.75 percent now, if the yield curve flattens and mortgage rates go below 8 percent, we will get a wave of refinancing that will be more negative for those companies that are negatively gapped than positive for those same companies given the current yield curve configuration. Question: With low interest rates, will consumers demand only fixed-rate loans? Hottensen: There is much speculation on this issue, and behind the answer lies an important strategy consideration: How do you address the issue of quality asset origination when your strategy up to this point has been to origi-

nate and hold adjustable rate mortgages and drive your earnings with a spread? I do not have the answer, but I think that is the big question for the 1990s. Pringle: The best people to talk to about this are the people who borrow. If you have an adjustable rate mortgage and it is tied to a one-year Treasury, your cost of borrowing has been declining since 1988. As long as the short rates continue to come down at a much faster rate than the long bond, which is what the 15- and 3D-year mortgages trade from, my guess is that you are not going to see as much refinancing as you are going to see people paying down principal balances to cut their risk because they are not sure they are going to have jobs. My feeling is that if long rates come down under 7 percent, a point where many people psychologically would like to lock in a longer term fixed-rate loan, Fannie Mae and Freddie Mac would get huge amounts of volume. Question: Why does the misconception still exist that advances are bad? Federal Home Loan Bank (FHLB) advances have a much lower end cost. Pringle: This raises the question of whether the U.S. government, through the FHLB system, should continue to provide a subsidy for the thrift industry by borrowing at agency rates, which are between 30 and 60 basis points off the Treasury yield curve-rates much lower than any thrift can borrow at elsewhere-and then lend to the thrift industry. From a philosophical standpoint, a free market would probably be better, although it will take some time to work. Wholesale funding in and of itself is not bad. In fact, First Wachovia is starting to reduce

consumer deposits and move into wholesale funding. The Bank of New York is, too, because it is cheaper than running a branch system and paying FDIC insurance. Banks should avoid situations in which a high level of wholesale funding poses funding risk if they have bad-asset prob-

lems. You have seen this in four institutions in the past six months. MNC Financial almost went under at the end of 1990 because it had huge outflows and huge debt payment needs at the holding company level. Southeast Bank Corporation had huge amounts of deposit outflows be-

fore its closing a couple of months ago. Hibernia Corporation is waiting to be closed by the regulators. You do not want to be anywhere near a hot-funded bank when it goes bad, because it unwinds very quickly.

65

Applying Banking Analysis to the Thrift Industry-Similarities and Differences Robert G. Hottensen, Jr. Vice President Goldman, Sachs & Company

Growth in the numbers and types of mortgage lenders has produced excess capacity in this industry. The consequences are likely to be a trend toward consolidation and the demise of inefficient competitors.

The savings and loan industry is not all doom and gloom. Despite the sensationalized news stories describing S&L fraud and identifying the perpetrators, the villain is not just the S&L industry but also excess capacity throughout the broadly defined financial services industry. The S&L industry has been burdened by legislation that supports various infrastructures and tax laws and by banking legislation that, in effect, supports parallel and redundant functions. Sometimes these functions conflict.

Excess Capacity: Sources and Consequences During the 1930s and 1940s, the government created a home lending industry supported by tax laws and the deposit insurance infrastructure, and we call that the savings and loan industry. Concurrently, the federal government chartered Fannie Mae, and later Freddie Mac, empowered to do the same thing. These agencies facilitate the transfer of mortgage assets to the marketplace for the purpose of reducing mortgage interest rates and providing homeowners with access to mortgages. One consequence of creating these institutions has been the decline of the savings and loan industry, but another has been the creation of more than $1 trillion in mortgages held by investors through mortgage-backed securities. The growth of excess capacity has also been the result of the emergence of the capital markets themselves as financial intermediaries. The evidence is clear: Money market mutual funds have grown to the point that they will claim more assets than the entire S&L industry very soon; commercial paper is used as a substitute for commercial bank borrowing; and growth has occurred in asset securitization of

mortgages and just about every other class of private and public indebtedness. These two trends-the parallel and overlapping functions of financial intermediaries and the emergence of the market itself as a direct intermediary-have had a dramatic effect on the outlook for financial companies. One of the consequences of overcapacity is the trend toward consolidation. The stronger, capitalrich banks and S&Ls face a buyer's market, and their market share will continue to expand. The second consequence is financial Darwinism; that is, the most efficient process is beginning to payoff. The marketplace will not continue to support or tolerate inefficient competitors. In the case of the mortgage industry-a $2 trillion industry growing at about 8 percent annually-the most efficient way to intermediate mortgage assets is to make them into commoditiesput them into a securities form, assign a risk factor, charge a guarantee fee, and let the marketplace risk adjust the prepayment risk. This process, called mortgage securitization, has come on like a speeding locomotive. With it, a sophisticated network of companies has evolved to facilitate the process of securitization. Despite the fact that some analysts believe banks and thrifts are efficient originators of mortgage credit, the number of bank-affiliated and nonbank mortgage companies competing in the traditional bank- and thrift-dominated field of mortgage lending has grown rapidly. The thrift share of mortgage holdings has shrunk to 20 percent from 30 percent in just five years; banks are holding steady at about 15 percent. Meanwhile, the leading mortgage company has doubled its market share in the past several years, and mortgage banks are now originating 55

nearly 50 percent of all mortgages. Thrift Industry Structure This new breed of mortgage company is not The structure of the thrift industry has changed sigburdened with expensive bank branching. They nificantly in the past decade. Table 1 shows the originate mortgages to Fannie Mae and Freddie Mac market capitalization of the 10 largest thrifts in 1983 standards, they sell all of their production so they do compared with the 10 largest in 1991. Only 3 companot carry residual interest rate or credit risk, and they nies that were in the top 10 eight years ago are in the are part of a competitive process that keeps mortgage top 10 today. The others are either option-valuerates low and spreads narrow enough to discourage only wards of the Resolution Trust Corporation or less-efficient financial companies, such as S&Ls, gone completely. Of the 10 largest thrifts today, 6 are from becoming portfolio lenders. That is, S&Ls find basically new conversions that have supplanted the mortgage assets less profitable to hold. S&L assets larger companies that have gone under. A $10 equalhave declined sharply in the past several years and weighted investment in this industry in 1983 was worth $5 in 1991. will continue to do so as this financial Darwinism Although the total cumulative market capitalizaplays itself out. tion of the industry has expanded during the past The securitization process has led to the emereight years, it is still less than $10 billion. The 10 gence of a strong and growing group of financial largest firms in the S&L industry have about oneintermediaries, including mortgage banking compathird of Fannie Mae's and Freddie Mac's total market nies, mortgage insurance companies, and Fannie capitalization. Ignoring the top three companies, Mae and Freddie Mac, all of which benefit from Fannie Mae alone is three times larger than the next financial Darwinism. For example, during the past seven companies combined. several years, the mortgage insurance business has Table 1 also shows the earnings asset size of the undergone a stunning revival as it has adapted to the largest 10 companies in 1983 and in 1991. Taken surging trend in securitization. Now it has a growtogether, the assets of these companies have grown ing niche within the financial services business. at a compound annual rate of only about 3 percent.

Table 1. Market capitalization and Average Earnings Assets Size, 10 Largest Thrifts, 1983 and 1991

Company Name

Price

Market Capitalization ($millions)

Average Earnings Assets Size ($millions)

1983 H.F. Ahmanson Great Western Financial Corporation California Federal S&L PSFS Financial Corporation of America Golden West Financial Corporation Home Federal Savings & Loan Gibraltar Financial Corporation City Federal Savings & Loan Imperial Corporation of America Total average earnings assets

27.7 27.8 20.4 35.0 15.3 20.6 20.5 16.2 12.8 14.2

$30.70 22.00 21.25 11.25 20.25 14.75 14.00 10.38 11.13 9.13

$850.4 611.2 433.3 393.8 309.8 303.6 286.6 168.4 142.4 129.6

$16,185 16,539 11,369 9,536 12,834 7,287 5,494 5,287 4,819 5,133 $94,483

1991 Golden West Financial Corporation Great Western Financial Corporation H.F. Ahmanson Washington Federal Savings Washington Mutual Savings Bank Standard Federal Bank JSB Financial, Inc. Downey Savings & Loan FirstFed Financial Corporation Cragin Financial Corporation Total average earnings assets

63.5 128.9 116.0 21.7 15.5 30.7 14.6 16.2 8.2 10.4

$39.13 16.38 16.63 36.50 29.63 14.63 18.63 14.75 28.75 21.00

$2,482.9 2,110.3 1,928.1 793.5 460.0 449.5 272.5 238.4 236.6 218.9

$22,366 36,725 47,176 2,558 6,503 8,694 1,567 3,649 2,953 2,429 $134,620

Source: Company reports.

56

Shares (millions)

Five of the largest companies today have less than $5 billion in assets. In 1983, virtually none of the largest savings and loans had less than $5 billion in assets. Thus, smaller companies are comprising more of the industry's market capitalization, as is evident in Figure I, Figure 2, and Figure 3, which show composite price performance for various companies between 1982 and 1990. Figure 1. Composite Price Perfonnance, selected Thrifts, December 1982-october 1991

Figure 3. Composite Price Perfonnance, selected Finns, December 1982-october 1991 19S2 = 100 900,-----------SOO 700 600 500 400 300 200 ~( 100

O:-:--~::_:___~=______:~-_:'_:::_---'-------l---'----l.....--.J ~

~

19S2 = 100 900 r-----------------~ SOO 700 600 500 400 300 200 100/--,

o' ::":S3::----;:'S::-:4:----:'SS 7:::---':-:-S6-:----:-::'S'=7--:-:'S'=S---,-'S-:-:9:---'c:'-90:-----,-J'9-1---' WFSL, FED, GDW GDW, GWF, AHM, WFSL, WAMU Key: WFSL

Financial Corporation FED = FirstFed Financial Corporation GDW = Golden West FinanciafCorporation GWF = Great Western Financial Corporation AHM = H.E Ahmanson WAMU = Washington Mutual Savings Bank

Source: Goldman, Sachs & Company.

Figure 2. Composite Price Perfonnance, selected Financial Institutions, December 1982October 1991 ------"

0'8=3:----:'S"-::4--:-:'S'=S--:-:'S"-::6--:-:'S"=7:-----'SLS--'SL9--'9LO--'9Ll----l

- - FED, WFSL, GDW - - - STBK, ONE, WB

Key: FED = FirstFed Financial Corporation WFSL = Washington Federal Savings Financial Corporation GDW = Golden West Financial Corporation STBK = State Street Bancorp ONE = BancOne WB = Wachovia Bank

Source: Goldman, Sachs & Company.

~

~

~

w

w

~

~

- - FED, WFSL, GDW - - - MRK, KO, BMY Key: FED

= FirstFed Financial Corporation GDW = Golden West FinanciafCorporation WFSL = Washington Federal Savings MRK = Merck = Coca-Cola KO BMY = Bristol Myers

Source: Goldman, Sachs & Company.

Determinants of Growth

= Washington Federal Savings

1982 = 100 900,-----------SOO 700 600 500 400 300 200 100

--,,-,

Like the banking industry, the thrift industry is asset based, and its principal engine of growth is asset growth. Such factors as expense control and asset quality merely cause some cyclical noise. Assuming good credit quality and proper expense control, the important things to look at in any asset-based financial company are how fast the relevant market is growing and the company's share in that growth; these factors are what drive earnings. The pool of mortgage debt is one of the determinants of asset growth, and changes in that pool are a good indication of how fast the market is growing. Table 2 shows residential mortgage debt outstanding from 1975 through 1990. Residential mortgage debt has never declined, although its growth rate is somewhat cyclical. It has been as low as 4 percent in 1982, when the prime rate was 21.5 percent, and it has been high when interest rates are near or below 10 percent. Many analysts prefer to look at residential mortgage originations, shown in Table 3, which tend to be more variable and cyclical than mortgage debt outstanding. They are not particularly relevant for assessing growth opportunities, however. We look at originations to analyze Fannie Mae and Freddie Mac growth expectations and targets. Despite the recession, 1990 was the third biggest year in mortgage originations. The growing number of mortgage refinancings, prompted by interest rate declines throughout the year, is the most likely explanation for the increased volume of mortgage originations. 57

Table 2. Residential Mortgage Debt Outstanding By Property Type, 1975-90 (billions of dollars, except as noted)

Year

Total Residential"

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 b 1990

$516.5 580.4 672.5 778.5 890.4 971.4 1,027.2 1,066.0 1,157.8 1,328.2 1,455.2 1,916.2 1,916.2 2,126.3 2,339.5 2,575.8

Percent Change

Total 1-4 Family

Percent Change

12.4 15.9 15.8 14.4 9.1 5.7 3.8 8.6 14.7 9.6 16.6 12.9 11.0 10.0 10.1

$434.6 493.0 578.7 677.6 783.5 857.5 913.9 948.1 1,032.2 1,182.6 1,294.4 1,506.9 1,709.3 1,902.8 2,108.5 2,343.3

13.4 17.4 17.1 15.6 9.4 6.6 3.7 8.9 14.6 9.5 16.4 13.4 11.3 10.8 11.1

Total Multifamily

Percent Change

$81.9 87.4 93.8 100.9 106.9 113.9 113.3 117.9 125.6 145.6 160.8 190.0 206.9 223.5 231.0 232.5

6.7 7.3 7.6 5.9 6.5 -0.5 4.1 6.5 15.9 10.4 18.2 8.9 8.0 3.4 0.6

Sources: Department of Housing and Urban Development; Fannie Mae. "Excludes farm and construction loans. b A new methodology was adopted in January 1990 that makes 1990 data not strictly comparable with previous periods.

Table 3. Originations of Residential Mortgage Loans by Property Type, 1970-90 (billions of dollars) Year

Total

Total

1-4 Family FHA VA Conventional

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990"

$44.4 70.2 91.3 93.3 79.8 88.5 125.1 177.8 201.3 202.3 146.3 110.1 108.7 223.4 231.3 275.0 504.8 495.4 421.8 383.2 484.8

$35.6 57.8 75.9 79.2 67.5 77.9 112.8 162.0 185.0 187.1 133.8 98.1 97.0 201.9 203.7 243.1 455.0 450.3 383.6 352.0 453.1

$8.8 11.0 8.5 5.2 4.5 6.3 7.0 10.5 14.6 20.7 15.0 10.5 11.5 28.8 16.6 28.4 62.0 52.3 32.6 34.6 59.2

$3.8 6.8 7.7 7.6 7.9 8.8 10.4 14.9 16.0 18.9 12.1 7.5 7.7 18.9 12.0 15.6 30.9 21.8 13.2 10.2 21.4

$23.0 40.0 59.7 66.4 55.1 62.8 95.4 136.6 154.4 147.5 106.7 80.1 77.8 154.2 175.1 199.1 362.1 376.2 337.8 307.2 372.5

Total $8.8 12.4 15.4 14.1 12.3 10.6 12.3 15.8 16.3 15.2 12.5 12.0 11.7 21.5 27.6 31.9 49.8 45.1 38.2 21.2 31.7

Multifamily Conventional FHA $1.9 2.8 3.2 3.1 3.4 2.1 2.0 2.2 3.2 3.9 3.9 3.9 4.1 4.0 4.7 3.5 8.7 6.8 3.0 1.0 2.0

$6.9 9.6 12.2 11.0 8.9 8.5 10.3 13.6 13.1 11.3 8.6 8.1 7.6 17.5 22.9 28.4 41.1 38.3 35.2 30.2 29.7

Sources: Department of Housing and Urban Development; Fannie Mae. Note: Beginning with the second quarter of 1984, data include originations by the federal savings banks. "A new methodology was adopted in January 1990 that makes 1990 data not strictly comparable with the previous periods.

58

Ironically, despite the large volume of originations, the thrift industry is losing market share to the mortgage banking companies and the bank-affiliated mortgage companies, which are handling a large number of the refinancings. These organizations are originating mortgages to Fannie Mae and Freddie Mac standards, securitizing the assets, and then flowing the mortgages through to the capital markets. This explains why Fannie Mae and Freddie Mac are experiencing growth in their total pool of mortgage debt at basically double the growth rate of the market for mortgage loans. The structure of the mortgage market is changing. Table 4 presents residential mortgage debt outstanding from 1975 to 1990 by lender/guarantor. The 5&L share of the residential mortgage debt outstanding has dropped from its peak of 50 percent in the late 1970s to roughly 20 percent in 1990. In 1990, 5&Ls and mutual savings banks combined had only 22 percent of the market. Banks are holding steady at around 15-17 percent. In contrast, Fannie Mae and Freddie Mac have grown from 0 to 22 percent of the market. In this environment, it is difficult for 5&Ls to grow their assets. Although the market is growing,

Figure 4. Ratio of Interest-Earning Assets to Interest-Bearing Uabilities, 5elected Thrifts 110 .,...-

..,·..,

.M'~

...

')

108 106

@104 Iil 102

0..

100 98 96

9/'90

12/'90 •

3/'91

6/'91

FED, WFSL, GDW

DGWF,AHM

= FirstFed Financial Corporation WFSL = Washington Federal Savings Financial Corporation GDW = Golden West Financial Corporation GWF = Great Western Financial Corporation AHM = H.E Ahmanson

Key: FED

Source: Company reports.

it is growing in ways that are not helpful to the whole industry. Offsetting that trend are the tremendous consolidation opportunities that will be available to a few companies.

Table 4. Residential Mortgage Debt Outstanding by Lender/Guarantor, 1975-90

Year

Totala ($billions)

S&Ls

Mutual Savin9,S Banks

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990d

$574.9 643.0 747.7 865.6 987.6 1,076.4 1,142.9 1,190.3 1,297.7 1,477.0 1,596.8 1,839.3 2,055.2 2,258.4 2,484.9 2,712.5

44% 45 46 50 44 43 42 37 34 36 34 30 28 28 25 20

11% 11 10 9 8 8 7 7 6 6 4 4 5 5 5 2

Commercial Banksb

Life Insurance Agencies

State & Local Credit Agencies

15% 15 16 17 17 17 17 16 16 15 15 15 15 16 17 17

7% 7 5 5 5 5 4 4 4 3 3 2 2 2 2 2

2% 2 2 2 2 3 4 4 4 5 5 5 5 4 4 4

Federal Credit Agencies 12% 8 10 10 10 11 12 13 12 12 11 9 8 7 8 7

Mortgage-Backed Securities Ginnie Fannie Mae/ Freddie Macc Otherc Mae 3% 5 6 6 8 9 9 10 12 12 13 14 15 15 15 15

0% 0 1 1 2 2 2 5 6 7 10 14 17 18 20 22

5% 7 4 4 4 4 4 4 4 4 5 5 5 6 6 11

Sources: Department of Housing and Urban Development; Fannie Mae; Freddie Mac; Ginnie Mae; Federal Reserve Board. Note: Percentages may not total 100 because of rounding. aIncludes construction and farm loans. b HUD made substantial revisions to the mortgage data in 1985 and 1986, resulting in higher volume for commercial banks and

lower volume for mutuals. cHUD double-counts Fannie Mae and Freddie Mac mortgage-backed securities, so they are overstated by that amount. This is also true of the "other" category. Also, the Fannie Mae/Freddie Mac mortgage-backed securities do not include Freddie Mac derivative securities; the Fannie Mae portion is net of such securities. d A new methodology was adopted in January 1990 that makes 1990 data not strictly comparable to previous periods.

59

Profitability Interest rate spreads are important to the valuation of thrift institutions. Figure 4 shows the ratio (in percentages) of interest-earning assets to interestbearing liabilities for FirstFed Financial, Washington Federal Savings, and Golden West Financial and for Great Western Financial and H.P. Ahmanson. This statistic is important because it represents several favorable practices. The more interest-earning assets exceed interest-bearing liabilities, the more the institution's net worth is in cash and the more the net worth itself becomes a hedge against rising interest rates. The ratio tells you something about nonperforming assets, noncash forms of earnings, and so forth. If a firm is building up cash, this relationship gets stronger, as evidenced by the ratios for the strong companies, shown in Figure 4. With the California thrifts, it is also important to compare the funding advantage or disadvantage to the 11th District cost-of-funds index, which is the principal index on which most of the adjustable rate loans are based. (Most thrifts in other regions of the country use other indexes.) Figure 5 shows that Great Western and Ahmanson have structural advantages, even over Golden West and FirstFed, in being able to fund efficiently relative to the index. All things being equal, a 250-basis-point contractual spread on an adjustable rate loan would translate into a 300-basis-point spread, factoring in the funding advantage of, say, 50 basis points on the loan. This is an important factor in assessing the strength of the future survivors-their continued ability to fund very closely to the banks, to fund below the competition, and to offset what has been a natural Figure 5. Funding Advantage Relative to 11th District Cost~f- Funds Index, 5eIected california Thrifts, January to september 1991

spread compression with more-efficient expense ratios and lower funding costs. FirstFed is an example of a thrift that has done things right for the past six or seven years. Table 5 presents some of its operating figures, including its expense ratio for 1985 through 1990 and estimates for 1991 and 1992. During this six-year period, its asset size will have tripled from $1.2 billion to $3.6 billion. The head count grew only about 25 percent from 322 to just less than 400 at year-end 1990. This has had a favorable effect on the expense ratio. The assethead-count ratio has been expanding, showing that the company has been more productive. Also, the coverage ratio (net interest income as a percentage of operating expenses) has shown continuous improvement. Interestingly, this company has generated a return on equity of more than 15 percent for six straight years, and its compound annual growth rate in earnings is more than 20 percent. The formula for success in the thrift industry is fairly simple. It is basically making a dime a day and making it the hard way. That is not a very appealing way to run a depository institution, but in hindsight, if this had been the approach that most S&L managements had taken, perhaps we would see more success stories or more companies that we could use in an index comparable to the strongest banks. Asset returns are basically driven by a leverage factor that shows a return on equity. A very important element in maintaining steady return on assets is an improving expense ratio. As Figure 6 shows, strong companies exhibit fairly steady and consistent Figure 6. Composite Return on Assets, selected Thrifts, september 1989-September 1991 1.8 , - - - - - - - - - - - - - - - - - - - - - , 1.6 1.4

C 1.2 <J)

~

<J) P-.

"

1.0 " " 0.8 ,,/ 0.6 0.4 0.2 L-_--L_---.L_-.l_ _.L-_---.L_--..L L--------l 9/'89 12/'89 3/'90 6/'90 9/'90 12/'90 3/,91 6/'91 9/'91

- - FED, GDW, WFSL - - - WFSL, GDW, AHM, GWF, WAMU Feb.

Mar.

Apr.

May

June

July

Aug. Sep.

--GDW,FED - - - GWF,AHM Key: GDW = Golden West Financial Corporation

FED = FirstFed Financial Corporation GWF = Great Western Financial Corporation AHM = H.E Ahmanson

Key: FED

GDW WFSL

= FirstFed Financial Corporation = Golden West FinanciafCorporation = Washington Federal Savings

Financial Corporation AHM = H.E Ahmanson GWF = Great Western Financial Corporation WAMU = Washington Mutual Savings Bank

Source: Company reports. Note: Excludes loss for Washington Mutual Savings Bank for the

Source: Company reports.

60

quarter ended December 1990.

Table 5. FirstFed Financial Corporation,5elected Operating Data, 1985-92

Year

Ratio (Operating Expenses to Total Earnings Assets)

Head Count

Asset Size ($billions)

Assets/Head Count ($millions)

1985 1986 1987 1988 1989 1990· 1991E 1992E

2.05% 2.28 1.96 1.53 1.49 1.54 1.50 1.46

322 369 376 373 374 398 NA NA

$1.2 1.5 1.9 2.2 2.6 3.1 3.4 3.6

$3.8 3.9 5.0 6.0 6.9 7.8 NA NA

Coverage Ratio

137.2% 144.6 169.0 182.3 182.9 214.1 248.9 240.3

Return on Equity

15.9% 22.1 17.6 17.6 16.5 16.7 16.9 17.1

Source: Company reports. ·Calculated excluding a one-time expense of $1.2 million related to litigation recorded in the first quarter. The ratio including the extra expense is 1.60 percent.

asset returns. They also exhibit fairly steady and consistent equity returns, as shown in Figure 7. High-performance companies also have no capital constraints. As shown in Figure 8, not only the level of capital but also the direction in trend is favorable.

New Competitors A new class of 5&L has come into the marketplace during the past six months. Table 6 presents data for three examples of this new breed-Cragin Financial, J5B Financial, and N.5. Bancorp. All of these companies have recently converted to public ownership. Figure 7. Composite Return on Equity, selected Thrifts, 5eptember 1989-September 1991 22.5 , - - - - - - - - - - - - - - - - - - - , 20.0 17.5 ~ 15.0 \ \ U

&12.5

,/

,

,

,/,/

/

''-

/

'- / 10.0 ' 7.5 5.0 L--_-l.-_---.L_-----l..-_-----'_ _L-_...l-_-'--_--' 9/'89 12/'89 3/'90 6/'90 9/'90 12/'90 3/'91 6/'91 9/'91

- - FED, GDW, WFSL - - - WFSL,GDW,AHM,GWF, WAMU

Key: FED GDW WFSL

= =

=

AHM = GWF = WAMU =

FirstFed Financial Corporation Golden West FinanciafCorporation Washington Federal Savings Financial Corporation H.E Ahmanson Great Western Financial Corporation Washington Mutual Savings Bank

They have large market capitalizations relative to assets and overabundant capital ratios. They are usually depository institutions, focused on very efficient depository networks that cater to specific ethnic groups or local populations that tend to save a lot. As a result, they have large dollar balances per account and per branch. This translates into very efficient depositories that have strong capital ratios. Companies of the new breed typically have higher loan-loss reserves than nonperforming assets. They have fortresslike balance sheets. Their only problem is that they cannot generate assets. Figure 8. Composite Tangible Equity/Assets, selected Thrifts, 5eptember 1989september 1991 7.75,.--------------------, 7.5 7.25 7.0 "E 6.75 ~ 6.5 ~ 6.25 6.0 5.75 -----5.5 _ - - - - - - 5.25 L--_-L-_---L--_-----l..-_---L_ _L-_-'-----_---L-_----' 9/'89 12/'89 3/'90 6/'90 9/'90 12/'90 3/'91 6/'91 9/'91 - - FED, GDW, WFSL - - - WFSL, GDW, AHM, GWF, WAMU

Key: FED GDW WFSL

= FirstFed Financial Corporation

= Golden West Financial Corporation

= Washington Federal Savings

Financial Corporation AHM = H.E Ahmanson GWF = Great Western Financial Corporation WAMU = Washington Mutual Savings Bank

Source: Company reports.

Source: Company reports.

Note: Excludes loss for Washington Mutual Savings Bank for the quarter ended December 1990.

Note: Excludes loss for Washington Mutual Savings Bank for the quarter ended December 1990.

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Table 6. Summary Data for Recent Conversions, september 30, 1991 Item

CRGN

JSBF

NSBI

$20.75 $18.75 $18.00 Price 11/1/91 Total assets ($millions) 2,630 1,654 1,362 Nonperforming assets/ assets ratioa 0.85% 0.18% 0.67% 11.36 19.87 15.47 Equity / assets ratio Regulatory capitalization ratiosb Tangible 7.87 15.73 11.79 11.79 Core 8.85 15.73 34.91 25.21 Risk-based 19.35 Book value $22.23 $27.31 $22.78 Price/book ratio 76% 82% 81% Return on average earning asset 1.15 0.91 2.07 12.38 9.18 4.17 Return on equity

Source: Company reports. aFor CRGN and NSBI, ratios equal nonperforming loans to total assets and nonperforming loans to total loans, respectively. bCapital ratios for JSBF and CRGN are for the quarter ended June 1991. Key:

62

CRGN JSBF NSBI

Cragin Financial Corporation JSB Financial, Inc. NS. Bancorp, Inc.

They cannot grow their assets in a way that will drive the engine of growth in earnings. Therefore, they have decided to stick with what they have and tread water on asset growth rather than leverage their balance sheets by making out-of-state loans or going into a new asset category and simply holding still or growing their assets only slightly. As long as the stock market values the total equity at less than book value, it makes sense for these companies to repurchase stock. The regulators have been hospitable toward this move, and all three of these companies have announced or commenced significant stock repurchase programs. N.S. Bancorp, which went public less than a year ago, has already repurchased 10 percent of its total market capitalization. Assuming no change in their expense ratios, spreads, and asset growth, repurchasing stock will result in nice earnings growth. This is ironic in an industry that has a shortage of capital, but it obviously reflects the inequitable distribution between the haves and the have-nots. Analysts should be aware that these companies are emerging. They have been a bright spot in this industry, and I believe these are the kinds of companies that are poised to create investor value.

Question and Answer session David N. Pringle Robert G. Hottensen, Jr. Question: Both of you have mentioned that savings and loans could look different in the future. Great Western Financial seems to be an example of the new look, particularly on the liability side. Please expand on the changes you envision. Pringle: One obvious change is that many thrifts have started calling themselves banks. Similarly, in New England, where banks have had some trouble, financial institutions are being called trusts rather than banks. Another change will be the creation of large financial institutions that are umbrellas for smaller institutions. I also believe that smaller community-based financial institutions will continue to serve their customers better. Four or five years down the road, some of these smaller financial institutions could become very profitable. There is something about actually knowing customers' names when they walk in the door. Many people still do not want to go to automatic teller machines. Hottensen: Until now, no one has been successful in transforming a basic thrift franchise into a commercial bank. The best performing S&Ls in the marketplace have been those that have milked the franchise and offered only limited services to consumers. In Great Western's favor is a growing buyer's market for well-capitalized survivors. Great Western is like the underachiever in school. Although this company has tremendous potential, it still has a C- stock performance because investors have not realized

its potential. There is a lot of goodwill among its depositors, the basic structure is growing, and it has good capital ratios, but the outcome is not C;l sure bet. Question: Do you think the industry will move to a 6 percent equity ratio? Isn't that too much equity? Pringle: Yes, because most of the problems in the banking system have been caused by the need to employ excess capital. Going forward, return on assets must create ROE. The only way to improve return on assets in a deleveraging environment, such as we have now, is to make customers pay for the services they use. Right now, the insured depository institutions' deposit rates are falling. Because the banking and thrift industries have no loan growth, their return on assets is declining. The only solution is to raise pricing. Hottensen: S&L and bank managers must have the flexibility to manage their equity and assets to the optimum. Strong institutions, such as Golden West, have three options: Repurchase stock, increase dividends, or make acquisitions in an increasingly buyers' market. If they have that kind of flexibility, in which they can demonstrate strength with respect to the regulators, then they will have a lot more of a shock absorber to the downside in their stock prices; in addition, the upside reflects those opportunities as they present themselves down the road. Question:

Should good finan-

cial institutions have their own examiners? Pringle: Not necessarily. The banks that can do that internally without spending a huge amount of money are going to be much better off, have a much more realistic view of the market, and take fewer risks than institutions that do not. The banks that have been most successful in dealing with the current environment have been in the Midwest. One reason is that they never bounced as high off the 1982 and 1983 lows as the rest of the commercial real estate industry. National City never disbanded its bad asset management team from the early 1980s. Manufacturers National never disbanded its team and has a strong cooperation between the asset quality people at the bank and the lending officers. People have to jump through many hoops to write loans. For outside examination, I believe that the Office of the Comptroller of the Currency standards should be applied not only to banks but also to thrifts. According to several people who run the credit quality side of large commercial banks and who have performed due diligence on several Middle Atlantic and Northeast financial institutions, the Comptroller of the Currency has done a more thorough job than the state regulators and the Federal Deposit Insurance Corporation examiners. State examiners and the FDIC have allowed banks to use two-year-old real estate appraisals. Managements still harbor a huge amount of denial, and I think in some cases that is politically motivated. This is evident 63

in the insurance industry as well. So between having an internal or an external examination process, it is probably better to have consistency within the industry, and that is imposed by the Comptroller of the Currency's office. Question: Will the proliferation of thrift initial public offerings continue? How might this affect future thrift buyouts, and who are the potential acquirees? Hottensen: Weare going to see more initial public offerings in the future. The principal beneficiaries will be depositors. The established formula (stock repurchase, reducing expenses above all else) creates value, and investors will have many opportunities. As far as who is going to buy these things, I think the banks will try to issue common stock. I think they would see these kinds of transactions as capital accretive, where they would build asset and liability mass in selected markets. Question: How will the California real estate market affect the big California thrifts? Pringle: That is hard to say, because real estate is a diverse subject, but I think California is still early in the real estate cycle. In commercial real estate, analysts must look at the mix of office buildings, shopping centers, and apartment buildings; how much of the portfolio is construction; and how much is owner-occupied as opposed to developerowned. The office commercial real estate trends in Southern California look amazingly like the trends in New England in 1986 and 1987 and the Washington, D.C., metropolitan area in 1989 and 1990. I understand that vacancies are going up. The effective rental rates, which is a more

64

important factor than vacancies, are starting to plummet. Question: Does an upward sloping yield curve help S&Ls more than banks? Pringle: I do not know if the yield curve by itself is sufficient to determine which group will outperform. Certain yield curves might favor one group over another. For example, with a steep curve, banks may be able to push deposit rates down faster than S&Ls. The real risk is if long rates come down to 7 percent, you essentially nationalize the singlefamily mortgage markets, because Fannie Mae and Freddie Mac will end up with fixed-rate mortgages refinanced by borrowers locking in low interest rates. Hottensen: Well-managed thrifts are surprising investors because the spread improvement has more than offset the weak residential markets and loss of market share through securitization. A lot of thrifts are rebuilding loan loss reserves and improving the quality of their balance sheets. With mortgage interest rates at 8.75 percent now, if the yield curve flattens and mortgage rates go below 8 percent, we will get a wave of refinancing that will be more negative for those companies that are negatively gapped than positive for those same companies given the current yield curve configuration. Question: With low interest rates, will consumers demand only fixed-rate loans? Hottensen: There is much speculation on this issue, and behind the answer lies an important strategy consideration: How do you address the issue of quality asset origination when your strategy up to this point has been to origi-

nate and hold adjustable rate mortgages and drive your earnings with a spread? I do not have the answer, but I think that is the big question for the 1990s. Pringle: The best people to talk to about this are the people who borrow. If you have an adjustable rate mortgage and it is tied to a one-year Treasury, your cost of borrowing has been declining since 1988. As long as the short rates continue to come down at a much faster rate than the long bond, which is what the 15- and 3D-year mortgages trade from, my guess is that you are not going to see as much refinancing as you are going to see people paying down principal balances to cut their risk because they are not sure they are going to have jobs. My feeling is that if long rates come down under 7 percent, a point where many people psychologically would like to lock in a longer term fixed-rate loan, Fannie Mae and Freddie Mac would get huge amounts of volume. Question: Why does the misconception still exist that advances are bad? Federal Home Loan Bank (FHLB) advances have a much lower end cost. Pringle: This raises the question of whether the U.S. government, through the FHLB system, should continue to provide a subsidy for the thrift industry by borrowing at agency rates, which are between 30 and 60 basis points off the Treasury yield curve-rates much lower than any thrift can borrow at elsewhere-and then lend to the thrift industry. From a philosophical standpoint, a free market would probably be better, although it will take some time to work. Wholesale funding in and of itself is not bad. In fact, First Wachovia is starting to reduce

consumer deposits and move into wholesale funding. The Bank of New York is, too, because it is cheaper than running a branch system and paying FDIC insurance. Banks should avoid situations in which a high level of wholesale funding poses funding risk if they have bad-asset prob-

lems. You have seen this in four institutions in the past six months. MNC Financial almost went under at the end of 1990 because it had huge outflows and huge debt payment needs at the holding company level. Southeast Bank Corporation had huge amounts of deposit outflows be-

fore its closing a couple of months ago. Hibernia Corporation is waiting to be closed by the regulators. You do not want to be anywhere near a hot-funded bank when it goes bad, because it unwinds very quickly.

65

Understanding Insurance Industry Basics David Seifer, CFA Vice President, Equity Research Donaldson, Lufkin & Jenrette Securities, Inc.

Trends in insurance continue to evolve as the industry learns the lessons of the 1980s and tunes up for the 1990s. These include consolidation among life insurers, growth in disability income and long-term care products, and a general tightening of the automobile market.

The life insurance industry is now investing all its new cash flow in the highest quality, most liquid assets available in the marketplace. This emphasis on quality will reduce the percentage of marginal assets in the portfolio over time. In addition, higher quality assets invested at lower yields are limiting the rates of return being promised to new policyowners. This improved quality of invested assets and reduction in promised returns should improve product margins and invested asset quality from the highly competitive conditions of the 1980s. In an attempt to provide their sales forces with competitive products, regardless of the profit margin consequences, many life insurers in the 1980s focused on offering products emphasizing potential yield rather than capital preservation. Investments made to match those unrealistically competitive products included those four horsemen of the apocalypse: junk bonds, marginal real estate, collateralized mortgage loans, and leveraged buyout bank paper. Those companies must now correct the cash flow problems caused by lost investment income from nonpaying junk bonds and nonperforming real estate investments.

Industry Trends We expect positive life insurance and annuity product cash flow invested in high-quality assets to reduce the percentage of marginal assets outstanding in life insurer portfolios. The combination of premium income, income from the reinvestment of maturing assets, and income from invested assets and capital and surplus should generate a revenue stream that covers benefit payments, administration and acquisition expenses, taxes and dividends, and most important, problem assets. We calculate that

66

the investment of 1992-93 cash flow in high-quality assets will reduce below-investment-grade assets to inconsequential levels. The caveats are that life insurers must have a premium-generating capability and that the products sold must have positive operating margins. The slowdown in individual life and group health premium growth reflects business maturation. The result will be a slowing of cash flow and investment income. What are the defenses for a life insurer when its revenue sources are diminishing and its tax rate is rising? Reduce costs. Merge. Consolidate. Tighter underwriting may have some impact on benefits paid, but contract terms and risk-exposure analysis are longer term influences. Agent compensation is being reviewed, but we observe little change in the heaping commission approach to agent production that has been in place for many years. The new tax on deferred acquisition costs has led mutual life insurers to reduce their participating dividend payment programs. Stock life insurers, marketers of nonparticipating contracts, are reviewing agent commissions and product prices, but no clear trend has yet emerged. We look for aggressive attacks on general and administrative expenses to reduce unit costs and rebuild operating margins in an environment of slower revenue growth. Historically, group health indemnity programs have been cyclical, reflecting pricing based on claims-cost experience. Health providers, primarily hospitals and doctors, have initiated product price increases at roughly twice the average inflation rate. When analyzing a typical industrial manufacturer's cost of goods sold, employee benefits would be the largest or second-largest component. To limit this seemingly uncontrollable growth in cost of goods

sold, insurers have been building managed health care programs in which health care providers are under contract and expenses can be tied into a defined revenue-expense relationship. Although the movement is still in the development stage, health care insurance providers are pushing aggressively to transfer their clients with better experience ratings from indemnity to managed care or contractual revenue-expense programs. A life insurance company portfolio provides a lot of information about the company. Increasingly during the past two years, companies have been emphasizing liquidity and quality as their primary objectives. Cash flow is a significant item to watch. Companies that have healthy cash flows will be reducing their problem assets as a percentage of the total. Those with shrinking cash flows will be the companies to be cautious about, because they will not be able to reduce their problem assets. The argument about marking portfolios to market continues. Now would be a great time for the insurance industry to do this, because it would be painless. Anything that increases conservatism will increase consumer confidence, and that is to the investor's benefit. Marking to market will be standard in the near future, and the companies should accelerate the changeover while they have the unrealized profits. Today, most insurance companies claim that the market value of their bonds exceeds cost, and most stock portfolios are throwing off unrealized gains. Real estate and mortgage values vary among individual portfolios.

Insurance Products and Profits Life-health-annuity purchase programs have evolved during five phases or groupings. First was the purchase of individual life-health insurance programs. Second was the addition of group life-health products. We are currently near the end of the third phase, the purchase of annuities. People are concerned that Social Security or corporate pension-retirement programs may not be available when needed. We expect the fourth phase to concentrate on disability income insurance programs. A family whose primary wage earner is unable to work and incurring medical expenses could be financially devastated. The working class market is still underinsured when it comes to disability income programs. Only about a fourth of all working people in the U.S. have some form of disability insurance. We believe this will be the next important insurance product sold. Another emerging product is long-term health care, including the cost of nursing homes and later-

life maintenance care programs. Few insurance products for long-term care are available at this time because the insurance industry has not developed programs that offer the policyholder an attractive benefits product that can still be profitable for the insurer. Still to be developed, long-term care products represent the next big insurance market.

Life Insurance Life insurers have shown growth in assets, earnings, and net worth, but few have demonstrated strong internal revenue growth, which is inhibiting priceearnings ratios. The life insurance industry needs to develop new revenue-producing products that can generate premium growth, offer good value to prospective policyholders, and also generate profits for the insurer. Premium growth on profitable products remains the missing ingredient to improving life insurer price-earnings ratios. The life insurance industry made a huge mistake in the mid-1980s. Until then, insurance industry cash-value products were paying out 4.5 percent and 5.5 percent a year. During periods of high inflation, the insurance companies could invest the cash at 10 percent, with the spread going to net worth. Then, the insurance industry reacted to perceived pressures from banks and savings and loans by introducing interest-sensitive products to answer the concerns about disintermediation, interest rate, and inflation. Life insurers replaced their cash-value programs with interest-sensitive products, eliminated low-cost cash flow and investment income resources, and replaced them with minimal-margin products that had high acquisition costs. This strategy pushed a life insurance company's break-even point from six years to perhaps never. Now, the policyholder gets that investment income spread advantage; the stockholder gets very little. By transferring cash flow to the policyowner, the life insurance industry has reduced the compounding of its cash flow through its capital account. The switch from a cash flow product to an interest-sensitive product was a mistake. With interest rates where they are today, the interest-sensitive products are paying about the same as cash flow products. A lot of consolidation is likely in the life insurance industry. Many life insurance companies, from a marketing standpoint, are no longer a factor. Virtually no one is selling interest-sensitive products. In fact, the growth rate for new life insurance premiums is down to the low single digits. Most people seem to feel they have enough individual life insurance. Group health and life programs for those who can get them seem to be fairly well saturated. The 67

growth rate of group program premiums is in the high single digits.

Annuities In the United States, many people are looking at the alternatives for retirement income. They fear that Social Security will not be there when they retire and that their pension programs may be compromised as corporations consolidate. As a result, they are buying annuities heavily. Annuities are a cash drain on the capital of life insurance companies, but that is their primary product now. The market for annuities is competitive, and they do not have a lot of margin. One positive factor for insurance companies with portfolios of older age annuities yielding, say, 8.5 percent is that, even though interest rates are coming down, that portfolio yield is coming down more slowly than the prime rate. Insurance companies are now offering new annuities at about 6 percent. The difference between the 8.5 percent earned on the existing invested asset portfolio and the 6 percent offered new contract owners is defined as earnings. American General, for one, has a big variable-annuity operation and is benefiting from that increase in spread. If interest rates rise, however, spread margins may not be as favorable.

Growth Products Two insurance products-disability income and long-term care-have considerable potential for growth. The disability insurance market in the United States is estimated to be 130 million. Currently, only 35 million are believed to have disability income insurance. So the market is still large. U.s. workers are beginning to understand that it is one thing to be living, but if you cannot work and you are not well, you need disability income coverage. The disability insurance business once was a blue-collar business. The policies historically became effective one or two weeks after a worker went on disability. For the past 20 years, disability income companies have been trying to defend against the negative loss experience caused by recession. Currently, people with disability income policies are concerned about their work positions, and employees are testing to see whether they can get on disability. We will see in the next 12 months how successful plaintiffs are in testing the definition of disability insurance. Long-term care is another potential growth market. Insurance companies have not been able to find a way to write this product profitably, but demand is growing from people who are worried about running out of money if they live too long. Insurance 68

companies are trying to write long-term care policies using a cash-value form, or investment program, whereby someone who is 50 or 60 years old buys a program and builds up a cash value that can be used to pay nursing home or at-home health care expenses. A problem is that most people in their 50s are not ready to buy protection against the need for nursing home care or outpatient care when they are 80.

Property/Casualty Insurance The commercial lines property/ casualty underwriting cycle has been on a down curve for more than five years. In the personal automobile insurance market, however, I expect to see slow improvement in pricing and margins. The private passenger auto insurance market is complex, and a number of large stock insurers have elected to abdicate personalized automobile insurance. These withdrawals are tightening the auto market to some degree, but regulatory meddling is limiting insurers from improving their margins sufficiently. The Wall Street Journal suggests that positive changes are coming for commercial insurance, but to date, none of my industry sources has been able to confirm those improving commercial product margins. Pricing on the basic commercial lines is still plus or minus 5 percent on renewal. Marine and aviation rates are finally on the upswing, but they represent only 1.5 percent of total property/ casualty industry premiums. I would like to be optimistic about the commercial insurance business, but as of now, nothing has changed, and I do not expect improved earning power until 1993.

Reinsurance Reinsurers have lost much of the excess-lines business (insurance over certain limits) to the primary insurers, who are retaining more of the premium for themselves. During the 1984-86 period, this made sense. The reinsurers were raising prices aggressively at that time, and the primary companies felt that at those price levels, it would be to their advantage to retain the premium and take the investment income. Since 1986, however, pricing has come down considerably in many commercial insurance products, so those retentions are aggressive exposures at this time. _

Legal and Regulatory Pressures To many people in the insurance industry, the tort and legal liability issue has run amok. This is illustrated by a recent case in Morristown, New Jersey, where a homeless person made the town library

his temporary home. Morristown attempted to ban the man, who then proceeded to take Morristown to court. The Federal District Court judge ruled that the homeless man's first amendment rights were being threatened. So Morristown is paying this person $150,000 in court costs. This proves that chivalry is not dead-it just got stomped on-and that the tort situation may be out of hand. Many meddlers have no sensitivity to what is happening in the insurance area. They appeal to policyholders and voters by telling them they can get their rates reduced. In California, the insurance department is currently pushing for big rate reductions, yet the California courts ruled that assigned-risk automobile plans deserved price increases of 79 percent; they really needed 185 percent, but they got 79 percent. A definite problem exists between affordability and pricing. Politicians and regulatory agencies are bringing some education to this program, and people need to be educated. Policyholders need to be told why their premiums are higher.

Other Factors Several other factors affecting the insurance industry also merit discussion. I project higher return on equity (ROE) for private passenger auto insurance in the United States, but it will not come the way analysts want it. Currently, capital is leaving the private passenger auto business. As losses develop, rates will rise, and on that reduced level of capital, ROEs will rise. In California, Pennsylvania, and New Jersey, smaller insurers have great encouragement to come in no matter what their capitalization or rules. Many of these smaller companies will become insolvent and put a lot of policyholders at risk. Then the regulators will come back to the companies that took their money out and say, "You have to put it back in the guarantee fund." Private passenger auto insurance companies can still have acceptable ROEs, but

the holding companies for these firms may have to use their own money to finance the guarantee funds, and that is a definite danger. Loss reserves for the property / casualty industry are not what they should be. Prior to the McDonnellDouglas case of 1967, an insurance company would show the actual-to-expected loss experience. If actualloss claims were greater than projected, then the company had a problem. If its projections were covering its losses comfortably and it had some redundancy, the analyst could see these relationships. Loss reserve adequacy is the most important consideration in the analysis of an insurance company. Companies must have conservative reserve practices. They should make the accuracy of their loss reserve judgment public in their annual reports. Accountants and analysts have attempted to obtain more detail on reserves, and some additional detail is being provided, but it is not as good a set of details as analysts need, because the companies are not providing actual versus expected losses. Until they do, we cannot give these stocks the value they deserve. Pollution still raises many questions. No one knows exactly who has it, how much, or how the courts will work on it. Litigation on this problem will be around for the next 15 or 20 years. Lawyers will love it. Glass-Steagall is almost out. I believe banks will be in the insurance industry heavily by the end of the decade. The international insurance and financial services giants operating in the United States will want to have greater penetration into the insurance industry, but they are scared because of the tort system and the liability problems. The insurance companies got clobbered in the late 1970s and early 1980s, and they are still paying those claims. Every time they feel they should step up their penetration in the United States, a new raft of claims comes in with a 1977 or 1979 date on them, and then they decide to wait a little longer.

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Question and Answer Session David Seifer, CFA Question: When the industry changes to a mark-to-market system, will both assets and liabilities be marked to market, or just the assets? seifer: I favor marking the assets to market and keeping the liabilities as a reserve. The liability side is much more complex than the asset side. Marking liabilities to market now is not as good as when you could invest reserves and liability cash at 8 percent to 11 percent. That made for a bitter argument about marking the liabilities down to reality. During my career, insurance stocks have correlated inversely with the long bond rate. This means investors have always kept in mind what is happening in the bond portfolio on the asset side and the reserves on the liability side. Question: Several government bureaucracies are working on banks and thrifts, including the Federal Reserve, the Office of Thrift Supervision, and 26 other agencies. Now, the Securities and Exchange Commission (SEC) has inserted itself into the insurance industry with respect to Travelers. How do you think the SEC will be received, what is its bone of contention, and what is its expertise? seifer: The SEC has always been involved in the insurance industry. Anytime an insurance company has a new offering, the SEC does the review. During the past year, the SEC has been more careful because of the balance sheet questions that have arisen. Anything that makes the industry more conservative is positive for the investor. If being more con-

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servative means the insurance industry is forced to put up more reserves at the expense of current earnings, I do not have a problem with that. I have a problem with grandstanding types of legislation or types of programs that appear to be a sensational quick fix to what is a long-term, complex problem requiring more intelligent work, although maybe a grandstanding approach will be the catalyst to make something useful happen. Question: You discussed the heavy cash drain caused by annuity business. What are the implications for analyzing a heavy annuity writer? seifer: A heavy annuity writer will need cash when it begins paying out on the annuities. Typically within 12 months, a certain amount of payment will be needed. In a straight cash value life insurance policy, enough cash flow and investment income will build up eventually to pay the benefit at death. In a retirement program, the curve is just the opposite. A company must put up 125 percent of the first-year premium in reserves to pay for those who will receive some sort of benefit within that first 12-month period. Guaranteed income contracts (GICs) have been a cash flow drain, even those that are real. This is just one area in which a company must watch its capital. Most companies today watch their capital, and when they get to a certain point, they stop writing new policies. Question: Please comment on the growth outlook and market share margins for GICs.

seifer: I have never understood why anyone would buy a GIC. In return for a fixed yield-in some cases, a pretax set yieldpeople who buy GICs limit their upside potential, because they cannot participate in any rally in the bond market. In years in which GIC sales have been heavy, typically either the stock or the bond market has an emotional response to some problem, followed by incredible rallies in both markets. When you see a lot of GIC programs, it is time to get into both the stock and bond markets. Question: Do you think the government will begin to regulate the GIC market? seifer: I have a great fear that the federal government will come in. I hope it will only provide guidelines. On the other hand, the insurance industry has been slow to make things happen, very slow to educate their older policyholders, and very slow to educate Congress. In 1983, I visited Senator Bill Bradley about some of the oncoming tax programs. He said to forget it, that Congress has absolutely no use for the insurance industry, and the House Ways and Means Committee has been somewhat alienated in recent years. The insurance companies have alienated Rostenkowski, who is the wrong man to alienate. The tax rate for the insurance industry keeps rising; it is probably 15 points higher than what industrials are paying today and appears to be going higher. Members of the House Ways and Means Committee believe the insurance industry lied to them and did not pay the taxes they should

have. So they are getting them and us, too. The House Ways and Means Committee is a definite near-term problem.

Question: What will it take to end the down cycle in property/ casualty pricing? seifer: Fear will end that down cycle. Unfortunately, this means some investors may be hurt in both the bond and stock markets, which hits all of us. Something must concern managements about their capital and surplus, but currently they feel pretty good about it, so no movement is occurring. If pricing has not changed within a year, property / casualty underwriting losses will be much greater than they are this year. I hope some negotiations have begun for January 1, 1993, renewals. The last four or five companies that have come into New York, however, have basically said that their book value

per share is equal to or higher than it was a year ago at this time. They do not intend to change their pricing programs as long as the competition is not changing its programs. That is a negative sign for changing the cycle or changing the industry's philosophy toward pricing and underwriting.

Question: Do you think a move toward higher margin products, such as whole life, is likely? seifer: Most people choose to buy term insurance and invest the difference in the premiums themselves. I have a few cash value policies with different companies, which is total heresy on Wall Street. Several years ago, the insurance companies encouraged me to switch to universal life. In retrospect, it is a good thing that I did not do it, and the insurance companies know that.

Question: How does disability income compare with worker's compensation? seifer: The general rule is that worker's compensation is a statutory fixed legal program in which benefits are established on a minimum basis. Disability income is not related to legal requirements. The genesis of worker's compensation is that when an employee got hurt, the employer did not want to payor refused to pay, so a system was established to protect the worker from problems. Disability income is a program to cover more than minimum health or minimum injury programs do. A definition of disability is needed, however--whether the individual is disabled and whether the coverage and the contract covers that particular instance. Worker's compensation defines disability broadly, and disability income defines disability as a single injury or problem.

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Analyzing the Insurance Market~nternal and External Factors A. Michael Frinquelli, CFA Managing Director Salomon Brothers, Inc.

Insurance company valuation depends on a variety of internal conditions and considerations, including competition, volume, surplus and return management, and loss reserves policies. Pertinent external factors include interest rates, regulatory activity, inflation, demographics, and globalization.

This presentation wiII cover the important internal and external factors affecting the valuation of insurance companies. Prior to reviewing these factors, I wiII describe the structure and size of the insurance industry.

Industry Structure The most basic dichotomy in insurance is the difference between life and nonlife companies. Although many people think of insurance as one homogenous product, the two major segments differ basically in structure and in the products they offer.

Size Comparisons of the relative size of the two segments depend on the measure used. They do not differ much in premiums: In 1990, life insurance premiums were $250 biIIion and nonlife $220 biIIion. The two biggest lines of insurance are health and automobile. Measured in assets, the life business is much larger than the casualty business. For 1990, life insurance assets were $1.3 triIIion and nonlife $560 biIIion. The asset spread reflects the fact that life companies are large money managers, and casualty companies are not. Measured in capital, nonlife companies are larger than life companies. At the end of 1990, life insurance capital was $86 biIIion and nonlife was $138 biIIion. Clearly, the life business is much more leveraged on an assets-to-surplus basis than the casualty business. Historically, this has been the case for good reason: life company liabilities were much 72

more predictable than those of casualty writers. Since 1979-the dawn of a revolution in the life insurance business-questions have been raised as to whether these companies should remain as leveraged as they are. The press, rating agencies, regulators, and legislators have also picked up on that concern. Relative to the stock market as a whole, this is a small industry. Insurance accounts for only about 3 percent of the S&P 500, with roughly two-thirds of the market capitalization in the property/casualty companies and one-third in the life insurance companies. One of the reasons for this is that, on the basis of assets, about half of the life insurance companies are mutual companies and half are stock companies. In fact, the largest five life companies-Prudential, Metropolitan, Equitable, New York Life, and John Hancock-all are mutual companies. In the casualty business, only 30 percent are mutual companies, and the remaining 70 percent are stock companies, although the largest company-State Farm-is a mutual company.

Economic and Domestic Concentration In the casualty business, two companies-State Farm and Allstate-have almost 30 percent of the personal-line business. State Farm is a personal-lines specialist and by itself holds 20 percent of the auto/homeowner's market. Allstate, which is a stock company only if shares are purchased through Sears, has almost 10 percent of the personal-lines market. The insurance business, both life and nonlife, is essentially a domestic industry. Very few U.S. insur-

ance companies do much business overseas. American International Group (AIG), the largest company in the business in terms of market capitalization, is an exception. It derives about half of its profits from non-U.S. sources, and it enjoys a relatively profitable, stable overseas business. This is because AIG has been involved in overseas work for a long time: The firm began in 1919 in Shanghai. Other companies that do some business overseas are Chubb, St. Paul Companies, and CIGNA.

Internal Factors in Valuation Company valuation depends on a variety of internal conditions and considerations, including competition, volume, surplus and return management, and loss reserves policies. For a property/ casualty company, the important considerations are what it writes, where it writes it, and how it writes it-or to put it another way, product, geography, and distribution.

Competition Competition has two aspects: the type of company and the degree of concentration. Because the life and nonlife businesses are so different, I will treat them separately, beginning with the nonlife segment. The first word that comes to most analysts' minds when thinking about the property/casualty insurance business is competition. This is a viciously competitive business. Depending on the definition of local, regional, and national markets, the United States has as many as 5,000 nonlife insurance companies. Some are big nationals, others concentrate in only one state, and some concentrate in one part of one state. Because it is a mature business and a commodity business, it is not a growth business. There may be a few growth stocks, primarily among the specialty companies, but by and large this is a mature, commodity, fragmented, competitive business. The most obvious form of competition in any business is market share. Most insurance managers consider the term market share to be a bad word. Very few companies admit they want to pick up market share, although in reality they all want to do so. For example, in 1981 AEtna decided unilaterally that it would raise prices in the property/casualty business, even though nobody else was. It raised prices by an average of 15 percent, and its market share went down dramatically-in certain lines by as much as 25 percent. The next year, it decided that strategy was not such a good idea.

The Importance of Volume The companies have several good reasons to pursue increased market share in what might appear to be an unprofitable business. One is that they need volume so they can reduce their exposure to loss from an individual policy; they need to spread risk over more policies. The National Association of Insurance Commissioners (NAIC) is currently developing risk-based capital standards for insurers. 1 One of the many tests under the risk-based capital guidelines is a credibility test: How credible are the company's reserves? In this case, credibility is a function of the size of the business. A company that writes less than $1.2 million of premiums in any given year has a zero credibility factor attached to its reserves because it does not have a large enough book of business. A company that writes more than $425 million of premiums a year has a 50 percent credibility factor. No one has it right all of the time, so no one gets a 100 percent credibility factor. So an important way to define credibility in this business is through the law of large numbers. This provides additional incentive for companies to get bigger. The critical mass for an insurance company depends on what the company does. Does it concentrate on one line of business, or is it a national writer of all major lines of business? My analysis suggests that a company that wants to be a national, multipleline writer of property/casualty insurance should have premium volume of approximately $3 billion to develop and maintain the kind of critical mass necessary. Critical mass includes maintaining an agency plant, branch office network, and computers. Technology has run amok in the insurance business for the past 15 years and is becoming very expensive. Analysts should look at the breakdown between fixed and variable costs. Generally, 60 percent of the costs in this business are variable (mainly commissions paid to agents) and roughly 40 percent are fixed.

Surplus and Return Management Another important internal factor is the company's capital, or surplus. Obviously, the amount of surplus (or net assets) determines to a great degree how much business a company can write. If surplus goes up a lot, a company can write more business. If surplus goes down, the company may have to write less business.

ISee A. Michael Frinquelli and Jay Cohen, "Risk-Based Capital-Getting Serious About Balance Sheets" (New York: Salomon Brothers, Inc., October 17, 1991).

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A number of factors determine a company's surplus. On the asset side, property/casualty balance sheets are dominated by publicly traded bonds. Bonds are carried at amortized cost, so the values do not jump around for regulatory purposes. In contrast, the stock market has a direct effect on surplus, because stocks are carried at market. A recent drop in the market, for example, cost this business about $2 billion in regulatory surplus. By comparison, the Oakland fire cost $1.2 billion and the California earthquake of 1989 cost roughly $1 billion. One thing for analysts to watch for is the way companies handle bad markets. For example, an insurance company can manufacture surplus by selling bonds when the market goes up. Some companies are already doing that, not only to be able to write business but also to pay dividends. That is a dangerous policy, but it may be going on now.

Reserve Policy Reserve policy is another key internal consideration in the nonlife insurance business. Loss reserves are estimates subject to change. Normal loss reserves are about two-thirds of a casualty company's liabilities and amount to roughly four times surplus. In 1986, CIGNA told the world that it had underestimated its reserves by 28 percent. That is a massive number, but companies can be off by that much, and CIGNA is unique only in that it cleaned its laundry in one shot and more publicly than any other company ever had. In the life business, companies go bankrupt because of problems on the asset side of the balance sheet. In the property / casualty business, companies go bankrupt because of problems on the liability side of the balance sheet-primarily inadequate loss reserves. Reserves are easy to skimp on because the companies do not have to payoff the losses for a couple of years. Reserves obviously drive surplus, so skimping a little bit on reserves can have a significant effect on surplus. Obviously, companies do not admit to this, but a number of them try. They call it "growing out of a problem": "1 know I have a reserve problem here, but if I can just grow faster, put more good business on the books, I can put more money into prior year reserves. Because I believe the business I am putting on the books is better business, I can grow myself out of that problem." It never . works. Reserves also have tax implications. The tax nature of loss reserves changed dramatically under the Tax Reform Act of 1986. Insurance companies do not discount reserves for statutory or shareholder reporting practices, but the Tax Act requires them to discount reserves. This change caused the second great-

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est negative impact on the insurance business (real estate losses had the most negative impact). Taxes are not an issue for relatively small claims, such as a $1,000 auto claim, which is paid almost immediately, but they become an issue for larger claims that pay out over many years. Take, for example, a $10,000 medical malpractice claim that takes 10 years to pay out. The insurance company puts up $10,000 in reserves against the $10,000 claim, but the time value of money is not taken into consideration for establishing reserves, either for statutory or shareholder reporting purposes. Reserves are discounted for tax purposes.

Product, Geography, and Distribution Product, geography, and distribution define any insurance company. Some property/casualty companies concentrate in personal lines, such as auto insurance, rather than commercial lines. The economics, regulation, and consumer issues around personallines are very different from those surrounding such commercial lines as worker's compensation and general liability insurance. Geography has been a factor in underwriting results. Historically, insurance companies have wanted to write business in the Midwest and Far West, and not in the Northeast-Boston through Washington. A company writing business in the Midwest should show better underwriting results because that area has less regulatory and social inflation. Distribution varies by company. In the property / casualty business, most companies write through independent agents, who often write business for six or seven insurance companies. The biggest companies in the insurance business-Allstate and State Farm-have captive agents, who write only for their companies. A few companies, such as GEICO, write business without any people at all. They write through the mail, television, radio advertising, and existing policyholder referrals.

Reinsurance Reinsurance is insurance bought by insurance companies. Insurance companies do not bet the company on any given risk, so to spread their exposure, they buy insurance. For example, the largest catastrophe this industry has ever had, 1989's Hurricane Hugo, cost the industry $4 billion dollars. Very few companies went out of business as a result of Hurricane Hugo because they bought reinsurance. The availability of reinsurance is cyclical-as is the cost of reinsurance and the quality. The quality of reinsurance-that is, how strong the reinsurance company is-is very important, a

fact that was not well understood in this country until 1985, when Mission Insurance failed. Its problems were inadequate reserves and poor-quality reinsurance. As a result, analysts began to look seriously at Schedule F, a form that provides information on who the company's reinsurers are. It is amazing how many reinsurers you have never heard of, and how many primary companies are being reinsured by companies you never heard of.

Management Direction Analysts must also evaluate the quality of management. In most companies, not just insurance companies, CEOs want to be big. The definition of bigness in most businesses is assets or revenues, rarely profits. Most CEOs in the insurance business want to be well known. This is done by running a big company, not necessarily the most profitable one in the business. Understanding what turns on a CEO is critical to understanding an insurance company. If it is the CEO getting his picture in the newspaper, you may want to be careful.

External Factors Affecting Earnings The external factors can be as important as the internal factors in analyzing an insurance company. Analysts often claim that you only need to know two things to invest in insurance stocks-interest rates and premium rates: premium rates up, stocks up; interest rates down, stocks up. Furthermore, if you are only allowed to know one of those two things on a near-term basis, you want to know the direction of interest rates rather than the direction of premium rates. In addition to interest rates, insurance companies are affected by regulatory activities, inflation, demographics, and globalization.

Interest Rates The effect of interest rates shows up on the balance sheet, the income statement, and ultimately the book value of an insurance company. Interest rates are important to investors because changes have a direct impact on an insurance company's market value. Most insurance company stocks are driven by mark-to-market book value rather than a given year's operating earnings. Marking to market essentially means marking the bonds to market. When interest rates go down, investor wealth accumulates, because the value of the bonds-which often represent three-quarters of an insurance company's assets-goes up. Insurance company managers, however, must concern themselves with how well they are managing the money flowing in. They do not like to see

lower interest rates, because they would ratherinvest at 10 percent than 6 percent. This is the classic problem of the average versus the margin. At the margin today, investors would be crazy to put a dollar of incremental capital into the property/ casualty business, because their combined ratio-cost of fundsfor bringing in new money is running 113; that is a 13 percent pretax cost. They are investing at between 8 percent and 9 percent, which is a negative spread. In the future, this negative spread will also hurt balance sheets. Stocks went up this year, and bond prices have come down. The investors and managements are both right. Ideally, in this environment, you want to find an insurance company that is not writing any new business, one that is only collecting on what it has done in the past. Return on equity (ROE) is another important consideration, but it is hard to define because we do not have one set of numbers. Most analysts define ROE as operating" earnings excluding capital gains divided by stated book value. Some analysts and investors define ROE as an increase in marked-tomarket book value plus dividends paid divided by average book value. For most companies, the difference between ROEs calculated using the different formulas is not large. Several years ago, however, I came across one company-C&A Financial, which is 80 percent owned by Loew's Corporation-that reported a lO-year operating ROE of 12 percent. Using the total return formula, the company's ROE was 23 percent. Over a longer period of time, that second definition is probably more important than the first.

Inflation Inflation is important to this business because liabilities are cost-based, not dollar-based. If you have a car accident, the insurance company pays the cost of fixing the car minus a deductible. It does not pay a flat amount per accident. Therefore, as inflation pushes costs up, claim amounts increase. One of the key components of inflation is medical care. The insurance business pays for doctors. If the insurance industry did not exist, the medical community would be very different. Consider worker's compensation, the largest line of commercial insurance in property/ casualty. More than half of those costs are medically related. If you are hurt on the job, you go to a hospital, and insurance pays for your hospital stay. More than half of the automobile insurance claims are for bodily injury as opposed to physical damage to a vehicle. Social inflation is referred to as the increasing propensity of Americans to sue each other. Social inflation was so named in 1973 by St. Paul Compa75

nies when they found out people were actually suing their doctors. You will not find social inflation in the consumer price index, but it is a big consideration for this business, particularly liability insurance.

Catastrophes Another external consideration is the size, number, and type of catastrophes such as fires, hurricanes, or tornadoes. This can be a big swing factor in any year. The worst year for this business was 1989-$7 billion in catastrophe losses. They have been running about $2 billion since then. They will run over $2 billion in 1991 because of the Oakland fire, Hurricane Bob, and so on. Catastrophes are important to property writers, who specialize in writing property insurance rather than liability insurance. Obviously, reinsurance is particularly important.

Regulatory Activities The insurance industry is regulated on a stateby-state basis, rather than federally, and state regulations vary widely. The McCarren-Ferguson Act exempts insurance companies from federal regulation and legislation. Every year, Congress talks about repealing that act, and within a few years, I believe it will be repealed. Federal regulation will focus more on solvency than on price.

Other Factors A host of other external factors also affect the insurance industry. These include consumerism, distribution networks, product diversification, and soon. Consumerism today is typically wrapped up in one number-Proposition 103, which has been in effect in California since 1988. Under Proposition 103, California voters mandated a 20 percent rollback in auto insurance rates. Consumerism is a big issue in this business. Also important are distribution networks. Some companies have career agents who write business mainly for one company; others use independent agents, general agents, personal-producing general agents, and a few are direct writers. An important source of competition in the life insurance business is other asset gatherers. In 1979, this business redefined itself from one that mainly provided protection for survivors in the event of premature death. It is now an asset gatherer. As a result, it competes with banks, mutual funds, money market funds, and other insurance companies. Product diversification is another factor. Life insurance, annuities, pensions, health insurance, and 76

disability insurance all have very different cost structures. Casualty business is highlighted mainly by level commissions. An insurance agent who writes a piece of auto business will get a 10 percent to 15 percent commission every year, even if the agent writes it for the same person for 20 years. Life insurance agents get very high first-year commissions-55 percent or more-and relatively low renewal commissions. In life insurance, agents are paid to sell, not service. Another factor is asset quality. Real estate is a concern in the life insurance business, not in the casualty business. Again, external considerations are interest rates. This is as rate sensitive a group as the casualty business. This is an industry in which asset/liability matching is a valid concept. If a company is matched, it should be relatively insensitive to interest rate movements. The industry is largely matched now, but investors have not caught up with that. The economy is another factor, probably more so than in casualty insurance. Buying many forms of life/health/pension policies is discretionary-it can be postponed. Casualty insurance is a demand product. You must have it if you want to drive a car. The more money people have, the more likely life insurance sales go up. The economy is also important because a sluggish economy leads to more claims in health insurance and disability insurance. Taxation is important in this business. Product creation is based on the tax laws. Other governmentaction issues that affect the insurance industry are health insurance, banking reform, and reregulation by states. Rating agencies are also important if you are concerned about a run on the bank. Demographics are a very pertinent consideration. An aging society wants retirement income today more than death protection. The way agents sell life insurance is around a life event-marriage, children, house purchase, and retirement. The prevalence of self insurance and whether a company operates captive insurance companies also affect insurance providers. Captive insurance companies-an industrial company owning an insurance company-are still popular, although the Internal Revenue Service has many problems with captive insurers that become risk-retention groups. Risk-retention groups can be looked upon loosely as group captives: Several people get together and collectively insure themselves. This is a growing threat to the traditional commercial carriers and a threat in a period of high interest rates, when the opportunity to invest the premiums prior to paying the claims is more valuable.

Conclusion In conclusion, factors internal to the insurance industry to be considered by investors in insurance include the observation that, overall, this is a fragmented, mature, average ROE business. Growth prospects of any given company must be considered within that industry context. Key distinguishing characteristics among companies include product (what the company sells), distribution (how the company sells its product), and geography (where the regulatory and other characteristics of the company's geographic

territory reside). Of overriding concern in this regulated financial services business is asset quality: assets in the case of life insurers, and liabilities (reserves) in the case of casualty insurers. Key external concerns when investing in insurance stocks include interest rates, the overall economy, regulation on a statewide basis, national legislative policies in such diverse areas as taxation and environmental liability, and societal considerations such as changing attitudes toward litigation, demographics, and life-styles.

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Question and Answer session A. Michael Frinquelli, CFA Question: How do you deal with skimping on reserves?

Frinquelli: The easiest starting point is to look at a company's growth in premiums and reserves. When one is getting out of line with the other, you should ask about it. The combined ratio is a function of several things. Not much can be done about paid losses to premiums earned, but look at the increase in reserves as a percentage of premiums earned and see what the trend is. If the trend has a blip in it, ask about it; if it is going down, ask about that. The expense ratio and policyholder dividend ratio are also clues. The gross numbers to look at are premiums, increases in reserves, and the pattern of what the company has been doing with the reserves. This business also has something called accidentyear loss ratios and financialyear, or reported, loss ratios. Historically, the industry underreserves when premium rates are going down and over-reserves when premium rates are going up. Premium rates have been going down for five years, and history would suggest that for some period during that five years, the companies have been under-reserving. That is a better term than cheating. Question: If a property/ casualty company starts increasing reserves at a rate higher than its historical trend, is that a danger signal that they are playing catch up and that several quarters or years of higher reserve provisions are in store?

Frinquelli: One of the many adages in this business is that the 78

first shot is rarely the last shot. A company does not wake up one morning and put up as much as it has to put up in reserves. Typically, it puts up as much as it can afford to put up. I can think of few instances in which a company put up for prior accident years reserves once but not in subsequent quarters or years. Companies always must say they feel their reserves are adequate. If they are not adequate, then the companies have lied to you. A blip off of trend, if they are increasing, will suggest you should be careful for a couple of years, not just that one time. Question: One of the most problematic areas is toxic waste. Please comment on that exposure and the government's Super Fund law.

Frinquelli: About a year ago, I did some work on environmentalimpairment liability (ElL). What I would like to know about ElL is not simply a number; it is the methodology. There are good reasons for companies not giving you a number. If they publicize a number, they know they will be sued for at least that amount. At a minimum, analysts should be told what they are doing about ElL. Is it accounted for in their reserves, and how? Environmentalimpairment liability for the United States as estimated by the Environmental Protection Agency could be as much as $750 billion. Actuaries have estimated the insurance industry's portion will be somewhere between 5 percent and 40 percent. If the industry is in the middle of that, and the companies paid it all today, they would be insolvent. So, on

ElL, ask the question, but do not expect to get a number back. Nevertheless, the companies should tell you if they carry this in their reserves, and how they do it. Question: Is there such a thing as over-reserving?

Frinquelli: Yes, personal-line companies tend to over-reserve. GEICO's lO-K indicates a consistent pattern of over-reserving in the early years and releasing in later years. That is the kind of pattern you want to see. You are more likely to see over-reserving in personal-line companies because it is relatively easy. You will run into an occasional company that is always redundant and many companies that are redundant at a given point in time. Compare reserve levels in these companies today with those in 1986 and 1987. Question: Why would any rational consumer ever purchase a life policy from a stock company? Stock companies attempt to transfer wealth from policyholders to stockholders, whereas mutual companies return wealth to the policyholders. Does this have implications in the long term for stock life company prospects?

Frinquelli: It is not clear who mutual company management is responsible to. Analysts should compare the efficiency and operating costs of stock companies and mutual companies to answer that question.' In a sense, the universallife policy is a participating policy. That is what mutual life companies sell-par business versus nonpar business. You can buy a par policy either through a

mutual company relatively inefficiently or through a stock company. You could not do that before 1979. Question: Equitable is a mutual company with a balance sheet that has deteriorated. Now the company wants to go public. How can value be placed on a large demutualizing life insurer such as Equitable? Frinquelli: The question of how to decide on value is currently being confronted by the New York Insurance Department. It is not easy. The easiest way for a stockholder is to base it on comparable value. Policyholders will get a piece of that, and shareholders will be allowed a piece through an initial public offering at some point. Question: What life or nonlife insurance companies have developed a culture that sets them apart from the rest? Frinquelli: The most obvious example is State Farm, which is a mutual company. State Farm does not have lavish quarters; it has linoleum, not carpeting. I think an important part of corporate culture is what you can see. Some inverse relationship may exist between profitability and how the senior management lives and entertains. When the office of the CEO of a 7 percent ROE company is huge, ask some questions. Question: What is the impact of foreign insurers injecting capital into U.s. companies such as Equitable, Mutual Benefit, and Executive Life via rescues? Will we see more of this foreign interest? Frinquelli: From a policyholder's point of view, it is very valuable that the foreign insurers

came in. From a long-term shareholder's point of view, it is probably positive also because we do not want too many feds and regulators on us. From a near-term, investors' point of view, we might be better off if they were not there. Question: Do you think the concern over life company commercial mortgage exposure is overblown because of the misapplied analogy to the problems thrifts and commercial banks experienced with commercial mortgages? Frinquelli: Yes. The only thing we have to fear is fear itself. Given time, insurance companies will work the problem out. If society and the media persist in focusing on the mega problems of a few companies, however, we will create a run on the bank. Question: What are the prospects for meaningful tort reform in the United States in the foreseeable future? Frinquelli: We had meaningful tort reform during 1985 and 1986 that gave the legal community time to regroup. The American Association of Retired People is the strongest lobby of any kind, and the second strongest is the American Trial Lawyers Association. It depends on what you mean by meaningful tort reform. More than 30 states enacted caps on pain and suffering awards, frivolous lawsuit penalties, and similar legislation in the 1985-86 period because people could not buy liability insurance. I think you will not see much more than that. The most meaningful element of tort reform we could put in place today is verbal threshold no-fault auto insurance. This is currently in place in three statesNew York, Florida, and Wiscon-

sin. It works because premium rates have increased at a significantly slower pace in those three states than in the rest of the country. Verbal threshold no-fault insurance takes lawyers out of the system, however, so it has not been enacted anywhere else. The Super Fund problem is very different from verbal threshold no-fault. If Super Fund could be placed on a no-fault basis, it would be more efficient in cleaning up the environment. Again, that does not seem terribly likely, because Congress feels a no-fault approach to Super Fund gets the insurance companies off the hook. Question: One of the great statistics is that we have 7 percent of the world's population and 50 percent of the world's lawyers. As with banks, many speculate that mergers will be a wave with insurers. Please comment on this. Frinquelli: I think you will see consolidation in this business for risk-based capital. Another consideration is expenses. The expense ratio in the property / casualty business has not really decreased since the 1960s. Work needs to be done in that area. The asset quality issue is another reason. The most likely candidates for consolidation, as a class, are mutual companies. One or two mutual company consolidations are going on now. Question: An estimated $60 billion of the $200 billion in guaranteed investment contracts (GICs) will mature during the next two years. If all that money moves out of GICs, will it affect the insurance industry? Frinquelli: I think a good portion of the $60 billion could move. Where it would go depends on the financial markets. In an up stock market, more

79

money would go into the stock market. In a down market, more money would go into money market-type funds. Insurance companies have alternatives. If people do not want GICs, the companies offer a menu of other things. So the $30 billion or $60 billion could migrate from weaker companies to stronger companies. Everybody wants to be insured by New York Life, Prudential, and Metropolitan. They could very well pick up while some of the weaker

80

companies lose. Question: What is a good source of information about separate accounts? Are these proprietary data and not generally available? How do you get them? Legally, are the claims on these accounts genuinely separate from general claims on the company? Frinquelli: In a separate account, you are buying that company's ability to manage

your money. In all other respects, however, it is your money. You get the upside, they get a management fee, and you get the downside as well. .As for public information, you can call some insurance companies, such as New York Life, and ask them what is held in your separate account. I do not know of any general source of that information other than the company itself.

Interpreting Property and Casualty Insurance Numbers Anthony 1. Cope, CFA Senior Vice President and Partner Wellington Management Company

To gain a clear picture of a property/casualty insurance company, analysts need to examine operating income-paid losses and reserves, the growth of written premiums as compared to the growth of expenses, and investment income-as well as reserves.

Property/ casualty companies have certain characteristics that differentiate them from other insurance companies. This presentation will focus on only two aspects of financial statement interpretation for property/ casualty companies: analysis of operations and analysis of reserves. Most illustrations will use The Chubb Corporation as an example.

Analysis of Operations A property/ casualty company's operating income is derived from insurance underwriting and from investment income. Underwriting income is the result of deducting losses and operating expenses from premium revenue, so the development of losses and the trend and nature of expenses are both important.

Loss-Development Analysis Loss-development analysis involves examination of a company's paid losses and reserves. Table 1 shows a 30-year progression of Chubb's loss ratio and of the ratio's two component ratios-paid losses and reserve increases. Over the long term, premium increases should reflect inflation and loss experience. During the 1960-90 period, Chubb's earned premiums compounded at 11.2 percent a year and paid losses compounded at 10.9 percent, but the changes in annual growth rates shown in the table clearly illustrate the cyclical nature of the industry's growth. Although the growth rates were virtually identical for this 30-year period as a whole, year-to-year changes in earned premiums and loss experience may differ considerably. When paid losses rise faster than earned premiums, illustrated by a rising paid loss ratio, the fundamental profitability of the com-

pany is under pressure. For instance, between 1978 and 1984, paid losses grew faster than earned premiums, and the paid loss ratio had a rising trend. This relationship reversed from 1985 to 1987 and then reversed again beginning in 1988. The trend could be changing again. Table 2 shows Chubb's loss development experience by quarter since 1985. For the first half of 1991, Chubb's paid losses were down 2.2 percent over the same period last year compared with a 9.1 percent increase in earned premiums. Figure 1 shows these same trends graphically en an annual basis. For most property/ casualty insurance companies, and for the industry as a whole, paid loss ratios have been significantly more volatile than total loss ratios. In times when paid loss ratios have risen, the tendency has been for reserve additions to be skimpier-and vice versa-and thus reserve accruals have tended to cushion the impact of changes in paid losses. Although legitimate reasons relating to the timing of loss payments explain some of this phenomenon, too much of a cushion effect should make an analyst suspicious. Chubb has been less prone to this earnings smoothing phenomenon than many companies, but Figure 1 does illustrate that the total loss ratio has been less volatile than the paid loss ratio. What is also shown is that the rate of reserve accrual has accelerated dramatically in recent years, compared with the historic trend. Such a change (which is characteristic of many property/casualty companies) raises questions about fundamental operating conditions. It can signal major changes in the nature of a company's business, requiring a higher level of reserves for each premium dollar. It can also indicate 81

Table 1. Chubb Corporati~Annual Loss Development, 1~1990

Earned Premiums

Year"

Volume Percent ($millions) Change

1960 1961 1962 1963 1964

$118.6 122.5 130.0 135.0 155.9

1965 1966 1967 1968 1969

Paid Losses Volume Percent ($millions) Change

Reserve Increase Total Ratio to Ratio to Volume Earned Earned Losses Premiums ($millions) Premiums ($millions)

+11.6% +3.3 +6.1 +3.8 +15.5

$63.2 66.9 72.2 83.8 91.9

+8.6% +5.9 +7.9 +16.1 +9.7

53.3% 54.6 55.5 62.1 58.9

$6.9 5.7 3.8 6.1 10.7

168.0 183.6 205.5 228.1 264.0

+7.8 +9.3 +11.9 +11.0 +15.7

100.0 108.0 120.1 136.5 145.5

+8.8 +8.0 +11.2 +13.7 +6.6

59.5 58.8 58.4 59.8 55.1

11.3 12.2 14.5 12.9 27.5

1970 1971 1972 1973 1974

326.3 385.8 444.8 515.2 588.0

+23.6 +18.2 +15.3 +15.8 +14.1

187.8 205.1 221.6 274.4 349.7

+29.1 +9.2 +8.0 +23.8 +27.4

57.6 53.2 49.8 53.3 59.5

1975 1976 1977 1978 1979

625.9 705.6 775.7 830.2 890.2

+6.4 +12.7 +9.9 +7.0 +7.2

407.5 397.8 409.9 444.6 504.1

+16.5 -2.4 +3.0 +8.5 +13.4

1980 1981 1982 1983 1984

942.9 1,010.5 1,059.2 1,140.5 1,325.4

+5.9 +7.2 +4.8 +7.7 +16.2

541.5 599.7 635.2 652.8 778.7

1985 1986 1987 1988 1989 1990

1,679.9 2,250.8 2,615.9 2,705.6 2,693.6 2,836.1

+26.7 +34.0 +16.2 +3.4 -D.4 +5.3

932.6 987.0 1,007.4 1,176.7 1,247.6 1,389.4

5.8% 4.7 2.9 4.5 6.9

$70.1 72.6 76.0 89.9 102.6

59.1% 59.3 58.5 66.6 65.8

6.7 6.6 7.1 5.7 10.4

111.3 120.2 134.6 149.4 173.0

66.3 65.5 65.5 65.5 65.5

27.3 31.7 50.1 51.4 110.8

8.4 8.2 11.3 10.0 18.8

215.1 236.8 271.7 325.8 460.5

65.9 61.4 61.1 63.2 78.3

65.1 56.4 52.8 53.6 56.6

49.9 96.4 103.1 74.3 60.7

8.0 13.7 13.3 8.9 6.8

457.4 494.2 513.0 518.9 564.8

73.1 70.0 66.1 62.5 63.4

+7.4 +10.7 +5.9 +2.8 +19.3

57.4 59.3 60.0 57.2 58.8

45.6 46.0 48.5 84.5 194.0

4.8 4.6 4.6 7.4 14.6

587.1 645.7 683.7 737.3 972.7

62.3 63.9 64.5 64.6 73.4

+19.8 +5.8 +2.1 +16.8 +6.0 +11.4

55.5 43.9 38.5 43.5 46.3 49.0

306.1 592.7 714.7 594.1 536.9 442.5

18.2 26.3 27.3 22.0 19.9 15.6

1,238.6 1,579.7 1,722.1 1,770.8 1,784.5 1,831.8

73.7 70.2 65.8 65.4 66.2 64.6

Sources: Company reports; Moody's manuals. "Data for 1965 and earlier are from pro forma for 1967 acquisition of Pacific Indemnity Insurance.

82

Loss Ratio

Table 2. Chubb Corporation--Quarterly Loss Development, 1985-mid-1991 Earned Premiums

Paid Losses

Year/ Volume Percent Volume Percent Quarter ($millions) Change" ($millions) Change"

Reserve Increase Ratio to Ratio to Total Earned Volume Earned Losses Premiums ($millions) Premiums ($millions)

Loss Ratio

1985 1 2 3 4

$382.2 404.0 432.5 461.2

+25.9% +24.9 +28.7 +27.3

$217.7 231.2 230.2 253.5

+16.9% +24.1 +20.5 +17.9

57.0% 57.2 53.2 55.0

$55.1 65.0 93.8 92.2

14.4% 16.1 21.7 20.0

$272.8 296.2 323.9 345.7

71.4% 73.3 74.9 75.0

1986 1 2 3 4

502.1 540.6 583.9 624.2

+31.4 +33.8 +35.0 +35.3

249.9 230.4 247.4 259.3

+14.8 -0.3 +7.5 +2.3

49.8 42.6 42.4 41.5

102.0 138.6 157.2 194.9

20.3 25.6 26.9 31.2

351.8 369.1 404.6 454.2

70.1 68.3 69.3 72.7

634.3 651.0 671.2 659.4

+26.3 +20.4 +15.0 +5.6

259.3 247.2 226.2 274.7

+3.8 +7.3 -8.6 +5.9

40.9 38.0 33.7 41.7

161.4 165.4 226.1 161.8

25.4 25.4 33.4 24.5

420.7 412.6 452.3 436.5

66.3 63.4 67.4 66.2

664.4 673.6 680.2 687.4

+4.7 +3.5 +1.3 +4.2

237.2 286.1 327.8 325.6

-8.5 +15.7 +44.9 +18.5

35.9 42.5 48.2 47.4

180.0 149.1 128.4 136.6

27.1 22.1 18.9 19.9

417.2 435.2 456.2 462.2

62.8 64.6 67.1 67.2

667.5 671.3 675.3 679.4

+0.5 -0.3 -0.7 -1.2

294.0 306.8 306.2 340.6

+23.9 +7.2 --6.6 +4.6

44.0 45.7 45.3 SO.1

130.0 133.9 156.0 117.1

19.5 19.9 23.1 17.2

424.0 440.7 462.2 457.6

63.5 65.6 68.4 67.4

682.0 692.9 716.2 745.0

+2.2 +3.2 +6.1 +9.7

328.5 347.4 350.6 362.8

+11.8 +13.2 +14.5 +6.5

48.2 SO.1 49.0 48.7

118.9 113.3 107.0 103.2

17.4 16.4 14.9 13.9

447.5 460.7 457.6 466.0

65.6 66.5 63.9 62.6

746.4 753.7

+9.5 +8.8

296.4 364.4

-9.8 +4.9

39.7 48.3

172.7 113.8

23.1 15.1

469.2 478.2

62.9 63.4

1987 1 2 3 4

1988 1 2 3 4

1989 1 2 3 4 1990

1 2 3 4

1991 1 2

Source: Company reports. "Change from same quarter in previous year.

83

Figure 1. Chubb Corporation Loss Development 100 90 80 70 '

"E 60 Q)

50

~ 0... 40

30 20 10

o ~

~

~

~

~

~

~

D Total Loss Ratio II Paid Loss Ratio Sources: Company reports; Moody's manuals. Note: Data for 1965 and earlier are from pro forma for 1967 acquisition of Pacific Indemnity Insurance.

that past reserve accruals have been inadequate and that reserves must be strengthened in order to be adequate to meet future claim payment requirements. In the case of Chubb, I do not believe the reserve increases are a sign of potential problems, although-like many companies-Chubb is finding that assumptions made about the extent of liability for losses arising from environmental pollution and similar coverages written many years ago have not been conservative enough. Rather, the type of business written by the company has changed quite significantly.

when volume is declining very difficult. When costs are broken down by type, the most important expense categories are commissions and underwriting expenses. Table 5 presents CIGNA Corporation's expense history since 1982. From 1986 to 1990, CIGNA's expenses grew only 2.4 percent. Because of the volume changes resulting from the company's restructuring of its property/casualty business, its expense ratios barely changed during this period. Written premiums declined between 1987 and 1990 in spite of inflation and economic growth, but expenses were difficult to reduce. Nevertheless, the company is now extremely well positioned when and if volume rebounds. Commissions tend to be variable expenses. All else equal, commissions vary almost directly with volume, although changes in corporate policy or business mix can bring the commission ratio down. CIGNA has experienced a minor decrease in its commission ratio as a result of changes in corporate policy relative to agency compensation. Other expenses, a relatively small part of total expense, also are mostly variable expenses. These are primarily premium-related expenses, taxes, licenses, and fees. Underwriting expenses are predominantly fixed, and the key to reducing the expense ratio is lower underwriting expenses. CIGNA's underwriting expenses continue to show some minor increases, but they decreased from $877 million in 1988 to $869 million in 1990, and further reductions were achieved in 1991. On an absolute basis, CIGNA is demonstrating good cost control, even though the expense ratio currently is not improving much.

Expense Analysis Analysts should also compare the growth of written premiums with the growth of expenses. Table 3 and Table 4 show Chubb's premium and expense history since 1960 on an annual and quarterly basis, respectively. Table 3 also shows Chubb's combined ratio-that is, its expense ratio plus its loss ratio-and its statutory underwriting profit in each of these years. The combined ratio, of course, is the basic measure of underwriting profitability; a ratio below 100 percent indicates that profits are being generated from underwriting. Statutory underwriting results are derived by deducting losses and expenses from earned premiums. The expense ratio is a basic measure of the company's efficiency. As in other financial businesses, cost control is getting increased attention in the property/casualty business. If property/ casualty insurance can be considered a commodity, then the low-cost producer has a significant comparative advantage. One problem is that some expenses are semifixed in nature, which makes reducing expenses

84

Investment Income Analysis The second part of an analysis of operations addresses investment income. Investment income is determined by three factors: cash flow, interest rates, and investment policy. Of those, cash flow is the most important. Many people think cash flow is the key to trying to time the underwriting cycle, believing that premium rates will increase when cash flow for enough companies, or for the industry as a whole, turns negative. Many companies are currently experiencing cash flow squeezes or negative cash flow, but so far that has not had any significant effect on industry pricing. A simple approach to analyzing and projecting cash flow is to equate operating cash flow, excluding proceeds from sale or maturity of investments, to written premiums less paid losses and expenses. Using this definition, Chubb's cash flow has been a little more than $500 million in its property/ casualty operations in each of the past two years. This number excludes some noncash charges and the impact

Table 3. Chubb Corporatio~pense and Loss Analysis, 1960-1990

Written Premiums

Year

Percent Volume Percent Volume a ($millions) Changea ($millions) Change +13.1% +2.1 +7.0 +10.7 +8.0

Ratio to Written Premiums

Expenses

Expense

Loss

+11.3% +4.2 +8.6 +5.4 +6.5

34.2% 35.0 35.5 33.8 33.4

59.1% 59.3 58.5 66.6 65.8

Statutory Underwriting Profit Combined ($millions) 93.3% 94.3 94.0 100.4 99.2

$6.1 5.7 6.0 (5.5) (0.6)

66.3 65.5 65.5 65.5 65.5

98.9 97.2 98.6 98.4 96.8

(0.1) 1.6 0.8 (1.3) 2.2

31.1 31.0 31.5 31.9 30.8

65.9 61.4 61.1 63.2 78.3

97.0 92.4 92.6 95.1 109.1

1.6 18.5 24.9 16.3 (59.6)

+2.7 +11.8 +16.1 +12.4 +11.1

30.3 29.6 30.9 32.4 33.8

73.1 70.0 66.1 62.5 63.4

103.4 99.6 97.0 94.9 97.2

(23.6) (3.3) 13.4 31.1 14.1

337.7 367.7 368.5 426.5 488.7

+8.5 +8.9 +0.2 +15.7 +14.6

34.4 35.1 34.0 35.0 34.3

62.3 63.9 64.5 64.6 73.4

96.7 99.0 98.5 99.6 107.7

18.1 (2.9) 7.0 (23.4) (136.0)

593.2 722.4 824.6 924.5 948.3 1,012.6

+21.4 +21.8 +14.1 +12.1 +2.6 +6.8

30.8 28.4 30.8 33.4 34.7 34.7

73.7 70.2 65.8 65.4 66.2 64.6

104.5 98.6 96.6 98.8 100.9 99.3

(151.9) (51.3) 69.1 10.2 (39.2) (8.3)

$42.4 44.2 48.0 50.6 53.9

1960 1961 1962 1963 1964

$123.8 126.4 135.2 149.6 161.5

1965 1966 1967 1968 1969

174.3 194.7 211.8 243.2 284.0

+7.9 +11.7 +8.8 +14.8 +16.8

56.8 61.8 70.1 80.0 88.8

+5.4 +8.8 +13.4 +14.1 +11.0

32.6 31.7 33.1 32.9 31.3

1970 1971 1972 1973 1974

352.9 420.5 470.5 542.9 607.0

+24.3 +19.2 +11.9 +15.4 +11.8

109.6 130.5 148.2 173.1 187.1

+23.4 +26.1 +13.6 +16.8 +8.1

1975 1976 1977 1978 1979

633.3 724.4 806.6 864.9 920.9

+4.3 +14.4 +11.3 +7.2 +6.5

192.1 214.7 249.3 280.2 311.3

1980 1981 1982 1983 1984

982.1 1,049.0 1,083.8 1,219.5 1,423.2

+6.6 +6.8 +3.3 +12.5 +16.7

1985 1986 1987 1988 1989 1990

1,923.7 2,546.2 2,675.6 2,765.3 2,734.9 2,919.7

+35.2 +32.4 +5.1 +3.4 -1.1 +6.8

Sources: Company reports; Moody's manuals.

of taxes, but it provides a good handle on what is happening to cash flow. Table 6 traces the trend in Chubb's net investment income (investment income net of related expenses) on a pretax and after-tax basis. (Modest rates of growth in 1991 reflect the reclassification of some investment income from property/casualty operations to corporate items.) Note that the effective tax rate on investment income is well below the corporate rate, reflecting the existence of tax-exempt, or tax-advantaged, income. An operating advantage enjoyed by property / casualty companies is the ability to deduct underwriting losses for tax purposes at the full corporate rate while earning tax-advantaged investment income. Investigation and analysis of investment policy should include consideration of current and projected tax rates on investment incorne.

Table 6 also completes Chubb's property/ casualty earnings statement. Note that although investment income shows steady growth, underwriting income is extremely volatile and frequently unprofitable, even after the related tax credits. In fact, during the entire six and one-half years shown in the table, underwriting has resulted in a cumulative loss of $130 million. Table 7 completes the analysis of Chubb's incorne statement for these periods by providing data on nonproperty/ casualty earnings, average fully diluted shares outstanding, and earnings per share (EPS). Note that the key EPS numbers exclude capital gains and losses. Generally Accepted Accounting Principles (GAAP) require insurance companies to include such gains and losses in reported net income. Virtually all analysts exclude these gains and losses in calculating EPS and in the number that is used in 85

Table 4. Chubb Corporation--Quarter1y Expense and Loss Analysis, 1985-mid-1991

Written Premiums

Ratio to Written Premiums

Expenses

Volume Percent Volume Percent Year! Quarter ($millions) Changea ($milIions) Changea

Expense

Loss

Statutory Underwriting Profit Combined ($milIions)

1985 1 2 3 4

$433.8 445.5 485.9 558.5

+32.1% +29.3 +30.4 +47.8

$137.6 141.1 150.3 164.2

+19.9% +15.6 +21.8 +27.9

31.7% 31.7 30.9 29.4

71.4% 73.3 74.9 75.0

103.1% 105.0 105.8 104.4

($28.2) (33.3) (41.7) (48.7)

1986 1 2 3 4

576.7 620.9 672.6 676.1

+32.9 +39.4 +38.4 +21.0

169.5 174.9 188.4 189.7

+23.2 +24.0 +25.4 +15.5

29.4 28.2 28.0 28.1

70.1 68.3 69.3 72.7

99.5 96.5 97.3 100.8

09.2) (3.4) (9.0) 09.7)

638.9 672.8 699.9 663.9

+10.8 +8.4 +4.1 -1.8

192.9 205.2 214.3 212.3

+13.9 +17.3 +13.8 +11.9

30.2 30.5 30.6 32.0

66.3 63.4 67.4 66.2

96.5 93.9 98.0 98.2

20.6 33.2 4.6 10.7

674.3 698.3 701.4 691.2

+5.5 +3.8 +0.2 +4.1

218.8 238.4 236.8 230.7

+13.4 +16.2 +10.5 +10.3

32.4 34.1 33.8 33.4

62.8 64.6 67.1 67.2

95.2 98.7 101.8 100.6

28.4 0.0 02.6) (5.5)

630.5 715.9 709.1 679.4

-6.5 +2.5 +1.1 -1.7

225.5 240.6 241.6 240.6

+3.1 +0.9 +2.1 +4.3

35.8 33.6 34.1 35.4

63.5 65.6 68.4 67.4

99.3 99.2 102.5 102.8

18.1 00.0) (28.5) 08.9)

659.3 765.7 749.6 745.0

+4.6 +6.9 +5.7 +9.7

237.1 262.9 253.7 258.9

+5.1 +9.3 +5.0 +7.6

36.0 34.3 33.8 34.8

65.6 66.5 63.9 62.2

101.6 100.8 97.7 97.4

(2.6) (30.7) 4.8 20.1

737.7 824.7

+11.9 +7.7

262.1 284.9

+10.5 +8.4

35.5 34.5

62.9 63.4

98.4 97.9

15.2 (9.4)

1987 1 2 3 4

1988 1 2 3 4

1989 1 2 3 4 1990

1 2 3 4

1991 1 2

Source: Company reports. aChange from same quarter in previous year.

price-earnings ratio (P IE) calculation. The reason is Analysis of Reserves they believe these numbers are too unpredictable Analysts should carefully scrutinize a property I caand are potentially subject to manipulation by mansualty company's reserves. The most comprehensagement, because the timing of realization of these ive information on reserves is found in Schedule P of gains and losses is at management's discretion. the annual statement each company must file with Some analysts also exclude the "fresh start" tax credstate insurance regulators. This information is voluits, which property I casualty companies enjoy as a minous and potentially confusing. As an illustraresult of the 1986 Tax Reform Act, but I do not tion, Table 8 and Table 9 show only two of 98 pages consider these substantial enough to be material. of the consolidated Schedule P filed by Federal InsurChubb's EPS recovered strongly from depressed levance Company, which accounts for more than 99 els in the 1985-87 period and have continued to percent of Chubb's premium writings. These tables trace the loss development pattern for Chubb for grow, in spite of the industry's down cycle. 86

Table 5. CIGNA Corporation-Expense Development Property/Casualty Operations, 1982-mid-1991 Other Expenses Total Expenses Underwriting Expenses Commissions Ratio to Ratio to Ratio to Ratio to Net Net Net Net Year/ Volume Percent Premiums Volume Percent Premiums Volume Percent Premiums Volume Percent Premiums Quarter ($millions) Change" Written ($millions) Change" Written ($millions) Change" Written ($millions) Change" Written

(14.4%) (14.9)

$611.4

(17.3%) (17.3)

$128.7

1982 1983

$510.5 525.2

1984 1985

591.9 632.9

+12.7 +6.9

(14.5) (13.2)

1986 b 1986R:

716.8 747.8

+13.3

(12.7) (13.2)

865.1

1987: 1

168.1 174.9

(11.4) (13.3)

210.4

+9.0

(14.3)

43.3

+3.7 +1.7

(13.2)

+2.6 +3.9

(16.0)

201.4

210.5 214.1

(13.8)

41.3 48.1

210.9 755.3

+3.8

206.5 841.5

-12.0

(13.5)

+1.0

(13.8) (12.9)

+0.9

(14.4)

197.7 195.1 223.6

14.6 11.5 11.0

(12.6) (14.8) (13.7)

217.7 205.9 228.4

+3.5

(14.2) (15.6)

203.9 815.3

-3.3

(13.9)

+7.9

(13.7)

225.1 877.1

+9.0 +4.2

+5.2 -1.7 -7.5 -{).3

(13.7)

2 3 4

1988: 1 2 3

4

1989: 1

2 3 4

1990: 1 2

3 4

1991: 1 2

202.8 191.8 206.8 191.0 792.0

+2.9%

-5.5

611.0 685.7 770.5

-D.l % +12.2 +12.4 +12.3

+0.6% +4.6

(16.0)

146.3

+8.1

(15.3)

167.3

+14.4

-2.2 +6.7

463.6

+4.8

(3.0)

460.0 1,772.1

+1.3

+3.0

(2.9)

455.0

+7.9

+6.1

(3.3)

(14.0) (15.3) (14.7)

44.6 43.8 46.1

-4.2

(2.8)

444.8 498.1

+4.2 +7.4

43.2 177.7

+1.4

(2.9) (3.0)

472.2 1,870.1

+2.7

(30.6) (32.1)

+5.5

(31.4)

+11.0 +11.0

(3.0)

467.1

+2.7

(31.5)

(3.4) (3.5)

457.3 471.6

+2.8 -5.3

(31.9)

Q,Q)

453.0 1,849.0

-4.1

(31.0) (31.5)

+1.4

(H,2) (14.7)

44.0 194.0

+1.9 +9.2

(14.2) (15.4) (14.1) (15.1) (14.7)

54.0 45.0 62.0 45.0 206.0

+9.1 -7.4

(14.3) (16.3)

57.0 43.0

(13.0) (12.7)

198.0 213.0

-7.8 -1.8

173.0 717.0

-9.6 -9.4 -9.5

(11.3) (11.6) (12.1)

233.0 225.0 869.0

+9.4 +3.2 +0.7

168.0 149.0

-7.2 -15.3

(12.7) (11.6)

190.0 209.0

-4.0 -1.9

(28.6) (32.5)

(3.1)

-3.2 -1.6

--8.2

+3.1

(2.8)

212.9

-10.7

(30.9) (30.9)

+12.1 -9.6

42.6 175.3

48.6 51.9

(13.5)

+12.9

(34.6) (32.3)

421.8 426.7

49.5

-2.9

+9.7

(2.9) (3.1)

(15.1) (14.3)

(13.1)

1,413.0 1,549.7

+0.7 +20.5

(14.5)

(13.8)

(35.4%) (35.8)

+1.2% +11.6

1,749.2

-1.3

214.8 216.9

(3.3) (3.0)

$1,250.5 1,265.7

(3.0) (3.0)

+5.3 -{).8

(13.4)

(3.6%) (3.7)

167.3

(14.7)

834.1

218.0 863.0

181.0 176.0 187.0

(16.8)

129.5 135.4

+12.6

+19.5 +2.3 +6.2 +5.6

-4.4

(3.3)

(3.9)

1,749.2

(3.2) (3.7)

433.0 434.0 482.0

(3.0) (3.5)

443.0 1,792.0

(4.3) (3.4)

415.0 401.0

+4.5 +3.7 -5.1

-1.1

(30.3) (30.0) (30.3) (29.6) (33.8)

(31.6)

-7.3

(31.1)

-5.1

(31.3)

+2.2

-2.2

(29.0) (29.7)

-3.1

(30.2)

-4.2

(31.3)

-7.6

(31.4)

Source: Company reports. "Year to year for annual data; quarter to same quarter in previous year for quarterly data. bRefiects restatement for charged allocation of expenses.

each accident year. An accident year is a block of business written in one particular year. For example, in Table 8, for the accident year 1981, Chubb's management and actuaries estimated at the end of 1981 that incurred losses for the year would be $666 million on that business (the second figure in the far left column); in 1982, that estimate was revised to $637 million; in 1983, the estimate changed again to $671 million; and so on. The final two columns on the right of the table show the incurred loss development patterns for the past two reporting years and the cumulative impact of reserve development for all

accident years. It shows, for instance, that in 1990, Chubb's estimate of liability for all the years prior to 1981 was increased by $65.8 million-adverse development. Estimates for the years from 1986 to 1989 were decreased-favorable development. In total, development for all accident years in calendar year 1990 was favorable to the tune of $61.6 million. Table 9 shows a summary of the paid losses as opposed to incurred losses shown in the previous table. Looking again at 1981 (the second row in the table), we see that by 1990, total cumulative payments on that business had reached $665 million. 87

Table 6. Chubb Corporation-lnvestment Income and Total Property/Casualty Earnings History, 1985-mid-1991 AfterTax Net Investment Yearl Income Quarter ($millions) 1985 1 2 3 4

$44.9 49.0 48.2 52.0

1986 1 2 3 4

Total Percent Changea

Tax Rate

+24.4% +31.0 +20.5 +7.9

30.8% 29.0 26.1 24.6

54.3 54.7 61.0 60.9

+20.9 +11.6 +26.6 +17.1

1987 1 2 3 4

62.7 66.2 74.0 75.9

1988 1 2 3 4

Investment Income ($millions)

PIC Percent Changea

34.8 35.6 39.2

+10.3% +23.0 +23.8 +22.5

23.2 19.0 18.7 15.9

41.7 44.3 49.6 51.2

+15.5 +21.0 +21.3 +24.6

12.4 13.9 16.8 16.6

85.3 88.4 100.2 103.2

+12.3 +33.5 +35.4 +36.0

1989 1 2 3 4

103.1 104.3 117.7 119.3

1990 1 2 3 4

1991 1 2

Underwriting Earnings ($millions) ($millions)

($20.7) (25.5) (35.9) (105.9)

$10.4 9.3 (0.3) (66.7)

+34.1 +27.3 +39.3 +30.6

(10.4) (2.5) (4.9) (12.1)

31.3 41.8 44.7 39.1

54.9 57.0 61.6 63.3

+31.7 +28.7 +24.2 +23.6

11.7 25.5 13.6 11.6

66.6 82.5 75.2 74.9

18.6 18.9 21.6 21.6

69.4 71.7 78.6 80.9

+26.4 +25.8 +27.6 +27.8

19.8 4.2 (4.4) (3.8)

89.2 75.9 74.2 77.1

+20.9 +18.0 +17.5 +15.6

22.9 20.9 23.9 21.6

79.5 82.5 89.6 93.5

+14.6 +15.1 +14.0 +15.6

4.9 (4.7) (14.5) (10.7)

84.4 77.8 75.1 82.8

115.5 115.2 131.5 132.7

+12.0 +10.5 +11.7 +11.2

19.4 18.8 21.2 20.5

93.1 93.6 103.6 105.5

+17.1 +13.5 +15.6 +12.8

(7.1) (7.2) 8.0 27.0

85.9 86.4 111.6 132.5

116.5 116.0

+0.9 +0.7

15.9 15.4

98.0 98.1

+5.3 +4.8

7.0 5.6

105.0 103.8

$31.1

Source: Company reports. aChange from same quarter in previous year.

This was the business for which the company initially estimated payments of $666 million, shown in Table 8. Table 8 also showed that by 1990, Chubb was estimating incurred losses for 1981 at $710 million, which implies that it is still holding $44 million in reserves for unsettled claims on 1981 business. After nine years, Chubb's best estimate is that it has paid out 93.7 percent of all the dollar amount of claims that will ultimately be paid for the business written in 1981. One common way of analyzing reserves is to review the relationship between paid and incurred losses and how that changes over time. Changes in the ratio can provide valuable insight into the com88

pany. This is known as the ratio of paid to incurred loss, 93.7 percent in our example. Most property/ easualty businesses have a skewed distribution of loss payouts, with a very long right-hand tail; hence the expression "long-tailed reserves." Chubb's business has a longer-than-average tail, with about 6 percent unsettled business after nine years. Changes in these reserves patterns can provide analysts with some clues about the future. For instance, looking again at the 1981 accident-year business, paid losses by 1986 were $623.3 million (see Table 9) and the incurred losses were $716.6 million, so development was 87.0 percent at the end of the fifth year. Five years after the 1985 accident year

Table 7. Chubb Corporation-Quarterly Earnings History, 1985-mid-1991 (millions of dollars, except as noted) Average Shares Outstanding (thousands)

Life

Real Estate

Other

Total

Earnings per Share

$ 10.4 9.3 (0.3) (66.7) ($47.3)

$ 7.3 8.7 9.2 9.1 $34.3

$8.0 6.1 8.4 7.0 $29.5

($1.4) (1.6) (0.8) (1.7) ($5.5)

$24.2 22.5 16.5 (52.2) $10.9

$0.38 0.30 0.21 (0.88) $0.01

63,044 63,044 63,052 63,062 63,050

$ 0.6 24.4 14.1 20.5 $59.6

$0.01 0.39 0.22 0.33 $0.95

$ 31.3 41.8 44.7 39.1 $157.0

$ 9.0 8.6 8.9 10.0 $36.5

$8.8 6.9 9.3 7.8 $32.8

($3.9) (3.7) (2.3) (2.0) ($11.9)

$45.1 53.6 60.7 55.0 $214.4

$0.62 0.69 0.78 0.69 $2.82

67,066 77,648 77,680 81,618 75,472

$14.1 20.5 11.4 7.6 $53.5

$0.21 0.26 0.15 0.09 $0.71

$ 66.6 82.5 75.2 74.9 $299.2

$ 6.5 6.5 4.7 6.2 $23.9

$ 9.7 7.6 10.2 8.6 $36.1

($4.1) (5.1) (3.6) ($14.5)

$78.7 91.4 86.5 88.0 $344.7

$0.98 1.09 1.03 1.05 $4.15

82,434 85,620 85,650 85,734 84,860

$ 8.6 3.9 9.6 (36.8) ($14.6)

$0.10 0.05 0.11 (0.43) ($0.17)

$ 89.2 75.9 74.2 77.1 $316.5

$ 6.0 7.2 7.4 10.9 $31.5

$11.2 8.2 12.2 8.4 $40.0

($5.3) (3.9) (3.2) (3.0) ($15.4)

$101.1 87.5 90.6 93.4 $372.6

$1.40 1.04 1.08 1.11 $4.43

85,926 85,950 85,954 85,958 85,948

$ 1.4 (4.5) (0.4) (9.5) ($13.0)

$ 0.02 (0.05) (0.01) (0.11) ($0.15)

$ 84.4 77.8 75.1 82.8 $320.1

$ 9.4 11.2 10.2 11.2 $42.1

$11.7 11.3 10.2 8.8 $42.0

($3.7) (2.0) (3.1) (5.5) ($14.3)

$101.8 98.4 92.4 97.3 $389.9

$1.20 1.17 1.08 1.11 $4.56

86,005 86,036 87,370 89,560 87,242

$ 3.1 8.7 9.3 9.8 $30.9

$0.04 0.10 0.11 0.11 $0.35

$ 85.9 86.4 111.6 132.5 $416.4

$10.2 13.5 10.7 10.7 $45.1

$13.1 10.7 8.5 7.7 $40.0

($3.4) (2.9) (1.3) (2.0) ($9.6)

105.9 107.7 129.4 148.9 $491.9

$1.22 1.25 1.51 1.74 $5.72

88,369 87,574 86,941 86,573 87,364

$ 5.2 3.2 15.8 6.0 $30.2

$0.06 0.04 0.18 0.07 $0.35

$105.0 103.8

$12.0 14.3

$ 7.5 6.1

($0.4) 0.7

$124.1 124.8

$1.45 1.43

86,667 88,279

$ 4.2 8.2

$0.05 0.09

Total Year/ Property/ Quarter Casualty

Capital Gains

Per Share

1985 1 2 3 4

1986 1 2 3 4

1987 1 2 3 4

0.7)

1988 1 2 3 4

1989 1 2 3 4 1990 1 2 3 4

1991 1 2

Source: Company reports.

ended, paid losses for that year were $1.032 billion and incurred losses were $1.207 billion, or 85.5 percent development. The tail of Chubb's reserves is lengthening. Turning now to further study of the Schedule P reserve disclosures, I am indebted in the following analysis to Paulsen, Dowling Securities, Inc., a Boston-based insurance securities research firm. Table 10 and Table 11 present typical products of Paulsen, Dowling's research, outlining further productive ways to analyze reserves. Table 10 presents Chubb's development in a different format. The topmost

panel presents incurred loss development for each accident year in the form of a loss ratio, showing how the best estimate of the loss ratio has changed over time. Using the same 1981 accident year as an exampIe, the first estimate was a loss ratio of 64.2 percent ($666 million divided by earned premiums for that year of $1.037 billion). The estimated loss ratio rose to 69.1 percent by the end of the fifth year, before stabilizing in a range of 68.5 percent to 68.8 percent. The table shows very poor development for the 1983 and 1984 accident years. This business was written at the bottom of the underwriting cycle,

89

when industry pricing was extremely competitive. underwriter. During the past 15 years, the medical Chubb's initial estimates of losses in those years were malpractice business has been extremely cyclical. much too optimistic. Development was less adverse Recurring medical malpractice availability crises and for the 1985 accident year, and significantly favorable huge rate jumps have taken place. This is illustrated development took place in the 1986 and 1987 acciby the wide variation in incurred loss developments. dent years, which is when prices went through the For 1984, for instance, in spite of a conservative initial roof. In those years, Chubb was much too pessimisloss ratio estimate of 88.8 percent, adverse developtic in its initial estimates of how that business would ment was $113 million. Yet only two years later, in 1986, an initial loss ratio estimate of 72.4 percent tum out. Perhaps the very adverse development of the 1983 and 1984 accident years, which became resulted in favorable development of $240 million. evident by 1986, set the scene for the price increases The analysis by line of business shows that St. of the 1986 and 1987 accident years. This pattern of Paul has experienced significantly favorable develdevelopment was by no means confined to Chubb; opment in its medical malpractice reserves in recent years ($129 million and $204 million in 1989 and 1990, many industry participants show similar patterns. Note that the first report for the 1989 accident year respectively). St. Paul's loss ratio has benefitted by shows favorable development and that Chubb's first 10 points in each of those years from favorable develloss-ratio estimate for the 1990 accident year is 62.9 opment. This obviously raises the question of how percent, lower than the initial estimates for the 1988 long and how much further that can go, and whether and 1989 accident years and the developed-loss ratio St. Paul's current level of reported earnings is susestimate for 1989. Chubb has little incentive to raise tainable. This is typical of the questions that this type prices in the face of four years of favorable developof reserve analysis brings up. The analysis outlined here makes no attempt to ment. judge the adequacy of current reserves, an even more The second panel in Table 10 shows the dollar complex subject. What has been outlined is a series amount of the reserve development on a year-to-year of analyses of past reserving practices that shed light basis for each accident year. For example, looking at 1981, Chubb showed a reduction of $28.5 million in on the dynamics of reported earnings. Of course, the first year (from $666.0 million to $637.5 million). company managements' past successes in estimating An equivalent number has been calculated for each future liability can give confidence about adequacy. A long and consistent history of modest annual acciaccident year, and these are cumulated to show the dent-year redundancies, although rare, is a signal of total dollar impact of reserve development for each stable earning power and good management. accident year. The lower two panels analyze reserves by accident year and by line of business-information that Conclusion can be found in other sections of Schedule P. Note As stated at the outset, this presentation has considparticularly that worker's compensation, a troubleered only two aspects of the analysis of property / casome line of business for many companies, continues sualty company operations. Other significant factors to develop unfavorably, but the unfavorable develshould also be addressed in a complete analysis, opment is overwhelmed by the favorable developincluding line-of-business and geographic breakment in commercial multiperil and other liability downs, analysis of assets, and considerations relatcoverages. Line-by-line analysis of Schedule P deing to capital adequacy and leverage. Application of velopment trends can produce useful insights into the techniques presented here will go a long way company operations. toward understanding the peculiarities of propTable 11 shows the same type of analysis for St. erty/ casualty company statements. Paul Fire and Marine, a major medical malpractice

90

Table 8. Incurred Losses and Allocated Expenses Reported at Year End, Consolidated Federal Insurance Company, 1981-1990 (thousands of dollars) Years in Which Losses Were Incurred b

Prior

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

Incurred Losses and Allocated Expenses Reported at Year End 1981

$512,528 666,004

1982

$604,717 637,521 690,409

1983

1984

$627,373 670,763 682,574 761,002

$700,734 658,799 707,118 768,324 913,385

1985

$854,388 717,243 787,127 907,388 959,205 1,075,922

1986

$894,096 716,576 796,288 938,446 1,013,028 1,132,386 1,323,490

1987

Source: Chubb Corporation, Schedule P, Part 2, Summary, Consolidated Annual Statement 1990. "Current year less first or second prior year, showing (redundant) or adverse. bReported reserves only. Subsequent development relates only to subsequent payments and reserves.

I,C)

1989

1990

$976,737 $1,014,560 $1,093,056 $1,158,852 711,427 713,314 713,423 710,380 796,014 788,919 787,933 792,981 947,603 953,197 960,309 962,464 1,055,949 1,082,536 1,098,020 1,106,560 1,144,298 1,165,704 1,182,041 1,207,621 1,268,116 1,217,455 1,209,480 1,142,087 1,563,047 1,472,103 1,400,300 1,336,441 1,740,735 1,635,969 1,631,779 1,727,536 1,715,368 1,773,580

Totals

I-'

1988

Development" Two One Year Year

$65,796 (3,043) 4,958 2,155 8,540 25,580 (67,393) (63,859) (22,190) 02,168)

$144,292 (2,934) 3,972 9,267 24,024 41,917 (75,368) 035,662) 008,956)

(61,624)

(99,448)

I,Q

N

Table 9. Cumulative Paid Losses and Allocated Expenses at Year End, Consolidated Federal Insurance Company, 1981-1990 (thousands of dollars) Years in Which Losses Were Incurred

Prior 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

Cumulative Paid Losses and Allocated Expenses at Year End a __ 1981 0 $272,014

1982 $188,585 447,156 297,520

1983

1984

$331,620 514,660 468,724 308,141

$450,372 561,470 534,035 529,405 364,687

1985 $543,163 600,917 596,143 628,443 642,046 392,019

1987

1986 $618,602 623,298 641,305 707,309 764,702 687,030 356,314

$668,827 641,511 677,589 767,448 855,364 817,605 603,724 353,073

Source: Chubb Corporation, Schedule P, Part 3, Summary, Consolidated Annual Statement 1990. aNet of salvage and subrogation received.

1988 $714,757 652,705 690,293 803,193 927,911 915,967 716,218 637,719 464,587

---_._--

1989 $764,829 659,651 703,898 828,068 974,493 979,747 803,878 747,502 789,229 476,076

1990 $803,100 665,445 715,695 843,038 1,003,266 1,032,281 869,486 824,678 942,875 870,366 468,392

Table 10. SChedule P Reserve Analysis, Chubb Corporation Year

Prior

Premiums earned ($thousands)

1981

1982

$1,037,640 $1,096;234

1983

1984

1985

1986

1987

$1,168,763 $1,337,602 $1,697,170 $2,264,496 $2,633,305

1988

1989

1990

$2,723,393 $2,701,119 $2,820,730

Accident year incurred loss development First year Second year Third year Fourth year Fifth year Sixth year Seventh year Eighth year Ninth year Tenth year

64.2% 61.4 64.6 63.5 69.1 69.1 68.6 68.7 68.8 68.5

63.0% 62.3 64.5 71.8 72.6 72.6 72.0 71.9 72.3

65.1% 65.7 77.6 80.3 81.1 81.6 82.2 82.3

68.3% 71.7 75.7 78.9 80.9 82.1 82.7

63.4% 66.7 67.4 68.7 69.6 71.2

58.4% 56.0 53.8 53.4 50.4

59.4% 55.9 53.2 50.8

63.9% 60.7 59.5

64.0% 63.5

($28,483) 33,242 01,964) 58,444 (667) (5,149) 1,887 109 (3,043) 44,376

($7,835) 24,544 80,009 9,161 (274) (7,095) (986) 4,958

$7,322 139,064 31,058 9,157 5,594 7,112 2,155

$45,820 53,823 42,921 26,587 15,484 8,540

$56,464 11,912 21,406 16,337 25,580

($55,374) (50,661) (7,975) (67,393)

($90,944) (71,803) (63,859)

($86,766) (22,190)

($12,168)

102,482

201,462

193,175

131,699

081,403)

(226,606)

008,956)

02,168)

6.7%

14.8%

26.5%

21.1%

12.2%

-13.7%

-14.5%

-6.3%

-0.7%

62.9%

Accident year reserve development ($thousands) First year Second year Third year Fourth year Fifth year Sixth year Seventh year Eighth year Ninth year Total development Percent of imtial incurred Total 1990 reserve development

$92,189 22,658 73,361 153,654 39,708 82,641 37,823 78,496 65,796 626,324

($61,624)

Reserve Breakdown by Year Prior to 1981 $355,752 1981 44,935 1982 77,196 119,426 1983 103,294 1984 1985 175,340 272,601 1986 1987 511,763 1988 688,904 1989 845,002 1,305,188 1990 Total reserves ($thousands) 4,499,401

~I

7.9% 1.0 1.7 2.7 2.3 3.9 6.1 11.4 15.3 18.8 29.0 100.0

Source: Paulsen, Dowling Securities, Inc.

Prior Year Development by Line of Business 1986 1987 1988 Homeowners Private auto liability Commercial auto Workers compensation Commercial multi-peril Medical maWtractice ~ecialliabi ity ther liability All other lines Total all Schedule P lines

($7,198) 25,151 5,149 27,657 70,323 193 0 58,808 9,464 189,547

($7,198) 2,286 3,775 4,288 41,245 (3,291) 0 84,212 (39,483) 85,834

($7,198) 3,240 03,140) 23,859 04,875) (58) 0 (6,893) (40,338) (55,403)

1989 ($7,198) (4,013) (7,734) 29,727 (7,413) (2,028) 0 (20,406) (30,927) (49,992)

1990 ($7,198) (8,074) (8,142) 23,516 (29,652) (3,897) 0 (41,531) 13;354 (61,624)

'£ Table 11. SChedule P Reserve Analysis, St. Paul Are And Marine Year

Prior

Premiums earned ($thousands)

1981

1982

1984

1983

1985

1986

1987

1988

1989

1990

$1,518,860 $1,530,285 $1,668,001 $1,846,947 $2,032,797 $2,492,010 $2,673,896 $2,631,684 $2,577,996 $2,769,560

Accident year incurred loss development First year Second year Third year Fourth year Fifth year Sixth year Seventh year Eighth year Ninth year Tenth year

77.6% 75.1 75.9 74.8 75.5 76.0 75.8 75.7 75.9

($75,882) (17,070) 15,589 (9,275) 2,886 (742) (6,580) (1,103) 14,707 (77,470)

($39,379) 12,245 (15,762) 9,897 8,385 (3,155) (1,958) 3,282 (26,445)

83,357

113,031

(10,270)

(239,684)

-7.2%

-2.2%

6.0%

6.9%

-0.6%

-13.3%

Accident year reserve development ($thousands) ($65,941) First year (53,682) Second year 27,763 Third year 1,856 Fourth year 34,856 Fifth year Sixth year 32,065 14,804 Seventh year 13,547 Eighth year 25,209 Ninth Gear 30,477 Tota develorment Percent of imtial incurred Total 1990 reserve development

($thousands) 5,881,727

3.2% 0.7 0.9 1.4 2.6 3.9 6.3 11.0 14.8 24.3 30.9 100.0

Source: Paulsen, Dowling Securities, Inc.

82.0% 84.2 86.1 86.3 84.0 81.5

72.4% 70.0 68.0 65.2 62.8

69.6% 70.4 66.1 60.9

69.5% 69.9 63.6

81.3% 85.6

$9,175 (166,259)

$110,686

(231,592)

(157,084)

110,686

-12.5%

-8.6%

5.3%

Accident Year-Accident Year Reserve Development $58,218 $95,126 $46,162 ($59,353) $22,398 (51,064) (113,664) 20,164 25,383 37,951 (70,236) (140,326) 18,482 29,258 3,220 (1,372) (46,585) (59,031) 14,720 (17,688) (51,018) 2,544 (30,949) (17,676) 178

78.7%

($280,248) _Prior Year Development by Line of Business 1986 1987 1988

Reserve Breakdown bv Year Prior to 1981 $190,136 38,876 1981 52,452 1982 80,043 1983 154,658 1984 230,710 1985 373,172 1986 649,412 1987 868,967 1988 1,428,745 1989 1,814,556 1990 Total reserves

83.5% 87.0 88.2 89.3 90.2 90.3 88.5 88.5

88.8% 94.0 95.4 96.9 96.9 95.9 94.9

70.6% 65.6 64.5 65.5 64.9 65.1 65.0 64.6 64.5 65.5

Homeowners Private auto liability Commercial auto Workers compensation Commercial multi-peril Medical ma~ractice ~ecialliabi tty ther liability All other lines Total all Schedule P lines

$7,536 4,057 2,538 33,354 (1,054) 64,386 (4,238) 64,206 (33,119) 137,666

($14,118) 14,826 26,494 4,549 1,867 (15,583) 27,268 32,799 (15,818) 62,284

$68 12,124 2,243 (5,686) 710 (25,456) 10,078 9,569 (22,855) (19,205)

1989 ($1,101) 11,397 (3,397) 4,424 (7,848) (128,827) (291) (84,326) (49,492) (259,461)

1990 ($2,563) 3,398 (6,313) 15,916 (9,914) (203,853) (3,353) (52,843) (20,723) (280,248)

Question and Answer Session Anthony T. Cope, CFA Question: What is the difference between earned premiums and written premiums? Cope: Under the accounting system insurance companies use, a premium is earned pro rata over the life of the policy, not when it is written. For example, assume you bought your annual homeowner's insurance and paid your $1,000 premium on the 1st of July 1991. In that case, the company would record in 1991 written premiums of $1,000 and earned premiums of $500, with the remaining $500 earned in 1992. The theory is that if you sell your house or change insurance companies, you would get a premium refund on a pro rata basis, so only the earned premium is recorded as revenue.

Question: How does one go about obtaining a Schedule P report for the various companies? Cope: Schedule P's can be obtained directly from the company or from the appropriate state insurance departments.

Question: Is a long tail on reserves good or bad?

Cope: A long tail may be good or bad. It is good in the sense that a long tail on reserves builds up very substantial assets for investment and produces a much greater amount of investment income. The longer the tail, however, the more difficult it is to estimate accurately the ultimate losses.

Question:

What is "fresh start"?

Cope:

The Tax Reform Act of 1986, among other measures, required companies to discount their reserves to present value when calculating deductions for tax purposes. To mitigate the severity of the impact of this change, companies were allowed an additional tax deduction when they initially discounted reserves on January 1, 1987. This deduction is known as the "fresh start" tax deduction because companies were, in effect, able to start fresh in the calculation of the tax liability on reserves. For accounting purposes, that additional tax deduction is taken into earnings over the remaining life of the then-existing reserves. Financial Accounting Standard No. 106, "Accounting for Income Taxes," when implemented, will change this accounting treatment, and the fresh start will disappear. Question: Is focusing on incurred-loss development rather than paid losses dangerous?

Cope:

Focusing exclusively on incurred-loss development numbers can be misleading because the numbers contain a very substantial element of management estimates, particularly in the early years. That is why I emphasized that studying the ratio of paid to incurred losses is important. I prefer to analyze incurred-loss development because I believe that the changes in management estimates from year to year give valuable insights of the type I out-

lined in my presentation. I am aware that other analysts study paid losses, particularly when trying to project whether reserve levels will be adequate. Question: Please explain the difference between GAAP and statutory equity. Cope: The principal difference between GAAP and statutory equity relates to the capitalization of acquisition costs. For GAAP purposes, companies are allowed to capitalize and amortize acquisition costs, creating an intangible asset on the balance sheet; statutory accounting requires immediate expensing of these costs. This is more a factor in the life insurance sector than in the property/ casualty sector.

Question: What is the reason for the huge change in St. Paul's medical malpractice reserve development in 1989 and 1990? Cope: The huge change came about because of massively favorable development of the 1986 and 1987 accident years and, to a lesser extent, the 1988 accident year. St. Paul encountered problems in the early 1980s, recording a loss in 1984. In my opinion, the company's response of reunderwriting and repricing its book of business overshot the mark. The pendulum swung too far in the other direction.

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Interpreting Life Insurance Company Numbers Myron M. Picoult Managing Director, senior Insurance Analyst Oppenheimer & Company, Inc.

Because insurance companies are in a capital-short business, they are susceptible to pressures related to the quality of their capital. The quality and level of disclosure of insurance companies' asset bases has improved, but the industry as a whole remains reactive rather than pro-active in providing data up front.

The life insurance industry is one many investors have overlooked. In recent years, however, a crisis in confidence has occurred because of the industry's well-publicized asset problems. A recent poll in the Wall Street Journal indicated that a majority of Americans have serious concerns about the financial stability of the industry. At question is the ability of the industry to remain solvent given its exposure to problem assets such as junk bonds and defaulting mortgages. In some instances, the public's concerns have been fed by erroneous news reporting and maudlin headlines. Part of the problem is the industry's rather anemic response to the questions that have been raised.

Insurance Company Insolvencies The beginning of this loss of public confidence goes back to April 1991, when the California insurance department took over First Executive Corporation. Four months later, the National Association of Insurance Commissioners (NAIC) formed a task force to examine the matter and issue a report. The task force found no imminent danger with respect to First Executive. In the meantime, a policy-surrender surge began, and new business dropped off. In essence, First Executive was facing a liquidity crisis. In May 1991, the California insurance department took over First Capital Holdings. After a proposed merger of Mutual Benefit Life with Metropolitan Life broke down in April, a surrenders and withdrawals spike began, which led Mutual Benefit voluntarily to accept protective custody by the New Jersey insurance department in July 1991. Looking back, the situations at First Executive and First Capital were not totally unpredictable, but

96

because Mutual Benefit was perceived as a conservative life company, its problems caused some surprise. Its main problem was too little capital and too much mortgage exposure. In each of these three situations-First Executive, First Capital, and Mutual Benefit-problem investments have been a major part of the story. After each episode, faith in the overall financial stability of the industry has wavered. The crisis is fairly widespread, and comparisons have been made to the savings and loan crisis. Some observers predicted that the industry would face an ever-increasing departure of policyholder funds. Even though the situation has calmed down somewhat, a fair number of dubious articles and comments are still being circulated. A recent article in USA Today, for example, used year-end 1991 rather than current numbers, which perpetuated the misinformation. Owning mortgages and junk bonds is not what creates an insolvent insurance company. The assets of an insurance company embody two types of risks: interest rate risk and credit risk. Although most companies limit the interest rate risk through duration matching, credit risk cannot be hedged. Generally, this will not be a problem because an insurer can hold on to an asset long enough for the credit to improve. If this is not possible, and a majority of the policyholders for varying reasons begin to let their policies lapse, the insurer quickly exhausts its supply of liquid assets and is forced to liquidate credit-impaired assets, normally at deep discounts to book value. The most dangerous exposure for a life insurance company is the exposure to policy withdrawals and surrenders. Policyholders' propensity to surrender their policies tends to vary with the distribution

source. Policies sold through securities dealers are more likely to lapse than policies sold through career agency systems. Securities dealers have no allegiance to any particular company and will often take advantage of a perceived problem to create a new commission. Career agents, however, depend on a particular company or group of companies for their livelihoods and will try to discourage policyholder relationships from lapsing. A "run on the bank" tends to be irrational, but it happens. Even the most sophisticated institutional policyholder may get cold feet when it hears of a run on the bank, because it does not want to be the last one at the window. Thus, runs tend to feed on themselves. Will more insolvencies occur? I will be surprised if they do not.

Analyzing the Financial Statements Solvency, in essence, is measured by a company's capital and surplus-its statutory net worth. Statutory accounting is designed to reflect the long-term nature of the life insurance business. My opinion of Generally Accepted Accounting Principles (GAAP) is that they are garbage. We capitalize the numbers and see the reports that include them. Too little attention is paid to statutory accounting. Statutory accounting is somewhat conservative, but given what has been going on in the business, perhaps more attention should be paid to the statutory data and a lot less to the GAAP numbers. Claims and expenses are paid out of statutory cash flows, not GAAP cash flows. The following items are critical in analyzing the balance sheets and income statements of life insurance companies. The mix of assets compared to industry averages is important, but a mutual company should be compared against the mutual segment of the business, a stock company against the stock segment, and so forth. For example, the industry as a whole has about 19 percent of its asset base in mortgages; the stock segment of the industry has 16.7 percent, and the mutual segment, 21.8 percenta meaningful difference. In real estate exposure, the stock industry has 1.3 percent and mutuals, 3.5 percent. The proportions of volatile and nonvolatile assets are also important-specifically, noninvestment-grade (junk) bonds and problem mortgages compared to the rest of the portfolio. NAIC categorizes insurance company assets into six grades according to quality. Categories one and two are considered investment grade, and three through six are considered to be, in varying degrees, questionable or

impaired assets. I like to relate the noninvestmentgrade issues to a company's statutory surplus, and I include the mandatory securities valuation reserve. I also try to get specifics on private placements and what portion of the portfolio they represent. Analysis of private placements should be similar to the analysis of publicly traded bonds. In many instances, the private placements are of better quality than some of the public debt. Reserves must be analyzed. Insurance companies must set up various types of reserves, and analysts should be able to get those figures from the companies on a quarterly basis, although companies provide only annual data. The revenue mix is the most important item on the income statement. Analysts should determine what portion is premiums, what portion is net investment income, and what is "other" income. The sources of the other income figures are important. For example, the company may have separate operations or subsidiaries that generate other income. For many holding companies, just determining what they own is difficult; the information may be buried in the other income category, and sometimes it is worthwhile to go digging. Premium mix is important. Analysts should determine the mix of ordinary life, annuities, group, and individual policies. They should determine whether the health component is a health maintenance organization or traditional indemnity and to what extent it is experience rated. A certain persistency factor relates to each of these lines of business, which should provide some information about the consistency of the company's revenue flow. Analysts should examine both first-year and renewal premiums. The bulk of the premiums for an insurance company are renewals. A dropoff in sales does not necessarily translate into an immediate diminution in premiums. If people are pulling back in the marketplace because they do not like the current pricing, that is not necessarily a negative. If as they are pulling back they clean up and restructure their insurance plan, that could prove to be positive if it enhances persistency net of business being lapsed. Net investment income has become an increasingly important and sensitive factor because it is a big number for most companies. Analysts should determine the average yields the company is getting on the various types of assets in its portfolio. In addition, they should look at the maturity of the bond portfolio. How much has come due or is coming due? This is a particular problem in the current interest rate environment. For example, because of the concerns being raised by rating agencies today,

97

many life insurance companies are forced to keep a bigger chunk of their asset base in short-term instruments. With the rather precipitous drop in short rates, many of these companies have suffered a double hit. Loadings are important as well. Analysts should determine to what extent companies try to adjust for changes in mortality, expense, and morbidity experience. They should also evaluate how timely the companies are in making the adjustments. Expenses are absolutely critical to the evaluation of an insurance company. Trends in expenses are particularly revealing. Analysts should evaluate any successes companies may have had in trimming their expenses and to what extent they could become more efficient. That is one of the key factors that will separate successful companies during the coming years. Finally, pricing is an important factor in the valuation of insurance companies. Is the price of insurance going up, sideways, or down? Some of the major mutual companies, such as Prudential and Metropolitan, indicate they are cutting back their dividends, which in essence is a price increase. This is inevitable. Companies in this industry, particularly the mutuaIs, do not have access to outside capital. To acquire capital, they must either raise prices or become more efficient. For the most part, insurance companies do not have a lot of volatility in their revenue trends-premiums and net investment income--nor do they have volatility on the benefit side. They will get blips from time to time in mortality and morbidity, but those even themselves out. We have another overlay now, a falling interest rate environment in which the companies are susceptible to varying degrees of asset writedowns.

Mortgages An insurance company's total mortgage and real estate exposure relative to its invested asset base is important, because this is where a lot of the problems have been surfacing. At a minimum, a company's holdings should be compared against some industry standard. The American Council of Life Insurance publishes quarterly industry data on real estate holdings. Analyzing the data for a company can provide valuable clues about its strength. For example, the geographic spread may indicate where economic problems are occurring and what the company's mortgage exposure is in those areas. Similarly, the mix of the mortgage portfolio among apartment

98

buildings, strip shopping centers, convention facilities, hotels, office buildings, and so forth provides valuable information on the potential problem areas for the company. Different types of facilities have different delinquency rates, and knowing whether the company has more or less exposure to delinquency risk is important. Another helpful piece of information is the average size of a company's real estate loans. Holding a $500,000 loan is quite different from holding a $4 million loan, recognizing that loans of different sizes will apply to companies of different sizes. The chances are that if the insurance company has a loan of $1 million or less, it has not bet the farm the way it would have on $10 million or $20 million deals. More of these data are becoming available. The lease maturities are also an important consideration, particularly if the asset-type mix or the geographic locations of the mortgages are a concern. Analysts should examine the mix of maturities and determine whether the leases are subject to an increasing rate of rollover during the next few years. Clearly, the sublet market is obfuscating some of the trends in rental rates. Although the sublets may be stabilizing, the key point is that when a mortgage was first made, a certain rental rate was assumed to be needed to service that mortgage. In many instances, the rental rates prevailing now would not be sufficient to cover mortgage service. That explains the writedowns and adjustments in property values. Not all mortgages are bad, but some obviously will have to be adjusted. If maturity seems to be a problem, analysts should find out as much as possible about the tenant mix. Are the tenants strong or weak? What kinds of corporate entities are involved? Is it an industry going through a shrink mode? Is it an industry that is holding its own? A sizable exposure to tenants that are in the financial services business will be viewed differently today than it was two or three years ago, because that industry is going through a certain amount of shrinkage. The types of mortgages written are also important. For example, analysts should determine whether the company writes bullet mortgages, and if so, when they come due. Some life companies have been opportunistic in writing their mortgages. Although they have picked up some grief, something at 220 or 250 basis points above the Treasury curve may not be so bad if it is a good-quality credit. I have seen companies reduce their mortgage and junk bond exposures just because of public and analytical perceptions, rather than for financial reasons. Analysts should examine the specifics of any mortgage foreclosures, restructurings, and delin-

quencies. If an insurance company tells you XYZ is Reporting of SurplUS delinquent, is it talking about 30, 60, or 90 days The makeup of statutory surplus is becoming indelinquent? Different companies use different stancreasingly critical. Analysts should determine dards, and the distinctions are important. whether any subsidiaries are included in the surplus All of this information on real estate holdings number. Suppose, for example, that a property liashould be related to statutory surplus, because GAAP surplus is not a meaningful number. Regulability company owns a life company. When it retors and rating agencies look at statutory, not GAAP, ports the surplus of the property liability entity, it numbers. The statutory numbers are supposed to includes the surplus of the life company. That surback up fluctuations and pick up any shortfall that plus is being counted twice. might occur. The advent of risk-based capital standards, acOnce a company's mortgage holdings have been cording to which companies must allocate surplus examined, analysts should look at the reserves the by business line, is leading to some interesting if not company has established. How much? How are difficult situations. Companies are beginning to they being funded? Over what period of time? Setcomplain about this requirement, because it focuses ting up appropriate reserves is not an easy thing to attention on their surplus. People are looking to see do. Not every problem mortgage is going to be if, for example, some type of surplus note is inworthless. Most mortgages have some value, in convolved-and, if so, whether the surplus is questiontrast to some construction and development loans. able or clean. The cleaner the surplus, the better off Nevertheless, some type of reserve must be set up to the investor. cushion some of the loss in value. Insurance compaThe NAIC has two task forces working on risknies differ widely in how they set up loss reserves, if based capital-one for the property liability business they do at all. and one for the life insurance business. This is long overdue. Although the task force will not settle on the formulas for a while, the draft of the life insurance Leverage Ratios report will be available soon. The task force will look at risk-based capital as it relates to the assets, mortalThe two important leverage ratios are surplus to ity and morbidity loadings, interest rates, expenses, invested assets and surplus to total assets. In calcuand business mix. How do the many life companies lating leverage ratios, I use the statutory data. The that do not allocate their capital by business line or mandatory securities valuation reserve can be inknow whether they are making a profit? segment cluded or excluded, as long as this is done consisTherein lies one of the major problems with many tently. companies in this business-trying to be too many Some interesting nuances differentiate the leverthings to too many people. age relationships for the different segments of the From my perspective, this is a capital-short busiindustry. For example, for the mutual companies, ness, and that explains some of the pressures develthe average ratio of surplus to total assets is about 4.6 oping at this juncture. The quality and level of dispercent; for stock companies, it is about 8.2 percent. closure of asset bases has improved as these quality These ratios have been tracked historically for each of capital questions have been raised. All too often, segment of the business to see how volatile they have the industry has been reactive, rather than providing been. The ratios for the stock and the mutual segments of the business have been fairly consistent. the data up front. This does not help its image.

99

Question and Answer session Myron M. Picoutt Question: What is a mandatory securities valuation reserve? Picoult: It is a reserve companies are required to establish against the swings in their common stock portfolios. As a general rule of thumb, life companies do not have material exposure to common stocks, but this is a way to protect their portfolios. The reserve is considered part of surplus. Question: The rating agencies have not done a very good job of warning investors about impending problems in the insurance industry. Are there any alternatives? Picoult: The ratings tend to be self-fulfilling prophecies, although in an attempt to regain their credibility, the rating agencies have become more proactive. Things do not change that drastically overnight, however. It is helpful that Moody's and Standard & Poor's are doing more in the insurance sphere. I watch the mutual segment, but I really do not go through individual companies very closely because I cannot buy them and sell them, unless they have a public subsidiary. In general, the amount of work the rating agencies do in the life business has not been very useful because people have ignored it. That situation has changed in recent months, however. This industry has a credibility problem, part of it based on the industry'S response to its problems. Given time, things will straighten themselves out. The rating agencies are doing a better job, and they are more sensitive to changes. If the agencies are

100

that concerned about the industry, however, they should lower their ratings on the companies by two notches. If they want to hold this industry to a higher standard, then they need to raise the standard for all industries. The way these companies are reviewed needs improvement.

Question: If more insolvencies occur, as you suggested, how will they affect public confidence? Picoult: I hope the insolvencies will be relatively small companies that do not make a lot of noise. The industry as a whole would go to some severe extremes to prevent a major public company from going down the drain. A run on the bank would be very difficult to stop. A lot of small- and medium-sized companies are out of business now, but they do not know it or do not want to tell anyone about it. As for guaranteed investment contracts (GICs), I doubt that all of the money in GICs is going to shift out of the insurance business, although it may go into different segments. More of it, if not all, will ultimately be shifted into forms of separate account business. Some of the small- and medium-sized insurance companies did not have a significant capital base from the outset, so any impairment to their business was bound to cause problems. Probably more mutuals and stock companies should merge.

Question: How many insurance companies are venturing into derivative swaps? Does this present a potential problem? Picoult:

One of the things to

look at for any holding company is other income-the other operations they have, and what is really there. Most insurance companies would have difficulty becoming involved in swaps in any substantive way unless they have an Aaa rating. Also, companies that are doing it, such as American International Group (AIG), are playing off of their balance sheet rating, because the client base willing to do business with them has a certain level of confidence. If a client does not have that confidence, then it should not be doing business with the company. You also should look at the extent to which the company has been involved in similar activities over a period of time and the extent of their success. Notwithstanding what AIG or others say, if one of these companies involved in swap trading were to go down and if they were to walk away, that will put a mark on the industry.

Question: Do you ever use GAAP numbers? Picoult: I have no choice but to use GAAP numbers because most of the data we get from companies is GAAP-reported. A couple of years ago, the Financial Accounting Standards Board first said for the life insurance business, as it had previously with banks, that companies must include their capital gains in earnings. That was one of the worst things the accountants ever did. Some companies have begun breaking those numbers out now between operating and net. I look at the statutory numbers fairly closely for solvency figures and expense trends, but you have

no choice but to use GAAP for price-earnings and price-bookvalue relationships because that is the way they are compared. You probably could make some adjustments, but you would spend your life doing them and would never be able to get to the analytical work. Question: Was the run on Mutual Benefit the result of the misuse of insider information?

Picoult: No, I do not think it was misuse. Obviously, people in the insurance business had some sense of the real estate exposure Mutual Benefit had. They knew where big clumps of investments were and what was going bad. They just made use of that intelligence. As a general rule, John Q. Public does not have access to that information. Question: Please discuss the deferred acquisition costs in the old National Liberty.

Picoult: That is something that rattles people with respect to Capital Holding and some other companies with large deferred acquisition costs. To their credit, they are writing that down to the extent that they speed up capital gains on their portfolios. Sometimes a company does take a chunk of a writeoff when it sells a

subsidiary, but that is buried somewhere or sometimes not revealed at all. Question: Nonperforming assets in banks include renegotiated reduced-rate loans. In life companies, these loans are considered performing assets. Is there any way to compare these?

Picoult: Looking at nonperforming restructured loans and delinquent ones is important, although the information is not always clear. If a loan was restructured properly, it should be performing. I have heard of instances in which insurance companies have shifted nonperforming assets and nonperforming mortgages among subsidiaries after 90 days, which is a way to avoid showing them as nonperforming. It is cheaper to pay the title costs than to show the nonperforming loan. Question: Should credit-tenant real estate or real estate for which the lease payments are guaranteed by an investment-grade issuer be classified as real estate or bonds?

Picoult: This is a more secure type of real estate, but it is still real estate. Eventually, real estate will be categorized by quality, but it is still real estate.

Question: Without regulatory oversight to help identify delinquent and problem loans, I do not have a lot of confidence in reported delinquency rates or American Council of Life Insurance (ACLI) averages. Can you suggest any alternative for industry averages?

Picoult:

I am not overly impressed with the quality of state regulation in this country. From my perspective, the NAIC would like to have the power after the fact. Admittedly, it has done more during the past six months than it has done in several years, because it hears the Feds behind it. The data being put out by the ACLI is about the best we can get, because it is a compilation of industry data. The quality of regulation needs a material upgrading, although it would be nice to think that most of it is done legitimately. That is one of the major problems with the industry. The quality of regulation has vast disparities on a state-by-state basis. Many states do not have an actuary on staff, not even a consulting actuary. How do you analyze an insurance company if you do not have an actuary? The amount of money put back into the insurance departments in most instances is negligible relative to the premium taxes collected.

101

Valuing the Securities of Insurance Companies Donald G. Zerbarini Analyst Lord, Abbett & Company

The process of valuing insurance stocks has progressed from an art form to one that borders on science. With the tools and knowledge base currently available, cyclicality will become less of a factor in evaluating insurance company securities.

The component segments of the insurance industry-multiline, life insurance, and property I casualty insurance companies and brokers and reinsurersdiffer in their performance determinants. I will discuss some characteristics of these different segments, some recent developments, and some of the key elements of the industry's profit and loss statements (P&Ls).

Historical Performance The stock-price performance of the various industry components relative to the S&P 500 during the past 10 years is shown in Figure 1. The history has been somewhat of a roller coaster. In 1984 and 1985, stock prices for reinsurance, property I casualty and, to some degree, multiline companies had a tremendous spike upward on a relative basis. This upturn happened principally because the rating environment improved. A large shortage of capacity developed in commercial liability insurance, and premium prices went through the roof. Reinsurance was also very scarce during that time. That development followed a prolonged period of lack of profitability in the industry, somewhat similar to what it is going through now. In 1986 and 1987, stock prices for all segments became depressed on a relative basis, except for the multilines, which meandered forward, primarily on the strength of their group accident and health (A&H) business. A&H is, on balance, primarily indemnity insurance because of the way it gets the benefits to the insureds. As such, profits are inclined to be ravaged by the forces of inflation. In fact, according to companies that provide group A&H

102

indemnity, their average trend factors run at about 18 to 20 percent a year to allow for projected inflation in their rate-making process. Group A&H might be construed to be somewhat profitable, although during the past 18 months, many analysts began to suspect that the party is about over, and group A&H profits will tum down again. Among other things, this A&H factor is a big depressant to the performance of multiline stocks, because these companies have the broadest exposure to group A&H. The patterns for price-earnings ratios (P I Es) and price-book ratios (P IBs) are similar patterns to those of stock prices. Life insurance company relative PIEs, as shown in Figure 2, and relative P IBs, as shown in Figure 3, improved dramatically in the 1984-85 period. Property I casualty company PIEs and P IBs are shown in Figure 4 and Figure 5, respectively. Table 1 provides additional PIE and P IB detail on specific insurance companies. The return on equity (ROE) is an important criterion as to when the underwriting cycle is going to tum. For the whole industry, ROE is approaching 2.5 percent. Investors in initial public offerings would be reluctant to put their money up for such low rates of return when they can achieve three times those rates in a risk-free bond environment. Price-book-value ratios for the life insurance companies and property I casualty companies are somewhat related, although the causality is less relevant to property I casualty companies. The stocks of life insurance companies in particular operate as bond surrogates. Typically, life companies largely invest in fixed-income securities, and book values move inversely with interest rates. Thus, as interest rates go down (up), their bond portfolios, and hence

Figure 1. Insurance Indexes--Stock Perfonnance Relative to S&P 500, 1982-91

Figure 2. life Insuranee--Price-Eamings Ratio Relative to the S&P 500, 197G-4Q1991 140 r - - - - - - - - - - - - - - - - - - - ,

1982 = 100

130

160

120

140

110

120 100 80

70

60 40

60 50 L -_ _L-_----.JL-_----"_ _---i_ _--'-------' '90 '92 '82 '86 78 70 74

,",

'82

'83

'84

'85

'86

'87

'88

'89

'90

'91

- - - Reinsurance Property /Casualty - - - - - - - - Life

---Brokers ................ Multilines

'82

'83

'84

'85

'86

'87

'88

'89

'90

'91

- - - T-Bond Yield

Source: Kidder, Peabody & Co., Inc.

their book values and stock prices, go up (down). This phenomenon is apparent in Figures 2 and 3. Recently, life insurance companies have been distressed by problem mortgages, junk bonds, and real estate defaults. All of this is meaningful because the aggregate of real estate and mortgages in their portfolios amounts to about $300 billion industrywide. The 20 percent to 30 percent default rate that Figure 3. Life Insuranee--Price-80ok-Value Ratios Relative to the S&P Industrials, 1970-401991 110 . . . . . - - - - - - - - - - - - - - - - - - ,

100 90

1::OJ u

80

>-<

OJ

p...

70 60 50 40 70

74

78

Source: Kidder, Peabody & Co., Inc.

'82

'86

'90 '92

Source: Kidder, Peabody & Co., Inc.

occurred in Texas might be predictive of what is in store for the United States. Commercial real estate is in oversupply, and because of the recession, demand is in a tailspin. Of course, some geographic areas and some business categories, such as hotels and office buildings, are more depressed than others, but for real estate nationally, I believe demand will not meet supply for three or four years. Considering that 20 percent of the life industry's $300 billion real estate portfolio is problematical and that the life insurance companies had approximately $76 billion in statutory net worth two years ago, you can see why some analysts refer to the industry as being bankrupt. Property/ casualty company earnings are strictly tied to the underwriting cycle, which relies on both reserve adequacy and prices charged for the business. Several factors affect the timing of the cycle. One is cash flow, which is currently running close to zero for the property/ casualty segment. The biggest depressant to cash flow in recent months has been storm losses. Aggregate storm losses for 1991 are estimated to have exceeded $4 billion. The property / casualty companies' net worth is about $138 billion, however, so the storm losses were not a tremendous deterrent to the ability of these companies to underwrite business. Their premium writings, or their exposure, is roughly 1.6 times their net worth; that is, each dollar of capital and surplus is roughly $1.60 of exposure. Typically, these companies begin to cry poverty when this ratio approaches 2.0, and the regulators look at these companies with a jaundiced eye. Storm losses and catastrophe losses would have to be much larger before they critically affect this business. This has been a very depressed period for insurance brokers because insurance pricing has been so weak. Brokers' revenues depend on commission income, and they are not recording much commission 103

Figure 4. property and Casualty Insuranee--Price-Eamings Ratios Relative to the S&P 500, 1970-401991

will have to seek out the services of reinsurers. To date, reinsurers are having a tough time assembling revenues, because the property/ casualty industry is retaining more risks in an attempt to save the cost of reinsurance and control the loss side of the P&L. Reinsurance will once again have its day, but right now that group is suffering under some depressants.

180 160

"E

140

Q)

u .... Q)

Risk-Based capital

120

0..

100 80 60 '70

'74

'78

Source: Kidder, Peabody & Co., Inc.

'82

'86

'90 '92

One of the most talked-about developments in the insurance industry is the concept of risk-based capital. The insurance industry, and Wall Street, probably should not depend on risk-based capital ratios to turn the underwriting cycle soon, because that whole thesis is still only on the drawing board. The National Association of Insurance Commissioners (NAIC) is currently spearheading a project wherein all insurance companies' solvency will be measured by a universal formula generally referred to as risk-based capital. Although not yet finalized, standardized risk-based capital rules for measuring relative capital strength should be a big plus to industry and Wall Street investors, as well as policyholders. Not only will what insurers put their capital into matter (e.g., bonds, stocks, mortgage loans, and policy loans) but also their corporate structure will be important. Companies that stack subsidiaries will be penalized relative to those carrying each entity on their own. So look for risk-based capital to contribute to a tighter underwriting cycle, but not in the immediate future.

income because of depressed prices. Because they have not been able to raise the 19 to 22 percent commission they charge, their revenues are declining. As shown in Table 1, insurance brokers currently trade at about 15 times 1992 estimates. The tangible book value of the broker companies is somewhat lower than I expressed simply because these companies are very acquisitive. That is how they grow during slack times. They issue equity or debt to grow, and then they buy up smaller "mom and pop" operations and increase their revenue growth and geographic penetration. The reinsurance companies are currently selling at a discounted P/E multiple, despite some fairly decent return on investment figures. Although the near-term outlook for the reinsurers is not bright, Evaluating the Stocks they are basically the means by which the industry is going to heal itself. If property/ casualty companies The key ratios analysts use in evaluating the insurance business are P/Es, P/Bs, and dividend yield. find themselves with a need for more capacity, they Comparing earnings ratios for insurance stock enFigure 5. Property and Casualty Insurancetails several caveats. For example, the earnings elePrice-Book-Value Ratios Relative to the ment of the equation should be examined carefully. S&P Industrials, 1970-401991 Insurance company earnings have only been defined 130,...--------------------, on a Generally Accepted Accounting Principles (GAAP) basis for approximately eight years. Prior to 120 that, many formulas were used. First Boston once 110 used dollars per thousand of insurance in force in evaluating life insurance companies. Currently, the 100 "E P /E multiples for insurance stocks are severely dis~ 90 counted from the S&P 500, suggesting that some of 0.. these stocks might be good investments. 80 Price-book value is a good ratio to examine, but 70 be careful how the book value is determined60 whether or not it is all tangible book value. Also, 50 L -_ _L -_ _-"----_ _-'--_ _--'--_ _--'----' definitions of book value are not necessarily compa'90 '92 '86 '82 '78 '70 '74 rable across all segments of the industry. Analysts also should pay particular attention to Source: Kidder, Peabody & Co., Inc. Q)

104

Table 1. Comparisons of Insurance Stocks

Price 10/30/91

PriceEarnings 1992E 1991E

52-Week Hi Low

Earnings per Share 1990 1991E 1992E

$39.63

$49

$29

$5.47 $5.55

$5.50

$2.76

7.0

7.2

7.1

88.13 68.00 51.25 24.75 93.25 SO.25 57.75 51.75 24.50 45.50 SO.75 39.25 63.75 15.25 34.00 21.38

102 75 57 31 103 64 63 55 28 50 62 45 74 16 39 25

62 37 33 16 76 44 43 31 19 30 42 25 47 8 20 12

6.40 5.44 3.75 1.06 6.21 2.91 7.05 4.84 1.53 4.71 3.52 3.78 7.62 1.42 2.56 3.28

7.05 5.85 4.90 O.SO 6.20 2.80 5.90 4.SO 1.80 4.75 2.80 3.45 7.60 1.70 2.90 3.00

7.65 6.30 5.25 0.60 6.75 3.10 6.40 5.05 2.00 5.50 4.50 4.05 7.60 1.90 3.40 2.75

0.50 1.48 3.04 2.60 1.68 2.00 1.72 2.72 0.16 2.48 0.44 1.48 2.60 0.24 0.20 1.60

0.6 2.2 5.9 10.5 1.8 4.0 3.0 5.3 0.6 5.5 0.9 3.8 4.1 1.6 0.6 7.5 3.8

11.5 10.8 9.8 41.3 13.8 16.2 9.0 10.2 12.3 8.3 11.3 9.7 8.4 8.0 10.0 7.8 11.0

12.5 11.6 10.5 49.5 15.0 17.9 9.8 11.5 11.1 9.6 18.1 11.4 8.4 9.0 11.7 7.1 12.2

18.88 20.00 12.25 74.75

28 28 17 87

16 19 11 66

1.29 1.42 0.65 4.15

1.20 1.10 0.60 4.10

1.40 1.20 0.90 4.40

1.00 0.64 0.36 2.60

5.3 3.2 2.9 3.5

13.5 16.7 13.6 17.0

27.13 43.50 37.50 SO.13 55.00 37.50 52.63 68.75 44.00

27 45 42 54 54 39 59 70 44

14 24 30 26 33 17 42 36 23

1.44 3.72 3.56 5.15 3.89 (0.31) 4.42 4.83 4.27

1.80 4.20 3.75 5.70 4.40 4.40 4.70 5.75 4.65

2.10 4.60 4.15 6.30 4.55 4.80 5.30 6.35 4.60

0.40 2.00 1.60 1.20 1.68 0.92 1.60 1.04 1.64

1.5 4.6 4.3 2.4 3.1 2.5 3.0 1.5 3.7 2.8

12.9 9.5 9.0 8.0 12.1 7.8 9.9 10.8 9.6 10.0

Yield Dividend

%

Latest Return On Equity(%)

5-Year Average Secular Shares Book Price- Growth Outstanding (millions) Value Book Rate

Market profile Average Daily Market Trading Value Volume (thousands) (millions)

Insurance Underwriters Aetna Life & Casualty American International Group Chubb CIGNA Continental Corp. General Re Hartford Steam mCorp. Lincoln National NACReCorp. Ohio Casualty Progressive Corp. SAFECO Corp. SI. Paul Companies SCOR US TransAltantic Travelers Corp. Average

$66.48

0.6

9

14.5 15.5 4.8 2.8 14.6 15.3 11.1 8.6 12.1 11.3 19.2 11.0 14.7 10.6 12.3 7.5 11.4

44.21 35.19 77.79 38.16 42.56 19.01 63.58 56.41 14.88 41.66 18.38 34.31 52.00 13.36 20.89 43.98

2.0 1.9 0.7 0.6 2.2 2.6 0.9 0.9 1.6 1.1 2.8 1.1 1.2 1.1 1.6 0.5 1.4

13 13 8 8 11 15 8 8 14 10 13 10 10 15 12 8

15.7 18.2 20.4 18.2 3.7

13.2 21.3 19.0 29.4 15.2

9.80 6.67 3.42 14.12 18.1

1.9 3.0 3.6 5.3 20.7

8 8 15 12

15.1 10.4 10.0 8.8 12.5 8.5 11.2 12.0 9.5 11.0

14.0 9.5 15.1 15.8 8.8 -0.9 26.5 11.8 6.8 12.6

10.32 39.06 23.63 32.53 44.18 36.14 16.70 41.10 62.69

2.6 1.1 1.6 1.5 1.2 1.0 3.2 1.7 0.7 1.7

10 10 12 12 10 12 13 12 6

8.2%

110.1

344

$4,363

212.3 88.3 71.3 54.5 86.9 21.0 137.0 44.8 18.2FD 17.9 25.8 63.1 42.2 17.9 22.9 101.9

419 ISO 115 101 123 23 220 78 22 46 74 128 162 1 13 210

18,709 6,004 3,654 1,349 8,103 1,055 7,912 2,318 326 814 1,309 2,477 2,690 273 779 2,178

40.7 14.3 11.0 72.7 3.5

37 7 1 96

768 286 135 5,434

81.6 111.0 64.7 44.6 34.2 47.7 52.2 33.3 15.4

158 300 40 56 33 67 47 90 20

2,213 4,829 2,426 2,236 1,881 1,789 2,747 2,289 678

Brokers Alexander & Alexander Gallagher, AJ. Hilb Rogal Marsh & McLennan Average

Life/Accident and Health American Family American General AonCorp. Capital Holding Jefferson Pilot Kemper Torchmark UNUM Corp. USLlFE Average

Source:

Lord, Abbett & Co.

Notes: E '" estimate. FD", fully diluted.

.... I

c::>

U1

the growth of a company's first-year policy sales relative to renewals. An insurance company can show increasing premium income or earned premiums at the same time they show a declining first-year sales trend. I would be concerned about that company, especially during recessions. Most life insurance companies display declining first-year sales trends. Life insurance is very difficult to sell, because it is a discretionary purchase-a choice on the part of the buyer. Furthermore, the purchaser does not receive the results of that purchase; someone else does. Nonetheless, first-year sales determine the future profitability of life insurance companies and therefore are an important component of any financial analysis. Persistency is another important factor. Persistency measures how long the business stays on the books once it is sold and how long it feeds the company premium volume. Usually, during the first 12 to 18 months of a life insurance policy, persistency is fairly low. The buyers are keenly aware of the price they are paying for the policy and the sacrifice they are making for an intangible commodity. An advantage of new sales is that the insurance company gets fresh underwriting information on that risk, so the disadvantage of low persistency is offset somewhat by the improvement in aggregate underwriting experience. Currently, low interest rates are a gross depressant for these companies' earnings. When a life insurance company sells a policy, it discounts the loss reserves by a factor that represents an assumed average earnings rate that the company might accumulate on those loss reserves. The discount assumption might range anywhere from 2.5 percent of earned interest to upward of 7 percent, depending on how recently the policy was sold. Companies that have low assumed average yield rates when new money

106

rates are high will accumulate a large amount of excess interest earnings. The loss ratio is an important factor in analyzing an insurance company. The loss ratio is the relationship of all of the losses the company is paying out currently, plus the loss reserves it is adding. Paid losses and loss reserves both are related to earned premiums. If we add the loss ratio to the cost of booking that business, mainly commission expense, the sum of the loss ratio and the expense ratio equals the combined ratio. One of these component parts relates to earned premiums and the other relates to written premiums, which effectively gives consideration to the cost of new business. A written premium is basically the amount a company collects after it deducts the cost of reinsurance. Because the combined ratio is related to both the earned premium and the written premium, it takes into account the liquidity, or the lack thereof, with which the book of insurance is growing. It gives the company some credit for first-year expenses. What determines the P&L of a broker are the commission revenues the broker receives for the bookings it makes. Short-term interest rates are extremely important for an insurance broker, and the depressed levels of current short-term rates is hurting them.

Conclusion I believe that the process of valuing insurance stocks has progressed from an art form to one that borders on science. Historical comparisons of relative PIEs and P IBs directs investor interest to revenue expansion, with the hope that profits will follow. With the tools and the knowledge base currently available, cyclicality will become less of a factor in evaluating insurance company securities.

Question and Answer session Donald G. Zerbarini Question: What characteristics do you use to select insurance stocks? Zerbarini: I select stocks based on relative P/£s, the risks involved based on the balance sheet, a subjective feeling about the quality of the management, and possibly the adequacy of the loss reserves, among other factors. Question: Why do multiline property/ casualty stocks sell at

discount and life companies at premium to book? What parameters indicate under- and overvaluation of these groups, given this tendency? Zerbarini: The group accident and health component reduces the earnings predictability of the multiline companies. In addition, they seem to be the center of concern about asset quality. A third component of insecurity would be the property/ casualty cycle.

Just a few weeks ago, when a prominent chief executive officer of a property / casualty company told a group of analysts that the property / casualty cycle was close to an end or at least turning upward, these multiline stocks just popped up like gangbusters. Unfortunately, his advisors needed a broader perspective; they must have been referring to a particular area. The prediction proved to be false, and the stocks gave up much of their gains.

107

Insurance Industry Dynamics Wilson H. Taylor Chairman, President, and CEO C/GNA Corporation

Trends in the property/casualty and health care businesses represent a sea change for the insurance industry. Because dramatic change often maximizes opportunity, companies that want to position themselves for success are clarifying their strategic focus and emphasizing execution.

This seminar has presented considerable information on the internal and external dynamics of both the property/ casualty and life sides of the insurance business. I will provide a briefreview of how one multiline insurance company is reacting to these industry dynamics-particularly in the health care and domestic property / casualty businesses, two of CIGNA's largest operations. I will also comment on several regulatory issues that affect our business, some of which Mike Frinquelli touched on in his remarks. 1 Today's insurance industry operates in a significantly different environment from that of the late 1970s and early 1980s. A more antagonistic legal, regulatory, and tax environment has created significant pressure on profit margins throughout our industry. Traditional relationships among insurers, their agents, and their customers have changed. We clearly operate in an era of greater competition, including more self-insurance of both property / casualty and health care risks. To succeed in this environment, we concluded that CIGNA needs to focus its resources on those areas in which we have particular expertise, strong market positions, and an ability to distinguish our products from those of our competitors.

Restructuring Strategies As part of our restructuring effort, we sold several businesses, including our individual life brokerage operation, a specialty personal lines business, and a life insurance operation in the United Kingdom. We 1See Mr. FrinqueIli's presentation, pp. 72-77.

108

recently announced that we were considering the sale of most of our property/casualty reinsurance business. We used cash from these divestitures and other funds to increase our position in health care-an attractive business in which we earned more than $200 million last year. Before describing how we have strategically positioned ourselves in that area, let me first comment on an even more challenging business: property/casualty.

Property/Casualty In the past decade, the average return in the property / casualty industry has been about 10 percent, excluding capital gains. An ever-diminishing number of companies are producing higher returns. CIGNA is not yet one of them. In recent years, the "traditional" cyclical influences seem to have diminished in importance. Clearly, pricing remains critical. Because of continued pricing weakness, the industry as a whole is nowhere near earning an adequate return and, until the current pricing inadequacy is corrected, overall industry returns will remain weak. Unfortunately, I see no immediate signs of price strengthening beyond a few specialty lines. Considering these persistent conditions, we have taken major steps to restructure our property / casualty operations with a far more specialized focus. We have changed the mix of our property/ casualty business and improved the level of service to the actual users of our products. We also have further reduced our expenses, making major strides in reducing both claims and operating costs. For example, we have consolidated 22 regional underwriting/processing operations and 75 marketing locations into 5 marketing centers. Equally important,

indemnity plans. In three years, the program has we have reduced our employee base by more than 2,000 positions. saved more than $200 million on health costs while In addition, we have moved away from the apmaintaining employee satisfaction with the care proach of being all things to all people-both indibeing received. viduals and commercial customers-as we had tried Except for Blue Cross and Blue Shield, CIGNA is to be before. In contrast, we have established custonow the largest provider of managed care in the mized commercial insurance programs concentratUnited States. We provide health benefits and sering on those market segments in which we believe vices to approximately 14 million people, including more than 2 million enrolled in our national network we can develop a competitive edge. Our analysis indicates that companies that have developed speof 40 HMOs. The service network is nationwide, so cialized markets are currently making reasonable this division can serve a customer at a single location returns in the business at a time that would typically or with multiple sites. be considered near the bottom of the cycle. We are confident that our health care strategy Where we cannot establish that competitive edge will produce superior returns. As business and legislative attention focuses on changes in the current or where the political climate prevents us from obtaining an adequate return, we have left or are leavUS. health care delivery system, our capability to ing the market. For example, CIGNA was among the provide employers with managed health care on a first property/ casualty companies to respond to the national basis will present us with important strateunreasonable state regulatory climate by beginning gic advantages. to withdraw from personal automobile insurance That is how CIGNA is responding to the market nationwide. Also, we began to reduce risk-transfer trends in two of our key businesses. I believe these workers' compensation writings, while shifting the trends represent a sea change in the industry, and business to our broker or special risk operation. dramatic change often maximizes opportunity, parThese operations write larger cases and specialized ticularly for those who have a clear strategic focus business on a loss-sensitive basis with limited underand execute well. writing risk. Although property / casualty results are still at unacceptable levels, we are beginning to see positive Regulatory Environment marketing results from the redistribution of our mix Several current public policy issues could have a of business. Cost-control efforts are also succeeding. Clearly, a meaningful improvement in property/ casubstantial effect on the insurance business and need sualty earnings depends on an improved pricing to be considered when analyzing the outlook for the environment, but I believe we will be well positioned industry. For example, there is some Congressional when the cycle turns. interest in repeal or substantial amendment of the McCarran-Ferguson Act, which governs antitrust issues for the insurance industry. CIGNA favors reHealth Care peal. We have allocated significant capital to expandThe Act provides no real protection and is an ing our presence in the health care business. In that easy target for those who want to attack the industry. effort, we have been concentrating on increasing our We need to accept the need for change, get on with capabilities in the "managed care" business. This is our business, and redirect resources to those legislathe segment of the business that uses contracts with tive and regulatory issues that can truly make a various providers-health maintenance organizadifference. The risk regarding McCarran is that in tions (HMOs), preferred provider organizations, and trying to remove the perceived antitrust protection, hospitals-to establish agreed-upon levels of cost the legislators could add yet another costly and difand services. Managed care can reduce the rate of ficult layer of regulation. Frankly, it is still too early medical cost increases without sacrificing quality, as to tell in what direction this will move. We would shown by the difference in health care cost trends, prefer to take our chances in an open, competitive which recently have increased annually by more environment, which is free of unnecessary regulathan 20 percent for traditional fee-for-service protory burdens. You need to keep an eye on how much grams and by between 10 and 12 percent for managed care. these changes would cost our business. Solvency is another area of obvious regulatory Using managed care, for example, CIGNA creconcern. Although the financial strength of individated and continues to administer a national program for Allied-Signal, Inc., whose growth rate for medical ual insurers clearly differs based on their capitalizacare costs is only one-half the rate for traditional tion and investment policies, even our most ardent 109

critics recognize the overall strength of the industry Conclusion compared with banks and thrifts, particularly for high-risk investments. I expect a significant degree of turbulence to be genI believe there are legitimate questions about the erated by issues surrounding state and federal reguability of state regulators to develop an effectively lation, various tax and industry-specific legislation, and what I call the "hyperlitigation" problem in the coordinated national regulatory program addressing United States. The industry itself remains intensely solvency concerns. In this respect, we also see the competitive, which has clear implications for marneed for change. We believe that some form of fedand profit. What that suggests is selectivity in gins eral oversight regarding solvency standards would an investment focus. Whether property/ caterms of be appropriate. How Congress addresses this quesor reinsurance, there are sualty, life, health, pension, tion would have a significant impact on the capital and followers. leaders structure and operating performance of various inAs for the two major industry segments I mensurance operations. tioned-taking health care first-I do not envision Noting the importance of the health care issue, the creation of a single-payer, federally managed as shown by the recent elections in Pennsylvania, health care system in the United States. The current both Democrats and Republicans will be trying to private/public partnership will change, however. carve out a position on health care with the broadest These changes will provide opportunities for compapossible voter appeal. I expect the voting public to nies that can deliver managed health care on a nabe deeply concerned about the implications of a national basis. tionalized health care system; additional taxes, raIn property/casualty, the underwriting cycle tioning of care, restrictions on choice, and additional shows no sign of turning, although industry returns bureaucracy will be important elements in the deare well below where they need to be. Pricing will be the engine driving recovery. bate.

110

Question and Answer session Wilson H. Taylor Question: What is your return on equity in the health care business? Taylor: Our long-term return in the health care business has been better than 15 percent-varying somewhat over time, but always in the upper teens or better. It is difficult to split the returns between indemnity and managed care because it becomes too arbitrary. The margins are somewhat better in the HMO business when it is well run. Question: Do you think you have any special advantage over the independent companieswhich have astounding numbers, either on a margin or return on equity basis-in serving the Fortune 1000 constituency, which is beginning to want to trickle down from indemnity to managed care? Taylor: Yes, we clearly have relative advantages there, but not absolute advantages. When a large national customer wants to do a trickle down, they want to do so at a reasonable cost. You must remember that any employer currently buying health insurance benefits is buying them because they are part of compensationthe purpose is to make employees happy. An abrupt, forced change is very difficult on employee relations, so a gradual change is desirable. Because we provide every level of managed care, we are particularly good at meeting those needs. At the same time, many large employers have more than one HMO. As people get to the most extreme end of the managed care control spectrum-a single HMO as the only option-we still face competition, sometimes from

some very good independents. Question: Please expand on your restructuring plan, with particular emphasis on how that has been received in the capital markets. Taylor: Our restructuring program took into consideration existing market conditions and our own capital needs. At any point in time, we make judgments about what we believe is in the best interest of our stockholders, including reducing the outstanding capitalization or improving our financial strength. The current restructuring involved a substantial amount of stock repurchase. We have not made any repurchases recently because, for both regulatory and customer retention reasons, we wanted to have greater financial strength by retaining those funds that would have been used to buy stock. As a result, we have kept our high ratings all along, which has been to our benefit. Question: Has CIGNA received a Securities and Exchange Commission inquiry on its mortgage loan reserves, and if so, what was the nature of the inquiry? Taylor: We have not had such an inquiry. On the other hand, about four or five months ago, in connection with our shelf registration, we received a comment letter on a prospectus that had a few questions, among which was how we handle mortgage reserving. The registration was effective, so they agreed with the language, and we have issued the debt. Question:

What will it take to

end the downturn in property/ casualty? Taylor: What it is going to take to end the downturn seems to be among the most elusive of all questions. Poor returns or inadequate prices alone are not enough. A point regularly seems to be reached at which people almost collectively recognize that this cannot go on, and then something changes. In hindsight, these points are easy to recognize; in retrospect, difficult. I would assume conditions now are good for a turn in that prices are poor, and virtually all of the industry management knows it. What will precipitate a change is hard to tell. No magic indicator exists. Change is a collective effect of surplus, cash flow, earnings, and recognition of how bad prices are. No one knows which is the determinant at any point in time. Question: Please comment on adequacy of reserves, for toxic waste problems and otherwise. Taylor: There are two issues relating to reserve adequacy. No ultimate definition exists of environmental liability kinds of risks. The hundreds of court decisions are in vast conflict with each other, and the question will take a long time to resolve. In the long term, the insurance industry is unlikely actually to have to pay to clean up the environment, because if it did, that would be the end of the insurance industry. On the other hand, the litigation will be costly and take a long time. I believe we need a change in the current Super Fund legislationnot to protect insurance companies, but because it simply does 111

not work. As a country, we are spending an enormous amount of money collected from the general public through companies to pay lawyers, but not to clean up anything. Contrary to what most people think, Super Fund does not clean up anything; it only sues and then gets sued back. In 10 years, it has only cleaned up 10 or 15 sites at a cost of several billion dollars a year. The other current reserve question is related to the insurance cycle. Given the trend of pricing during the past five years in the property / casualty business-either what companies have said about pricing or what aggregate premiums have doneand traditional long-term cost trends, adjusted for the prevailing level of inflation, one would assume that loss ratios would have worsened more sharply than they have. This raises a question about the adequacy of current accident year reporting for the industry as a whole. History supports the wisdom of being skeptical about accident year loss ratios in the worst part of the cycle. In part, I think, recognition of that will affect when prices start to change. I think the industry is underreporting current accident year loss reserves again. Question: Do you need higher reserve increases now that you are shrinking your book a bit?

Taylor: From a credibility standpoint, we still have a very large book of business. If anything, making the book more homogeneous, with sure lines of business and fewer classes, it should be easier to maintain adequate reserves. Question: What is your outlook for the reinsurance segment of the industry?

Taylor: 112

The reinsurance busi-

ness, like much of the property / casualty business, has a considerable amount of competition, and without any significant withdrawal of capacity, somewhat excessive competition. The reinsurance market is shrinking because primary companies tend to buy less reinsurance and to keep larger retentions. The companies have consolidated among those with the strongest security at the moment, which has put pressure on many of the second-level players. That has generally worked to our advantage because we are good security. Reinsurance is a business with a lot of turmoil, however, and it is very disrupted by the current events in London in which the traditional backup to reinsurers-retrocession coveris falling apart. Question: To some degree, you are doing some trading in the business. You are taking other people's health care business and adding it to your book with some economies of scale and adding reinsurance and whatever else to somebody's bigger book in which it would make more economic sense for them. Will that continue to go on?

Taylor: In essence, we are reallocating our business interests, and I believe more of it will occur. It fits into traditional business management. If a business is doing some things reasonably well or has advantages, its interest lies in doing more of that. Conversely, if it is not particularly advantaged in something or does not do that as well as some others, it is usually wise to do less of it. We have been trying to reallocate capital into places in which we do a good job. I believe the industry will do more of that; there have been signs of it recently. Significant changes are taking place in who participates in the health

care industry. The smaller players without the economies of scale have acknowledged they are disadvantaged in trying to keep up with the big health care companies. Some of those firms that have gotten out of this business are very large, but not in health care. As the service expectations and quality expectations in the pension business have gone up, the smaller players in the pension business are beginning to withdraw. As an example, UNUM Corporation, for either security or cost reasons, has said it would get out, even though it is very good at some other businesses. Mutual of New York is apparently about to go out of the business. They are 401-K players that are leaving. I think you will see greater concentration among the successful and less tolerance among the unsuccessful. Question: How do you feel about the life insurance business?

Taylor: We were reasonably good at the life insurance business a few years ago, but the business was not very good, so we decided to make an effort to exit it. Some potential buyers misread this decision and thought it was a distress sale, which it was not. We merely wanted to determine if anybody would pay more for it than it was worth to us. Because nobody did, we kept it. At the same time, the market has changed significantly. Because of First Executive and a couple of the other companies, there were two effects: Buyers began to pay attention to who the sellers are, and individual life agents (a rather testy group) changed their attitude about what we have to offer. The agents' feelings about the adequacy of our responsiveness improved when they found that those customers who were with us were doing well and

those customers that had replaced us with weaker companies were unhappy. The effect is that our returns have almost doubled in that business in the past three years, making it quite a good business.

Question:

In your effort to seek niches in the property/ casualty business, a critic might say that you are out to out-ehubb Chubb. That is obviously an overgeneralization, but not everybody can go for niches, because they would cease to exist. Please com-

ment on this observation.

Taylor:

That theory has a touch of truth and a touch of hyperbole. In large part, even Chubb drifted into what became niches. It was not always a lines player, and it gradually moved toward things it did best. If everybody pursued the same niches, there would be no niches. On the other hand, trying to do everything simply does not work in this business, because the business is too competitive. If a company has to do things it is

not good at, it does not do well, and the industry returns are low; conversely, if it specializes in some things it is good at, it does better. Most manufacturers or service companies do not try to do everything. They try to do the things they are best at and try to do them better than their competitors. In essence, that is what we are trying to do. In fact, we have a fair number of areas in which we do well and better than the competition.

113

The Art of the Interview AmyW. de Rham Vice President, Investments Massachusetts Financial Services

Gavin R. Mon Vice President, Financial Relations CIGNA Corporation

For analysts to discover the kinds of detailed information they require during a corporate interview, they must be prepared to ask probing questions. In the case of an insurance company, items to cover include key issues for the major areas of business, pricing structures, and cost containment efforts.

de Rham:

Interview styles are personal. There is no prescribed method of conducting one. I will try to provide a basic format from which to work when approaching a multiline insurer. The objective is to learn more about the company, to understand its businesses and outlook, and to see if it presents a good investment opportunity. I normally start an interview with current fundamentals or the key issues for the major areas of business. CIGNA has three major businesses-property I casualty (PIC), group life and health, and annuity and financial services. The stock is now selling for about $52, and it yields about 5.8 percent. In the PIC segment, the underwriting cycle is a big factor. About 80 percent of CIGNA's premiums are earned in the commercial PIC policies. Gavin, CIGNA's PIC premiums written through the third quarter were down about 15 percent. In addition, the combined ratio, which is the sum of the loss ratio (losses incurred to premiums earned) and the expense ratio (expenses incurred to premiums written) is 116 percent versus a combined ratio last year of 117.7 percent, but that covered about 2 points of restructuring charges. Can you explain your performance in light of the current pricing environment?

Premiums in our PIC business were down about 15 percent through nine months for two reasons. First, the domestic underwriting market is fairly unattractive, so we are downsizing our book, particularly in areas in which we are not particularly strong. We are decapitalizing that Arton:

114

business in favor of other parts of our organization for which the returns are more attractive. We are down almost 50 percent in the worker's compensation agency book business from two years ago and down about 50 percent in the personal automobile business. We will be out of the personal automobile business almost entirely by the end of next year. Those are long-tailed lines that put a drag on future earnings long after a company exits the business. Second, we have a very large international presence. We are the second largest U.S.-based insurance company conducting business overseas. Not surprisingly, the international market is more competitive and more cyclical than it once was-a different cycle from that in the United States. Europe is a good example. Insurance companies are already competing across country borders, which has made the business quite competitive. The cultural differences between countries provide considerable opportunity but also competition. As a result, we have a property book that has been caught up in this competitive environment, and we have written some poor business. Recently, we have shrunk that book by 10 or 12 percent.

de Rham: We have heard a lot about cash flow and premiums being down. Is it fair to assume that for 1991 and 1992 investment income will be flat year-over-year, not showing much growth until you get more premiums? In short, yes. But the true answer is more complicated, because it involves several pieces. In this industry, you need to be very careful about how you define cash

Arton:

flow. Unlike manufacturing, where cash flows are simple to define and it is easy to tell whether you are covering your expenses, in the insurance industry, positive cash flow is typically defined as new money going from the underwriting department to the investment department. One of the reasons the PIC industry is in such trouble now is that about 15 years ago the industry decided it could take advantage of the high interest rates on cash flow to offset the losses on the underlying business. But we forgot the fundamentals of how to price our underlying business. General Electric does not sell light bulbs at a loss so that it can make money on some other product, and then use those profits to justify its light bulb business. My definition of cash flow is new money coming in. With our premiums down 10 or 15 percent, no new money is going into the pot. Therefore, as investments mature, we are spending our investment income and dipping very modestly into the capital of the PIC investment portfolio to meet current cash flow needs. I expect that trend to continue into next year. de Rham: Is it reasonable to assume that the premiums written in 1992 will be down less than for this year-say, in the middle-single-digit range? Arton: This is a difficult question to answer because within the Pie segment we have four separately run pieces-an agency division, a broker division, an international division, and a reinsurance division. The agency business is fairly unattractive, the broker division is a reasonable business, international has a lot of unrealized potential, and reinsurance mayor may not be sold. If you add all of the pieces, our premiums will probably still be down, largely because of the decline in the agency marketplace and the absence of the cycle turn. We find certain aspects of the international and broker markets appealing, and those overall businesses may actually grow. Overall, I think that is a reasonable assumption to expect premium declines to be less.

de Rham: Do you have an assessment of the exposure and the bottom line cost of the Oakland fires after the 1989 earthquake? Arton: CIGNA is not really a homeowner's writer, but the company did have some exposure to the Oakland fire. We have somewhere between $10 million and $12 million in aftertax losses from homeowner policies in Oakland. This represents about 30 homes and acouple ofsmall businesses.

de Rham:

Because of the Super Fund, the insur-

ance industry has to be concerned with environmental hazards. Do you think we will continue to see adverse reserve development in insurance recoverables in asbestos and environmental hazards? Do you think CIGNA's PIC segment will continue to reserve about $200 million ayear against these problems?

Arton: CIGNA has almost $10 billion of reserves on its total PIC book of business compared with annual premiums written in the neighborhood of $5.5 billion, so we are pushing two-to-one coverage of the business currently being written. The reserves are high because we have some prior-period claims in this area; i.e., claims that are more than two years old. In the past several years, we have paid out approximately $250 million to $300 million in claims from prior periods in this area. I expect this number to remain relatively stable going forward. We were one of the largest writers of the worker's compensation business through the 1970s and into the early 1980s. We also wrote some unusual new coverages that brought long-tailed liabilities that nobody, including the buyer of the contract, knew we would have to pay, but the courts decided against us on the basis ofthe deep-pocket theory. As for the individual lines, asbestos claims are largely leveling out. Few people can acquire asbestos coverage because the product has been neither manufactured nor insured for about 15 years. The level of environmental claims seems to be manageable. It has been a steady dribble, not an accelerating one. People seem to understand better that the money should be directed at cleaning up problems, not paying lawyers. In asbestos, lawyers have had an opportunity to make a lot of money and not pay very much to the claimant. The dynamics may be changing somewhat, but our prior period losses will be with us for the foreseeable future-at least the next five years. We will probably continue to add to reserves at least $100 million a year for those losses. The rates of payout should decelerate, but the amount unfortunately will still be large.

de Rham: Are prices still low, ordo you anticipate some improvement in pricing? Arton: Pricing is still fairly unattractive. It has not improved in the major lines, although it has shown some signs of strengthening in marine and aviation insurance, which are largely international lines driven by lead underwriters in London. Aviation policy prices will probably need to increase 400 or 500 percent. They have already risen by more than 100 percent, but they still have two or three times that to go. Marine insurance also has responded since the Gulf War to some needs for better pricing. 115

Some of the catastrophe reinsurance programs have seen increases in Europe, but not in the United States. That improvement is significant, but not a material event, because most U.S.-based companies buy a relatively small amount of catastrophe loss protection. They do not spend a lot on it, so if they get a 20 percent increase in their reinsurance premiums, it is usually not a material event for the primary company. All of the signs are in place for a market turn, but no broad-based movement has occurred. de Rham: Employee benefits is one of the most exciting areas of CIGNA's businesses. With health care costs reaching 12 percent of gross national product and rising, this is an area CIGNA has focused on and is investing in. Turning to employee benefits, how is the integration of Equicor progressing, and how soon will we see some returns from that acquisition? Arton: Equicor is a very large health care company that we purchased for about $800 million dollars in early 1990. At the time, it was the seventh largest company in the industry, and CIGNA was the fifth largest. Combined, we represent the largest.

The integration of Equicor is going very well. Absorbing it involves integrating about $5 billion of its revenues into some $7 billion ofour own. We will probably have between $20 million and $25 million aftertax savings this year from combining the two companies, and that number should go up each of the next two or three years. We are looking for about $50 million annually in savings from the new combined operation. The integration has resulted in some employee layoffs, some consolidation of offices, and some new and better ways of doing business on a coordinated basis. de Rham: Do you expect the enrollment in managed care, which is roughly two million at present, to increase? How optimistic are people that enrollments will start growing? Arton: We are optimistic that our health care enrollment will grow this year. In 1991, the growth in enrollment was about 4 percent. Growth in health maintenance organization (HMO) enrollments is generally a January phenomenon, because most people do this on a calendar year basis. One ofthe less attractive features ofintegrating Equicor is that we lost sales momentum in 1990, which meant that 1991 revenue numbers went fairly flat and so did enrollment growth. We have taken some very aggressive steps to get enrollments back on track. Our customer focus is not only on selling to the employee benefit manager, although that has traditionally been a good strategy for us; it also involves deeper penetration within each 116

account. We have increased the number ofsalespeople who go into companies to talk with the employees and then help them sign on. I am optimistic that we will be able to increase enrollments at least 10 percent over time. de Rham: The group health business's cost trends are increasing about 25 percent a year. Sometimes pricing in the managed care business is under the umbrella ofgroup health pricing on the indemnity side. It surprises me that the cost trends factor for the indemnity business has not come down much during the past 24 months. Do you think this business as a whole will be under only moderate cyclical pressure? This would be better for everybody in terms of pricing. Is the cycle less cyclical than in the past? Arton: It is important to differentiate between the cycle in the employee benefit business and the cycle in the PIC business. Simplistically put, the PIC cycle is driven by irresponsible people in the insurance business fighting with each other and lowering prices to take business from the other person. In the employee benefit business, the cycle is generally driven by some external event-usually the federal government shifting cost to the private sector. If that happens in mid-February, and you priced the business in January, you have to live with it for 12 months. As we characterize it, you spend between 12 and 18 months chasing trend. The inflation rate (or trend factor, as we call it in the unmanaged health care business), or the traditional group insurance market, is 25 percent. That means if you bought coverage X in 1990 for $100, in 1991 it is $125. That is a powerful incentive for employee benefit managers, CFOs, and CEOs to change. Our solution is managed care. Managed care adds an intelligent buyer to the process. In its purest form, it is a staff model HMO in which patients go to certain doctors who work at fixed locations owned by us. The doctors control the patients' medical case histories and make the referrals. Patients can no longer directly call their own specialists when they have heartburn; they must go through their primary care physician. Introducing case management and using the primary care doctor as the "purchasing manager" for other medical services can take 10 points off the top of the cost. This plan saves money on hospital costs, too. Think of it in terms of buying hotel rooms for the convention business in the hospitality industry. With 14 million people in our system, we can negotiate better prices at hospitals than individuals can. Between managed care and buying power, the cost of health care can be cut dramatically and the savings shared with our customers. More than halfofwhat we do in the health care business is administrative services only. For a fee, which is clearly our profit margin, along with our claims handling capabilities, we can provide the benefit of our bulk buying and managed care expertise to self-insured customers.

de Rham: CIGNA has taken a nationwide approach to health care services, managed care in particular. Some would argue that managed care is a local business. Do you think that is changing as more people and employers are educated about managed care as a viable national network? There is no question that health care is delivered locally and always will be. People are not going to fly from Philadelphia to Boston with their children to have their head colds treated. If you work for a Boston-based employer group and you are in Philadelphia, however, we can deliver care in both of those locales. The advantage of operating nationwide is that our primary customer base is the Fortune 1000 companies. We do sell to much smaller companies, but the largest portion of our revenues comes from companies with more than 2,000 employees. We get the advantage of buying from national drug chains and hospitals in more than one location. We think there are some economies of scale in pricing on a nationwide basis. Local differences do exist, and health care will always be delivered locally, so we market it locally. Arton:

de Rham:

Regulatory threats are an important consideration in this industry. Many people advocate making managed care a beneficiary ofany program that develops, because it is the low-cost provider. What are your views on this subject?

Arton: Prior to the election of Senator Wofford in Pennsylvania, we made tremendous headway in Washington educating legislators. Every one of the congressional leaders who had aprogram in development or being introduced had met with someone from our company. By the time we ended each ofthose meetings, they understood much better that managed care is not the whole problem. The system has two problems-eost and access. Managed care tries to work with the cost side of the equation. The United States has the finest care in the world, but it costs too much. We limit access for our customer base but do not deny health care. Insurance companies have to do a better job of being part of the public solution. We see some positive opportunities coming out ofa program that would adapt aform of managed care to help control costs. Politically, this idea is very popular. I could see some kind of national umbrella taking care of the uninsured. I do not see asingle-provider system. I do see us being a beneficiary of the ultimate system. I expect a lot of public discussion during and after

the election. This might be disturbing for our stock price in the near term, but I do not think it will be disturbing for our business over the long term.

de Rham:

I view pension and individual life as a steady-growth type of business, despite the mortgage problems. One of the things not evident for CIGNA as opposed to some of the other multiline companies is that the majority of the pension contracts are experience rated, and the book performance affixed-income investment and commercial mortgages is passed through to the policyholder. Please comment on that, and mention why you think this puts CIGNA in a better position.

Arton: Several years ago, when guaranteed investment contracts (GICs) were extremely popular, we were not competitive in that marketplace. We wanted a higher margin than the market would bear and, therefore, sold very little GIC business. Instead, we sold an enormous amount of participating products-market value products. Pension customers came to us because we had access to the private placement market, because we knew the fixed-income area, and because we knew the commercial mortgage market. Given the results, we made a wise decision on GIC pricing. As a result of not writing a lot of GICs relative to most other insurance companies, we have a very small exposure to GICs, and our product mix leans heavily toward market value products. We pass through about 70 percent of the experience of our mortgage portfolio, which is clearly participating in the current poor real estate market, and we pass through about halfofourfixed-income experience. That has dampened the negative effect of problem loans on our earnings by those proportions in each of those investment areas. Relative to many of our colleagues, our reserve needs are less, our problems are less, and we hope the long-term impact on the company will be less. It is a combination of luck and skill. A distinguishing feature between us and abank is that we are allowed to restructure our loans while they are still performing but not performing according to our original terms. We have about $900 million of underperforming loans in the restructured category, which are paying 7 percent cash. That may not be the most attractive yield, but it is two points over passbook savings. These properties are very sound. They are spread nationwide and very diversified by property type. They may not be as attractive as they were when we first did them, but they are not nonperforming loans.

117

Question and Answer Session Amy W. de Rham Gavin R. Arton Question: How valuable are meetings with top managements?

de Rham:

The most valuable meetings are one-on-one sessions with management. Our firm has always emphasized that our research staff has to know each company. I recently spent two days with CIGNA's health plan people, which opened the door to learning and understanding about their operations there. Talking to as many people as possible is very helpful. Question: When making the initial contact with a company, what type of questions should an analyst ask? Are you more general, or do you go for the jugular right away?

de Rham:

The appropriate approach depends on the analyst's knowledge of the company and how established a relationship he has with the company. For instance, I know Gavin fairly well, so I try to go for the jugular as many times as I can. Question: Please comment on collecting loss payments from reinsurance companies. Arton: Reinsurance recoverabIes are one of the solvency is-

118

sues currently facing the industry. It is a declining issue for our company because we are shrinking the number of reinsurers we do business with. We have a rather rigid security process in place, although we put it in place later than perhaps we should have. Since about 1984 or 1985, we have had people with strong financial backgrounds analyzing other companies with whom we are doing business. That has cut down on the proportion of failures we must absorb. We still have 2 or 3 percent of our total ceded reinsurance book that may not be able to pay claims to us. We also have about $350 million of reserves set up to meet that funding. I would treat it like a bad debt, and I think that the reality is that bad debts rise in times like this for most industries. Question: Please comment on bank director and officer liability insurance. What has been CIGNA's experience in this area? Arton: We do not write very much director and officer liability insurance for banks, for reasons now very apparent. We do have some modest exposure, and we will continue to avoid that class of business for financial companies in the current environment.

Question: What is the most important question analysts do not ask? Arton: I do not have an answer to that, but I do have a couple of comments on questions I do get asked that I think are unfair. One is, "What do you think of the various things that are happening with your competitors?" This puts us on the spot, so we do not comment on competitors and hopefully they do not talk about us. The other question is, "Why don't you just undo the Connecticut General/INA merger and get rid of the PIC business?" There are some significant legal barriers to doing that. The companies are fully integrated. Some rather dramatic customer overlaps exist at this point, and it would be viewed as an abandonment of the other half of their insurance needs. Maybe even more important, in a number of parts of the PIC business, such as the broker and the international segments, we have very important franchises. Also, we run the business a little better now than we have historically. I would acknowledge that some parts of the business could be sold off, but overall it is not a simple question to answer.

Understanding the Structure and the Financials of the securities Industry John E. Keefe1 Editor Upper Securities Industry Financial Analysis Service

The brokerage industry commands a lot of attention but is a relatively small portion of the U.S. financial system. Analysts following companies in the industry should examine revenues (and a firm's "propensity to compensate"), inventories, other assets, and book value per share.

Twenty years ago, most of Wall Street was privately about $1 billion to repair all the various errors and misjudgments of the 1980s. owned. A few initial public offerings came out in the 1970s, and there were a few more in the 1980s, a time "Deep pockets" own these companies, and corwhen investors would buy anything. In the midporate pride wants to keep all these brokers in the 1980s, a number of acquisitions took place as all sorts business. The result is that we probably have more of companies tried to cash in on the very high returns capacity than is needed in the brokerage business. of the U.s. brokerage industry. Today, only a few firms are truly private and Brokers and the Financial System independent. Most have some parent or affiliate. The brokerage industry makes a lot of noise and Goldman, Sachs is the most prominent privately commands a lot of attention, but it is relatively small owned firm, but not even it is completely indepenin the mosaic of the U.S. financial system. The dent, because a large Japanese insurance company United States has about 4,000 brokerage firms, of owns a fair amount of it. Other firms have merged: which the top 10 account for about 60 percent of the Sears/Dean Witter and American Express/Shearson Table 1 shows the key financial statistics industry. are two examples. During the mid-1980s, the brokerNew York Stock Exchange (NYSE) member firms for age industry was seen as a savior to profits, and by segment, and Table 2 shows the key financial industrial and commercial companies got into the statistics by company size for the second quarter of business. 1991. The major segments of the industry are naThe brokerage business has produced many diftional firms, investment banks, regional firms, and ferent stories, legacies, and a few successes. Dean discount brokers. The size of the industry is about Witter is a well-kept secret; it has done very well for $25 billion in total equity, about one-tenth of the Sears. Smith Barney took some time to get going, but 2 equity of the banking sector. it has done very well for Primerica. The most curious The industry has relatively high leverage, with firm is Salomon Brothers. In 1981, Salomon, a private an assets-equity ratio of 24.2 times. This translates company, was acquired by Phillip Brothers, a firm of into an equity-asset ratio of about 4 percent, which commodity traders. Phillip Brothers is completely compares with 6 or 7 percent for banks in general. gone now, an unintended consequence for the peoInvestment banks are more leveraged than regional ple at Phillips. retail-type brokers. Many of the remaining brokerage firms have Brokerage stocks have been somewhat volatile been either static or a disaster. Shearson has been a compared to the S&P 500. Figure 1 shows the S&P financial disaster for American Express; it will cost 2

1Mr. Keefe now is president of Keefe Worldwide Information

Services.

These data come from the New York Stock Exchange's "Survey of Member Firms Doing a Public Business," June 1991, as reported by the Securities Industry Association.

119

Table 1. New York Stock Exchange Member Finns--Anancial Results by Industry Segment, second Quarter 1991 (millions of dollars, except as noted)

Item

National Firms

Investment Banks

$1,054 1,537 665 2,056 5,311 872 4,440

$300 1,455 665 2,278 4,697 2,258 2,439

1,279 1,168 1,499 3,946

290 924 803 2,017

Regional Firms

Discount Brokers

Total Industrya

$484 313 244 470 1,510 93 1,417

$188 8 0 200 397 78 319

$2,568 3,781 1,657 6,846 14,851 4,833 10,018

419 388 420 1,228

18 94 159 271

2,168 3,031 3,517 8,716

Income Statement Commissions Trading gain Underwriting fees Other revenues Total revenue Interest expense Net revenue Registered representative compensation Staff compensation Other expense Total noninterest expense Pretax income Pretax margin

494 11.1%

422 17.3%

189 13.4%

24% 35 15 29 26 34

12% 60 27 12 38 33

34% 22 17 30 27 30

59% 3 0 6 29 50

26% 38 17 22 30 35

44% 38 19 36 54

24% 32 52 31 15

14% 15 2 9 16

3% 4 1 2 2

100% 100 100 100

49 15.2%

1,302 13.0%

Composition of net revenues Commissions Trading gain Underwriting fees Registered representative compensation Staff compensation Other expense

Proportion of total industry Revenues Pretax profits Assets Equity Personnel Balance Sheet Receivables from customers Receivables from brokers Reverse repurchases Securities owned Other assets Total assets Owners' equity Pretax return on ending equity (annual rate) Assets / equity

$15,633 28,459 24,244 29,781 15,106 $113,223 8,797

$9,564 63,153 135,610 96,904 7,874 $313,104 7,729

22.4% 12.9x

$3,314 1,737 2,984 2,888 1,836 $12,759 2,184

21.8% 40.5x

34.7% 5.8x

$2,679 793 2,271 1,530 583 $7,855 598 32.5% 13.1x

$34,253 124,093 229,361 178,745 30,764 $597,216 24,655 21.1% 24.2x

Sources: Securities Industry Association; New York Stock Exchange. a"Total Industry" is greater than sum of segments because of data classifications.

500 and the brokerage stock index from 1982 to 1991. The volatility of the brokerage stocks provides opportunities to make money by trading them. The brokerage industry has shown somewhat erratic profits. Figure 2 shows industry profitability, measured in terms of pretax return on equity and pretax profit margin, for NYSE member firms from 1981 through 1991. Figure 3 shows the profitability by type of firm. Profit margins have been falling since the begin120

ning of recorded history in the brokerage industry, which starts in about 1960. At that time, the margin for the industry as a whole was about 30 percent, measured by dividing pretax income by net revenues (net revenues is defined as total revenues net of interest expense). The net revenue concept is an important one. As shown in Tables 1 and 2, the pretax margin during the second quarter of 1991 was 13 percent, the highest since 1986. Profitability in the first quarter of 1991 was similar.

Table 2. New York Stock Exchange Member Rnns-Financial Results by Company Size, Second Quarter 1991 (millions of dollars, except as noted)

Item

Largest 10 . Firms

11th-25th Largest Firms

Largest 25 Firms

Total Industry

$1,071 2,472 1,060 3,908 8,511 2,869 5,642

$430 769 287 1,618 3,104 1,559 1,545

$1,501 3,179 1,347 5,589 11,615 4,428 7,187

$2,568 3,781 1,657 6,846 14,851 4,833 10,018

1,251 1,618 2,053 4,922

377 482 537 1,396

1,629 2,211 2,478 6,318

2,168 3,031 3,517 8,716

Income Statement Commissions Trading gain Underwriting fees Other revenues Total revenues Interest expense Net revenue Registered representative compensation Staff compensation Other expense Total noninterest expense Pretax income Pretax margin

720.1 12.8%

148.9 9.6%

869.0 12.1%

1,301.8 13.0%

19% 44 19

28% 50 19

21% 44 19

26% 38 17

22 29 36

24 31 35

23 31 34

22 30 35

56% 55 60 58

15%

72% 67 90 74

Composition of net revenues Commissions Trading gain Underwriting fees Registered representative compensation Staff compensation Other expense

Proportion of total industry Revenues Pretax profits Assets Equity

11 30

16

100% 100 100 100

Balance Sheet

Receivables from customers Receivables from brokers Reverse repurchases Securities owned Other assets Total assets Owners' equity Pretax return on ending equity (annual rate) Assets/equity

$21,906 71,904 137,185 107,086 20,197

$4,674 36,301 77,509 54,724 4,445

$26,580 108,206 214,694 161,810 24,643

$34,253 124,093 229,361 178,745 30,764

358,279 14,187

177,653 4,017

535,932 18,203

597,216 24,655

20.3% 25.3x

14.8% 44.2x

19.1% 29.4x

21.1% 24.2x

Source: Securities Industry Association.

121

Figure 1. Brokerage Share Price Index, 1982-91

In a good year, the industry earns 15 percent as a pretax margin and between 20 percent and 22 percent return on equity. This is about one-tenth of the profit of the banking industry in dollar terms. The Securities Industry Association cites this fact when banks say they want to be in the underwriting business because they need an additional source of income: Even if banks owned the entire business, it would add only 10 percent to their earnings. In a bad year, profits disappear. This is illustrated in Figure 4, which shows for NYSE member firms the mix of expenses and between compensation and other expenses, quarterly for the past five years. Compensation usually represents between 50 percent and 60 percent of net revenues.

1982 = 100 400r--------------------, 300

I I ' I

200

I \

/

I' \

, ...... /' \ ....

/

..

I

.,f

I

100

- - S&P500 - - - Securities Brokers Index

Source: Lipper Analytical Securities Corporation.

The changes in the industry since 1986 are reveal- Industry Financial Statements ing. Based on the results of NYSE member compaThe returns in the brokerage industry depend on the nies in 1991 compared to all public companies in interaction of the product and market cycles. Figure 1986, Wall Street was about the same size, profit 5 shows the relationship between the balance sheet margins were about the same, and revenues were and income statement for the brokerage industry. about the same in both periods. Earnings today are The amounts have been indexed to create a hypothetprobably of somewhat higher quality, though, beical, "average" firm with $100 million in assets. The cause the 1986 results reflected about $1 billion of returns are a function of competition in the marketjunk bond fees and $1 billion of merger and acquisiplace, and what happens in the market is a function tion fees-which represented about 20 percent of net of a number of factors, including interest rate condirevenues. That is all gone now, and the industry tions. seems to be making a higher quality profit even The following example illustrates the product though it has fewer sources of revenue. cycle phenomenon: Ten years ago, the mortgageFigure 2. New yort< Stock Exchange Member Finns--Profitability, 1981-91 15

45

10

30

§ .c-

§ l::

"Eo

'5

0-

5

15

os ~

~

l:: 0

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'81

'82

'83

'84

_w~~J.

__._

'85

__.L_ ___.L_ ___.L_ ___'C__.._C__..C__.._ _' _ _ d

'86

- - Pretax Return on Equity

Source: Securities Industry Association.

122

'87

'88

Pretax Margin

'89

'90

'91

-15

Rgure 3. New York Stock Exchange Member Finns--Profit Margins By Type of Rnn 1981-91 20,---------------------, 15

"

""

I I I,

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-5 L-----l._---L_---l.-_l...-----l_--'-_----L_...l.-_l--------' '81

'82

'83

'84

'85

'86

'87

'88

'89

'90

'91

- - National Firms - - - Investment Banks - - - - - Regional Firms

Source: Securities Industry Association.

backed bond business was very profitable, but competition has made it less profitable in recent years. Today, the derivative business is something everyone is excited about, because it has a very high return. In five years, it is likely to be more cutthroat and less profitable. Some types of income can be traced to specific assets. Interest income is generated by securities investments, inventories, accounts receivable, mar-

gin accounts with individuals, or resale agreements. Most of the important sources of income, such as investment banking fees, do not flow from specific assets on the balance sheet. People are an important asset of the brokerage industry, although that never shows on the books. The people have relationships with companies and work on the trading desks. The sum of their knowledge is what makes one firm different from another. In essence, investment banking fees represent the productive capacity of the workforce. Because many people-intensive sources of income are off the balance sheet, and a lot of a company's net worth is off of the balance sheet, calculating what a brokerage company is really worth is difficult using only the financials. The primary sources of revenue, comprising about 80 percent of net revenues, are commissions, trading gains, and underwriting fees. The remaining 20 percent of net revenues are generated by net interest income, asset management, and so forth. Wall Street has been making a transition away from transaction revenues-that is, from one-at-a-time revenues for which you have to go out and start over again every single day. The industry has moved toward recurring revenues. Commissions and trading profits are two more reliable, renewable sources of income. As Table 1 shows, commissions represented

Figure 4. New York Stock Exchange Member Finns--Composition of Expenses, 1985-91 12,000

10,000

8,000

c

6,000

~

~

=

4,000

2,000

o Pretax Loss '85

'86

'87

• Compensation

'88

'89

0

'90

'91

Other Expenses

Source: Securities Industry Association.

123

Figure 5. New York Stock Exchange Member Finns--Balance Sheet and Income Statement

Flows of Revenue and Expense (thousands of dollars)

Assets Cash Customer receivables Broker receivables

June 1991 $1,453 20,779 5,735

Resale agreements

38,405

Inventory (long)

29,930

Revenues Commissions Trading profits Investment banking

Interest income Investments Plant and Equipment Goodwill and other Total

2,028 100,000

3,045

Long-term debt

4,970 5,264

Equity

~etinterestincome

(138)

Other revenues revenues

1,546 6,710

Expenses Compensation

3,483

Floor costs Occupancy and communication Advertising Other

292 835 146 1,082

~et

7---:~,~'""--

51,506 15,639 15,447

Total

3,099 3,237

1,539

Repurchases Payables Inventory (short)

Deferred compensation and taxes

Interest expense

131

People Off-balance-sheet items

Liabilities Bank loans

2Q 1991 at annual rate $1,720 2,472 1,110

95,872 4,128

__

Total noninterest expense

5,838

Pretax income

871

Income tax

248

~etincome

623

Source: Securities Industry Association.

about one-quarter of net revenues in the second quarter of 1991. This may be somewhat unrepresentative of how the industry fares over time, however, because it does represent a very profitable period. Trading profits, most of which come from bonds, are about 40 percent of the total. Relatively little of the trading profit is contributed by other operations. For example, in several recent quarters, Wall Street's bond trading profit before taxes was about $3 billion. Underwriting fees come and go as rapidly as trading profits and are about 15 percent of revenues.

securities Broker Archetypes The different periods of man's evolution can be explained using what social scientists refer to as spacial archetypes. Spacial archetypes are general geometric shapes, such as a pyramid or a grid. In the Paleolithic era (Stone Age), the important spacial archetype was the "sensitive chaos," which is a spiral 124

shape, a swirling thing. At that time, people subsisted by hunting, and they did not have permanent dwellings because they did not want to disrupt the land. In the Neolithic era (Bronze Age), when people began cultivating crops, domesticating animals, and growing fruit trees, the spacial archetype was the "great round," and people lived together. I find this evolution a lot like what has happened on Wall Street. Formerly, brokers would come in ready to trade and make their commission for the day. Now, they no longer want commissions, because commissions are not predictable enough. They want to have steady, repeatable revenues. They do not want to hunt for their meals every day. Thus, Wall Street is moving from the Stone Age to the Bronze Age. The broker of yesteryear earned his revenues from trading gains and commissions; his stylistic archetype was a big pair of cuff links and a cigar. Today's broker has a little more overhead but is more stylish and sophisticated; he carries a cellular

phone and a laptop computer.

Company Analysis Several characteristics of the brokerage industry affect the way a company analysis should be conducted. For example, earnings comparisons should be made on a quarter-to-quarter basis, rather than a year-over-year basis. Because situations change so much from one year to the next, annual comparisons may not be germane. Similarly, analysts should focus on net, rather than gross, revenues. Gross revenues can be too high if the firm has significant interest expense, so as with bank income analysis, interest expense should be deducted. Analysts should figure out where the revenues come from and how persistent they are. This applies especially to trading income. Those firms that have very persistent trading income tend to outperform the industry and the market. Analysts should also examine where the revenues go. The key element is the proportion of revenue used for compensation. With apologies to the father of all economists, John Maynard Keynes, I have devised the marginal propensity to compensate (MPC)-what happens to compensation in response to small changes in net revenues. In the brokerage industry, the marginal propensity to compensate is between 50 percent and 60 percent, depending on the company; of each additional dollar earned, 50 or 60 cents goes to the employees. The "correct" level of MPC varies from company to company. In general, public shareholders want a low MPC (and thus a higher incremental pretax margin). The MPC has been coming down. The national full-line firms are paying less in compensation. Since 1987, they have cut their break-even points by about

$1.4 billion a year, primarily by reducing compensation. Measures of company performance should in some way be keyed to the compensation expense or to the number of people employed-pretax profit per employee or the productivity of brokers, for example. Beyond compensation, between 30 percent and 35 percent of the revenues usually go to suppliersto pay for the telephone, rent, and so forth. Because this part of the expense burden is relatively small and more or less fixed, however, it is much less important than compensation. The most important asset a brokerage company shows on its balance sheet is its inventory. Analysts should find out what inventory consists of and whether it contains stuff that will get a firm into trouble, such as too many equities or too many junk bonds. Analysts should also compare a firm's inventory to its equity base. Many analysts think margin loans are a desirable asset because they generate a lot of interest income. I disagree, because they also tend to be terribly risky from a credit viewpoint. Analysts should look carefully at the other assets category, because there are often disasters hiding in this area. Shearson is a perfect example. Its other assets look relatively small because the inventories are so big. Lurking in other assets, however, are a number of problem investments that are large relative to net worth. Book value per share is probably the most widely used statistic, because growth in book value is really the only long-term systematic measure of what the company is earning for the shareholder. Book value per share is an abbreviated measure, but it dearly shows how fast the shareholders' investment is growing without the static and noise of the entire income statement.

125

Question and Answer Session John E. Keefe Samuel G. Uss Question: Each of you stressed the asset management operations of brokerage firms. The management fees for this service are quite high relative to my industry standard, particularly in money market funds. We could be managing a money market fund in competition, but we cannot do much on the gross side without taking undue risk. A high cost base lowers the net return. Is the investor going to be conscious of this or simply transfer out of the brokerage side? Does he know the difference? Liss: One reason the move to asset management is so attractive to these firms from an investment standpoint is that the only public proxies in the asset management business, whether Dreyfus, Franklin, or T. Rowe Price, all have price-earnings ratios in the 15 to 20 times range. Brokerage stocks are trading at 10 times current year's earnings. So recurring revenues, margins, and earnings mix are not the only benefit of the asset management business; there is also a valuation message. On the fee side, those in the business who have gone through two or three waves of performance fees are no longer amazed that performance fees have come and gone with such alacrity and not really affected their business to a meaningful extent. One area in the brokerage business in which fee pressure should logically mount is the wrap fee business. Wrap products generate fees on business received through retail brokers of 2 percent or 3 percent to 132

direct their customers' money into the firm's commingled fund, which matches its existing portfolio. When it comes to their management of assets, however, consumers have proven willing to pay for advice. Keefe: The mutual fund business is unusual. Wrap fees are a good example of most individual financial products, where the clients do not know the price of what they are paying for. If people intend to use a full-service broker-and feel they need to pay nondiscount commissions and engage a financial planner account executive-they probably do not care about whether they are paying a fee of 50 basis points on their money market fund or 28. The business is fairly price-insensitive. Question: Are derivative products going to remain profitable for securities firms, or will other firms-like J.P. Morgan and Bankers' Trust-take the business? Liss: Two issues to note are swap and counterparty credit rating advantages; second is to reorganize some of the relationships which logically flow from core lending relationships. Technology investments is one variable that plays a role, as do dollar indexes.

Keefe: As far as derivatives and related products go, we are still at a very high profitability stage. Because the credit requirements are fairly high,

there will be few participants in that business. As the markets get more efficient and the systems get better, there will probably be lower profitability at the broker level. Question: Analyzing balance sheet exposure is quite primitive. Most security firms have a great deal of exposure to off-balance-sheet items. How should analysts approach off-balancesheet items? Keefe: A lot of work needs to be done in this area. Each company accounts for these items differently. Finding out what the exposures are is difficult. Each company is dealing with it differently now, and standardization, or disclosure even in footnotes, will probably take several years. Liss: When looking at the credit side of a brokerage firm, analysts should first look at its footnotes on its notional value. The numbers can be enormous, particularly when a company books a large bevy of futures and forward contracts, which of course the companies argue are fully collateralized. Certainly on a hedging basis, one hopes they are. Obtain a brokerdealer balance sheet, which the broker must publish every six months, and query the accounts. If you are coming from the bank credit side and have a revolving line, push your leverage to gain more information. If they will not provide information, and it is a smaller regional brokerage firm or even one of the larger ones, then you have

to decide whether you know enough relative to your own risk profile. Notional footnotes of the values are not uniform among brokers. High-yield inventory must be declared, sometimes on a net basis and sometimes just the long position. Merchant banking disclosures have also improved, but analysts/creditors still need to query them. Question: In gathering assets, the industry has produced poor products-limited partnerships, government-enhanced funds, wrap fee asset management, high-risk and high-yield collateralized mortgage obligations. Will this change, and does it hurt client continuity?

Uss: I am more careful about generalizing; you listed a number of products which in fairness have had a range of experience and returns. Limited partnerships were clearly driven by tax laws. The performance on limited partnerships during the past three years were often aggressive in design, and brokers lost some clients because of that. Be very careful about putting wrap fee business into the same boat. Wrap fee business and much of the money market and sweep account business is very profitable and arguably serves a worthwhile role. Keefe: From a client-service standpoint, certainly real estate limited partnerships and cattle feeding were disasters. When I worked at Drexel, I saw some of these very risky deals. The people who created them knew they were risky, and the brokers knew they were risky, but it all went ahead because they carried some very large fees. Wrap fee programs may not carry risk to investors' assets of

the same sort, but they are terriblyoverpriced. Fortunately they are not very big, and those of you who talk to broker managements will hear them overstate the importance of wrap fees. The brokers want to have recurring income, to replace the commission stream with a fee stream. Charging clients 3 or 3.5 percent of assets year-in and year-out, instead of charging commissions, will be difficult. Wrap fee accounts will probably work to the benefit of clients' portfolios, but the retail brokerage industry has to go a long way to train its people to provide the level of service warranted by such high fees. Question: If it is not possible to determine product profitability, how do securities firms determine the appropriateness of their products? Why, for example, have some recently stopped trading particular products?

Liss: I am suggesting the GAAP public financial statements do not provide enough information to determine profit segmentation. Internally, firms have their own management reports that enable them to subjectively gauge expense allocation to a S,OOO-person brokerage force; whether to add a new product or products; and whether to contain that new operation, set up a separate expense allocation, or have a shared-revenue component. This accounting is discretionary. Internally, certain firms are operating with an increasingly sophisticated transfer pricing mechanism. It is still, unfortunately, one built on historical fiefdoms. Nevertheless, with current external reporting, we are left to heavy "guesstimating" on product profitability.

Question: Will asset management necessarily add stability or just a higher level of earnings at the trough? I am thinking about volatility and recurring revenue streams as assets under management shift between money funds and bank and equity funds.

Uss: Asset management is building on top of what is a significant wave of customerdriven business. If you strip away my scenario about rollover CDs and the disintermediation is closed off in 12 months by general market yields lifting, then some of the market transaction activity will also drop off and earnings will quickly contract. In late 1991, brokerage firms are earning above normalized levels. Most brokerage firm managements would suggest that their operating mode is to build a recurring base so that in a weak market, such as in 1984 or 1990, at worst they break even. Keefe: With that in mind, the real hurdle for the brokerage firm is to get the assets inhouse. Whether assets are in a money market fund, equity fund, or bond fund is less important than the fact that they are earning a fee. Of course, there is a high incremental margin between the different fund products, but most mutual fund money does not shift around much. Question: When Salomon went public through the aegis of Phillips Brothers and lost its partnership status, that seemed to be a potential watershed. It was not, as things turned out. Yet someone like Goldman has kept that culture. How important is culture? 133

Uss: Culture has always been a somewhat troubling concept in our business. A brokerage firm operating in a partnership form very often means that only a few of those partners truly know the economics of the business. A Wall Street firm built as a partnership might bring the connotation of collegiality and shared interest. When that firm goes public, if servicing clients
Uss: All broker-dealer balance sheets are required to be made public every six months, but they are not the parent company balance sheets. If you are 134

lending on a secured basis and they will not give you parent company data, but that is who wants the money, then hold out for it. Brokerage firms have varying levels of disclosure for their creditors, including private firms as well. Be conscious of period-end window dressing. Public disclosure of an income statement is not required. Keefe: Asking questions never hurts. You will get more information from them the bigger the lender you are, but persistence should help. Unfortunately, the data they are required to give are relatively few. However, a series of healthy balance sheets implies a healthy income statement. Question: Will Warren Buffett be successful in changing the compensation scheme of the securities industry so that shareholders reap the benefits of risk taking and not the employees? Keefe: The reason Salomon's securities business only netted a 10 percent return on equity in 1990 was because so many employees took out $1 million a year in salaries. The industry's biggest expense is compensation. Salomon has made a number of different cutbacks, but all of Wall Street is waiting for somebody to make the first move, to downsize a lot of businesses. For instance, the equity business is too big-too many analysts and salesmen, a lot of people making many unnecessary phone calls. This requires an immediate personnel change. It also requires some technological change. A lot of people in the industry agree with me, but nobody seems to think that it needs to happen at their firms. So if some big

changes do come at Salomon, they will be readily followed. Having said that, the compensation managers at some of the major firms are having a tough time scaling back now because profits are so high and everybody is accustomed to being paid well. Thus, new policies will be hard to implement.

Uss: Managements have tried for years to come to grips with the issue of payout versus profitability. Internal books are twisted by the internal politics of allocation and of capital costs. Profit judgments made after payouts is something the Street has moved to change. From a shareholder's perspective, the change should be viewed positively. The idea of running a brokerage firm with a fixed payout relative to revenues, as Bear Stearns and Morgan Stanley have tried to do, does not sound like a bad way to run a service-driven business. Question: Who are the shortterm and long-term winners as a result of the Salomon difficulty? What are the implications for the industry? Keefe: I think nobody wins. I doubt that any tremendous shift in business will occur. It is a pothole for Salomon, but I do not see it as being disruptive to the rest of the industry. It has been handled entirely differently from Drexel's situation. Some internal changes have taken place within Salomon, but as far as having a big chunk of business flow to one company or another, I doubt that will happen. Longer term, there may be structural changes in the Treasury bidding process. Question: How do you view long-term investment prospects

for Salomon? On one hand, it has a greater shareholder orientation than previously, but will it be willing to take the risks that earned it big profits in the past?

Keefe: We cannot tell what Salomon will do. Having articles in major newspapers is

nice, but that needs to be translated into real behavior this month, this year, and for several years down the road. What has happened so far has not been life-threatening. Hang on for another 6 or 12 months, and we will see the lasting effects of internal motivation.

Uss: I would close by suggesting we not believe all that is written in the press. We view our clients as central to our business. Salomon will continue to emerge from this process as more customer oriented.

135

Valuing the Stocks of Securities Firms Samuel G. Liss Director, U.S. Research Salomon Brothers, Inc.

Value-oriented managers often have trouble investing in brokerage stocks. Significant money-making opportunities exist in the industry, however. The trick is to measure the inflection points correctly.

The valuation of brokerage stocks is a peculiar science. In no other subset of the financial stock group does emotion seem such a large factor in the valuation process. In no other finance group do investors get so hot and so cold. The industry is also cyclical and historically has been unable to sustain earnings. Earnings are not easily forecasted. For all these reasons, value-oriented managers have had a lot of trouble investing in brokerage stocks. This concern is probably valid over the long term, as the brokerage industry is not likely to be a profitable investment over the long haul. In the short term, however, there are significant moneymaking opportunities in this industry.

Valuation of Brokerage Stocks

stocks. At times, price-book discounts have been significant and sustained for a period of time-often when earnings momentum is hard to decipher. Periods of low price-book ratios have proven to be a good time to accumulate stocks, making these stocks attractive for a trading-oriented stock group. For firms that have a low capital demand product mix, price-earnings ratios (PIEs) carry stronger importance. We have found that when a brokerage stock valuation rises from a price-book discount to a significant price-book premium, analysts usually focus on the PIE and sometimes the present yield to substantiate why they are interested in the brokerage firm stock. But PIEs are historically dangerous to trust in a valuation approach. Discount brokerage firms, trading-oriented institutional houses, and small regional brokers that might gather half of their earnings from asset management have very different economics. In the same breath, differentiation is not a trademark of the securities brokerage stock sector. The love affair with asset management has clearly moved to a state of infatuation for many brokerage firms. Asset management generally indicates high margin activity, and it is a recurring fee business. It is becoming a significant profit base for brokerage firms and has become a common strategy. For now, however, it is a stabilizing factor on what had been a purely customer-driven, if not proprietary-driven, profit stream. This is a key customerdriven business that is not purely transaction oriented.

I will discuss several variables that have an impact on the valuation of brokerage stocks: fundamental, technical, emotional, business segment valuation, as well as retail, discount, and institutional considerations. Stated book value has proven to be a technical and fundamental benchmark for value in the brokerage business, but with a twist. It is a fundamental value because in comparison to other financial institutions, a brokerage firm has one very strong guideline: It must mark to market assets at the close of each day. In the wake of Drexel Burnham's recent demise, it is prudent to judge the availability of third-party asset pricing-defined as liquidity. As brokerage firms have been pressured to substantiate to the credit agencies that they do not have Trading History any apparent capital squeeze, they have been forced Stock price data for 11 securities brokers are shown to demonstrate and increase the liquidity of their in Table 1. For most, their year-to-date stock perforbalance sheets. mance (I 991) has been phenomenal-partly because Price-book ratios are a signal for trading these

126

Table 1. securities Broker Perfonnance, 5elected Brokers, November 1987-91 Price Performance

Securities Brokers A.G. Edwards Alex Brown Bear Stearns Charles Schwab LeggMason Merrill Lynch Morgan Stanley Paine Webber Quick & Reilly Raymond James Financial Salomon Brothers, Inc.

11/91

11/90

$34 20 16 38 21 52 53 31 21 30 28

$11 8 8 13 12 18 25 12 10 10 24

11/89

11/88

11/87

$16 11 12 13 15 28

$11 10 9 8 12 28 27 17 12 7 26

$11 11 8 9 13 24 17 17 14 7 20

34

17 16 11 24

Percentage Change Year One Two to Date Year Year 148% 134 66 230 61 149 96 123 101 141 14

199% 149 107 194 72 186 115 153 117 197 17

113% 80 38 188 42 84 58 76 32 168 16

Source: Salomon Brothers, Inc.

of poor previous performance. Until recent years, few brokers were public firms, so the history in brokerage stocks is not long, and relative multiple and regression models are logically of limited use. This relative youthfulness is part of the difficulty in giving managements too much credit for their skills. In a related vein, broker managements have taken advantage of this lack of historical performance data when they needed access to the debt markets or for a variety of other reasons. The first major peak in brokerage stocks in terms of making money for people came during the 198283 rally, from August into the following July. At its peak price in 1983, A.G. Edwards was a $16 stock. Merrill Lynch was a $54-$55 stock in 1983, which is about where it was trading in late 1991 for the first time since 1983. Morgan Stanley was not public in 1983. Paine Webber peaked at $47 and has never achieved that price again. For comparison, the S&P 500 in 1983 was 170, and as of late 1991, it was at 390. Another peak period occurred in 1986, but none of the public companies surpassed their current valuation. The initial public offering (IPO) history of brokerage firms is shown in Table 2. Few brokers were public vehicles, available to most institutional investors, until the early 1980s. During the 1970-80 period, money managers often used Merrill Lynch as a stock exchange index proxy: As brokerage stocks did, so did the general equity market. Retail brokerage volume and New York Stock Exchange volume were closely linked to price performance, but there were very few public brokers to own. The only time Merrill Lynch delivered significant performance in the decade was coming out of the 1974-75 downturn, and even then the window was only six months long. The IPO count rose sharply in the 1980s. During the explosive 1982-83 market, driven by generally

existing economic growth, 10 brokers went public. The most noteworthy in today's world was Quick & Reilly; the others were small, retail-oriented, and clearly taking advantage of the valuations applied to the public brokers of the time. Few IPOs occurred in 1984, when underwriting was dropping off. In 1985, business picked up again, and Bear Steams went public. In 1986, nine brokers went public, marking a significant shift in the evolution of our business. Retail brokers in the early 1980s took advantage of the valuations available to expand operations. In the mid-1980s, institutionally oriented brokers needed capital to maintain their competitive position. The last round of IPOs was in 1987, with Shearson Lehman and Charles Schwab. Schwab came out in May of 1987 at about $26 and did not see that price again until this year. The significance of this historical data for valuation is that not one brokerage firm went public below 1.5 times book, regardless of its P IE ratio. Table 3 shows intra-industry merger and acquisition (M&A) activity during the 1980s. This is perhaps another method to substantiate external or

Table 2. securities Brokers' Initial Public Offering History, 1970-87 Year

!P0s

Selected Insurers

1970 1971 1972 1980 1983 1984 1985 1986 1987

1 5 3 1 10 3 3 9 2

Donaldson Lufkin & Jenrette Merrill Lynch; A. G. Edwards Dean Witter Advest Quick & Reilly Bear Stearns Morgan Stanley; Alex Brown Shearson Lehman; Charles Schwab

Source: Salomon Brothers, Inc. Note: Minimum price-book = 1.5x.

127

Table 3. Merger and Acquisition Activity, selected Brokers, 1981-89

Date Announced

Securities Brokers Prudential/ Bache Group American Express/Shearson Phibro/Salomon Brothers Sears, Roebuck/Dean Witter Shearson/Lehman Equitable Life/Donaldson, Lufkin & Jenrette G.E. Credit/Kidder Peabody Schroders PLC/Wertheim Dillon Read-Barings /Travelers Sumitomo Bank Ltd./Goldman Sachs Primerica/Smith Barney Shearson Lehman/E.F. Hutton Interstate Securities/Johnson, Lane Credit Suisse/First Boston Pru-Bache/Thompson McKinnon

3/19/81 4/17/81 8/4/81 10/8/81 3/29/84

draft, brokerage firms dropped in value, rendered to discounts to book.

Offer PriceBook

Correlation of Profits and Stock Perfonnance

2.1

2.9 2.4 2.3 2.5

2.0

11/6/84 4/25/86 6/10/86 7/16/86 8/6/86 5/27/87 12/2/87 7/15/88 8/1/88 7/1/89

3.1

2.7 2.8 2.1 1.2 1.8

Source: Salomon Brothers, Inc.

Note: Minimum price-book = 2.0x (1980-87).

private market value. The strategic choice of these firms typically was to acquire a broker for distribution purposes and sometimes for some more romantic pursuit. Not one M&A deal done between 1980 and 1987 was below two times stated equity, regardless of P /E. Two companies-Dillon Read, which sold to Travelers in 1986, and Morgan Stanley, which went public in 1986-had not had an annual return on equity below 25 percent prior to these transactions. In late 1987, in concert with the market down-

Table 4 shows pretax margins for several full-line and retail-oriented companies and some institutionally oriented companies. From 1984 through 1990, these companies had a fair amount of variability in their pretax margins. The Morgan Stanley and Bear Stearns numbers are more stable than those of the retail-oriented houses, for whom compensation is more variable and operations more diverse. High variability in pretax margins leads to a fairly high beta in terms of earnings predictability and perhaps offers substantiation of stock volatility. The income statement under Generally Accepted Accounting Principles for brokerage firms was developed in concert with brokerage firm managements. This is probably the reason segment reporting has never been required. Profitability does not typically depend on a single product, and analysts can only guess about allocation of profit among products, which is crucial given the wide range of different products. For example, it is not possible to separate government-desk profitability or retail profitability from institutional profitability, or to gauge how much the government desk made as opposed to the municipal desk. Predicting the earnings stream from a profit and loss standpoint is difficult. Thus, analysts/investors tend to take a ''back end" approach in determining earnings streams for firms, by imputing a return on equity. The balance sheet is a credible valuation guide

Table 4. Pretax Margins, selected Brokers, 1984-91 1991 2Q

Securities Brokers

3Q

Full-line and retail-oriented Dean Witter A.G. Edwards Merrill Lynch Paine Webber Shearson Lehman

NA 16% 13 10 6

NA 17% 15 10 NM

NA 14% 13 10 5

11% 15 4 4 NM

10% 13

Institutionally oriented Bear Stearns Morgan Stanley Salomon, Inc.

22 27 21

23 25 31

25 27 41

14 22 17

13

14

NM

New York Stock Exchange Members

lQ

1990

1989

1988

1987

1986

6% 11 9 4 2

8% 19 6 6 4

9% 17 11 9 14

17 30 25

20 29 12

16 21 4

22 23 12

7

5

2

15

5 3

Sources: Company filings; New York Stock Exchange. Note: Margins are based on net revenues. NA = Not available. NM = Not meaningful.

128

1985

1984

NM 15% 7 5 13

NM 16% 2 1 6

23

20 17

30 18 6

14

7

for brokerage firms-either a consolidated firm or a broker-dealer-because the categories in asset classes are fairly clear and distinct. Some of the off-balance-sheet issues, depending on the broker, are meaningful, but typically in today's reading of the financial statements, they are not emphasized. Many financial institutions would love to have the return on equity (ROE) of the brokerage companies on the institutional side. As Table 5 shows, the securities brokerage firms have outperformed the New York Stock Exchange member composite, and they posted relatively strong returns. Granted, the risk profile of brokers demands relatively higher returns.

Figure 1. Menill Lynch Stock Price 60 50 ~ .$

40

o

30

"0

20

'81

'82 '83 '84 '85 '86 '87 '88 '89 '90 '91

Shaded areas represent recessions.

Source: Salomon Brothers, Inc.

Table 5. Aftertax Return on Average Common Equity, selected Brokers, 1987-91 Securities Brokers

1991

1990

1989

1988

1987

Full-line and retail-oriented A.G. Edwards Merrill Lynch Paine Webber Shearson Lehman

15% 17 15 NA

16% 5 NM NM

18% NM 4 7

12% 14 NM 8

14% 12 10 7

18 21 20

10 14 8

14 28 15

17 33 8

16 25 4

7

6

Institutionally oriented Bear Stearns Morgan Stanley Salomon, Inc.

New York Stock Exchange Members

14

NA

NM

Source: Company filings. Note: NA = Not available. NM = Not meaningful.

As companies went public, they accessed the capital market and in some cases subsequently raised additional equity. Most brokerage firms today are dealing with twice the equity base they had in 1980. Maintaining a return on equity similar to 1980's, given pressure on some of the traditional customerdriven businesses, is what has driven proprietary trading activities. The asset management theme of the retail houses is also an additional strategy for trying to recoup and maintain historical ROEs. Figure 1 shows the trading history for Merrill Lynch during the past decade. I chose Merrill Lynch because it is among the largest in capitalization and most liquid, and it also is one of the few firms with a reasonably long trading history. The shaded portions of Figure 1 indicate U.s. economic recessions. (We were still fairly optimistic, showing a mid-1991 end to the recession.) In August 1982, the market started to run. The employment picture started to brighten, and corpo-

rate profits for Standard and Poor's (S&P) companies started to improve. The upswing in Merrill Lynch's stock price did not slow until July 1983. Then, the market sagged as interest rates calmed down for a while. Corporate profits continued to expand, and brokerage stock earnings estimates were up on a relative basis. What did not materialize was a continuation of the earnings momentum Merrill Lynch sustained for the three or four quarters leading into mid-1983. Wall Street had a tough underwriting period during 1984. This proved to be a good time to accumulate shares of Merrill Lynch. Interest rates had declined in the summer, and Merrill Lynch was trading at about its book value. Other drop-offs occurred in October 1987, in the latter half of 1989, and again in mid-1990, when most financial stocks got clocked. As of mid-1991, stocks have had a great year coming off of a major correction phase in 1990, and we have had terrific earnings momentum on a quarterly basis when contrasted to depressed prior year levels. Obviously, the economic numbers have not come in the same comforting sequence as they did during the 1982-83 period. This is my key current concern relative to brokerage stock valuation. The recent earnings results from Merrill and most of the other houses have been terrific. Figure 2 compares three variables for three brokerage firms. One is the book value, which tends to be the anchor when brokerage stocks are under attack, although sometimes you must be patient. Note that the book value discount widened significantly for Merrill in 1989 and 1990. Second, I have plotted trailing four quarter earnings to judge momentum. Third is a straight plot of price performance. Figure 3 shows a lO-year plot of a retail weighted broker index against the yield curve. Figure 4 shows price and yield spread for an institutional mix of brokers and perhaps suggests a

129

Figure 2. Trailing Four-Quarter Eamings Per Share, Book Value, and Share Price History,

Figure 3. securities Brokers Index, Market-Weighted Price YS. Yield Spread, selected Brokers

1981~1

60 r - - - - - - - - - - - - - - - . . , 6 0 0

60 r - - - - - - - - - - - - - - - - , 6.0

50

50 i!l ::§

8

~

4.0 ~

40

20

2.0 ~ i!l 0 ~

10

-2.e?

30

200

o

10

<J}

.... ::§

8

~ 4.0 ~ ~ 3.0 ~

30 20

=§

2.0 0

10

o '----'--_.L-----'-_--'--_'-----'--_-'--------L_--'----' '83

'84

'85

'86 '87 '88 '89 Morgan Stanley

'90

1.0

'91

35 r - - - - - - - - - - - - - - - . . , 2.5 30 2.0 ~

25

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ment. Certificates of deposit (CDs) are moving into the 4 percent range, and more than $2 trillion of them are outstanding. In our low interest rate environment, investors have reached a point of liquidity preference and begun to roll out of CDs looking for yield. The asset management companies that have had such explosive growth in the 1980s have found that no matter what the yield, fixed-income sales have been three-quarters of overall mutual fund sales during the decade, and broker-dealers have certainly played an important role in the distribution of mutual funds. In the late 1980s, brokers began to embrace the strategic idea of a broad construct of client asset management-that is, if brokers carry X dollars in total customer assets within their respective securities accounts and participate in new allocation choices, recurring revenue will build. Strategically positioning their retail broker to be able to vend both external and internal asset product-but 40, 50, or 60 Figure 4. securities Brokers Index, Market-Weighted Price YS. Yield Spread, 5elected Brokers 400

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little better correlation. These past few years, as the yield spread has widened between 30 years and 3 months, the brokerage stock action has improved. When interest rates go down, financial stocks have tended to do well; a rotation process takes place. Brokerage stocks certainly have participated in this phenomenon.

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percent of the time be able to provide a competitive product versus the outside vendor-has enabled that broker to have a more consistent control on client assets and flows. When joined with cash management accounts, individual retirement accounts (IRAs), wrap fees, and related recurring noncompensable product revenues, this suggests a different orientation to dependence on an expensive research effort for stocks and bonds. This has been a significant strategic change in the makeup of brokerage firms on the retail side. It involves the development of better trained financial account executives, but not necessarily financial planners. The goal is to control a larger portion of the clients' total assets. The financial account executive touches the assets, which give him perhaps some incentive to sell internal versus external manufactured products. The firms started to develop cash management sweep accounts and to decrease the amount of free credits, which is where the retail brokers used to make most of their money. The annual fees on sweep accounts, lRAs, fixed-income funds, and equity funds provide a more stable, but more consistent, earnings flow. The product mix in the major retail houses suggests that they are trying to do away with the basic connotation of volatility and unpredictability of

earnings. Merrill has carried this process the furthest. Paine Webber has adopted this policy and so have Smith Barney and Dean Witter on various scales. One challenge we foresee is the relative shortage of people older than 55 with personal wealth of $1 million or more looking for advice. They are getting called upon by six different brokerage firms, all with the same strategic focus.

Conclusion Financial stocks in total make up about 10 percent of the S&P market capitalization, banks and other banklike institutions make up 3 or 4 percent, the insurance group totals about 3 percent, and brokers are maybe 2 percent. Brokerage firm managements have adopted a pro-shareholder stance, and have promoted increasing internal shareholder ownership. Some will be successful and some not in delivering or building book value. Brokerage stocks-in direct reflection of the difficulty in making earnings prognostications-are trading-oriented securities. This does not mean ample returns have been unavailable. What has occurred historically is that brokerage stocks tend to trade to extremes. The trick is to measure these inflection points correctly.

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Question and Answer Session John E. Keefe Samuel G. Uss Question: Each of you stressed the asset management operations of brokerage firms. The management fees for this service are quite high relative to my industry standard, particularly in money market funds. We could be managing a money market fund in competition, but we cannot do much on the gross side without taking undue risk. A high cost base lowers the net return. Is the investor going to be conscious of this or simply transfer out of the brokerage side? Does he know the difference? Liss: One reason the move to asset management is so attractive to these firms from an investment standpoint is that the only public proxies in the asset management business, whether Dreyfus, Franklin, or T. Rowe Price, all have price-earnings ratios in the 15 to 20 times range. Brokerage stocks are trading at 10 times current year's earnings. So recurring revenues, margins, and earnings mix are not the only benefit of the asset management business; there is also a valuation message. On the fee side, those in the business who have gone through two or three waves of performance fees are no longer amazed that performance fees have come and gone with such alacrity and not really affected their business to a meaningful extent. One area in the brokerage business in which fee pressure should logically mount is the wrap fee business. Wrap products generate fees on business received through retail brokers of 2 percent or 3 percent to 132

direct their customers' money into the firm's commingled fund, which matches its existing portfolio. When it comes to their management of assets, however, consumers have proven willing to pay for advice. Keefe: The mutual fund business is unusual. Wrap fees are a good example of most individual financial products, where the clients do not know the price of what they are paying for. If people intend to use a full-service broker-and feel they need to pay nondiscount commissions and engage a financial planner account executive-they probably do not care about whether they are paying a fee of 50 basis points on their money market fund or 28. The business is fairly price-insensitive. Question: Are derivative products going to remain profitable for securities firms, or will other firms-like J.P. Morgan and Bankers' Trust-take the business? Liss: Two issues to note are swap and counterparty credit rating advantages; second is to reorganize some of the relationships which logically flow from core lending relationships. Technology investments is one variable that plays a role, as do dollar indexes.

Keefe: As far as derivatives and related products go, we are still at a very high profitability stage. Because the credit requirements are fairly high,

there will be few participants in that business. As the markets get more efficient and the systems get better, there will probably be lower profitability at the broker level. Question: Analyzing balance sheet exposure is quite primitive. Most security firms have a great deal of exposure to off-balance-sheet items. How should analysts approach off-balancesheet items? Keefe: A lot of work needs to be done in this area. Each company accounts for these items differently. Finding out what the exposures are is difficult. Each company is dealing with it differently now, and standardization, or disclosure even in footnotes, will probably take several years. Liss: When looking at the credit side of a brokerage firm, analysts should first look at its footnotes on its notional value. The numbers can be enormous, particularly when a company books a large bevy of futures and forward contracts, which of course the companies argue are fully collateralized. Certainly on a hedging basis, one hopes they are. Obtain a brokerdealer balance sheet, which the broker must publish every six months, and query the accounts. If you are coming from the bank credit side and have a revolving line, push your leverage to gain more information. If they will not provide information, and it is a smaller regional brokerage firm or even one of the larger ones, then you have

to decide whether you know enough relative to your own risk profile. Notional footnotes of the values are not uniform among brokers. High-yield inventory must be declared, sometimes on a net basis and sometimes just the long position. Merchant banking disclosures have also improved, but analysts/creditors still need to query them. Question: In gathering assets, the industry has produced poor products-limited partnerships, government-enhanced funds, wrap fee asset management, high-risk and high-yield collateralized mortgage obligations. Will this change, and does it hurt client continuity?

Uss: I am more careful about generalizing; you listed a number of products which in fairness have had a range of experience and returns. Limited partnerships were clearly driven by tax laws. The performance on limited partnerships during the past three years were often aggressive in design, and brokers lost some clients because of that. Be very careful about putting wrap fee business into the same boat. Wrap fee business and much of the money market and sweep account business is very profitable and arguably serves a worthwhile role. Keefe: From a client-service standpoint, certainly real estate limited partnerships and cattle feeding were disasters. When I worked at Drexel, I saw some of these very risky deals. The people who created them knew they were risky, and the brokers knew they were risky, but it all went ahead because they carried some very large fees. Wrap fee programs may not carry risk to investors' assets of

the same sort, but they are terriblyoverpriced. Fortunately they are not very big, and those of you who talk to broker managements will hear them overstate the importance of wrap fees. The brokers want to have recurring income, to replace the commission stream with a fee stream. Charging clients 3 or 3.5 percent of assets year-in and year-out, instead of charging commissions, will be difficult. Wrap fee accounts will probably work to the benefit of clients' portfolios, but the retail brokerage industry has to go a long way to train its people to provide the level of service warranted by such high fees. Question: If it is not possible to determine product profitability, how do securities firms determine the appropriateness of their products? Why, for example, have some recently stopped trading particular products?

Liss: I am suggesting the GAAP public financial statements do not provide enough information to determine profit segmentation. Internally, firms have their own management reports that enable them to subjectively gauge expense allocation to a S,OOO-person brokerage force; whether to add a new product or products; and whether to contain that new operation, set up a separate expense allocation, or have a shared-revenue component. This accounting is discretionary. Internally, certain firms are operating with an increasingly sophisticated transfer pricing mechanism. It is still, unfortunately, one built on historical fiefdoms. Nevertheless, with current external reporting, we are left to heavy "guesstimating" on product profitability.

Question: Will asset management necessarily add stability or just a higher level of earnings at the trough? I am thinking about volatility and recurring revenue streams as assets under management shift between money funds and bank and equity funds.

Uss: Asset management is building on top of what is a significant wave of customerdriven business. If you strip away my scenario about rollover CDs and the disintermediation is closed off in 12 months by general market yields lifting, then some of the market transaction activity will also drop off and earnings will quickly contract. In late 1991, brokerage firms are earning above normalized levels. Most brokerage firm managements would suggest that their operating mode is to build a recurring base so that in a weak market, such as in 1984 or 1990, at worst they break even. Keefe: With that in mind, the real hurdle for the brokerage firm is to get the assets inhouse. Whether assets are in a money market fund, equity fund, or bond fund is less important than the fact that they are earning a fee. Of course, there is a high incremental margin between the different fund products, but most mutual fund money does not shift around much. Question: When Salomon went public through the aegis of Phillips Brothers and lost its partnership status, that seemed to be a potential watershed. It was not, as things turned out. Yet someone like Goldman has kept that culture. How important is culture? 133

Uss: Culture has always been a somewhat troubling concept in our business. A brokerage firm operating in a partnership form very often means that only a few of those partners truly know the economics of the business. A Wall Street firm built as a partnership might bring the connotation of collegiality and shared interest. When that firm goes public, if servicing clients
Uss: All broker-dealer balance sheets are required to be made public every six months, but they are not the parent company balance sheets. If you are 134

lending on a secured basis and they will not give you parent company data, but that is who wants the money, then hold out for it. Brokerage firms have varying levels of disclosure for their creditors, including private firms as well. Be conscious of period-end window dressing. Public disclosure of an income statement is not required. Keefe: Asking questions never hurts. You will get more information from them the bigger the lender you are, but persistence should help. Unfortunately, the data they are required to give are relatively few. However, a series of healthy balance sheets implies a healthy income statement. Question: Will Warren Buffett be successful in changing the compensation scheme of the securities industry so that shareholders reap the benefits of risk taking and not the employees? Keefe: The reason Salomon's securities business only netted a 10 percent return on equity in 1990 was because so many employees took out $1 million a year in salaries. The industry's biggest expense is compensation. Salomon has made a number of different cutbacks, but all of Wall Street is waiting for somebody to make the first move, to downsize a lot of businesses. For instance, the equity business is too big-too many analysts and salesmen, a lot of people making many unnecessary phone calls. This requires an immediate personnel change. It also requires some technological change. A lot of people in the industry agree with me, but nobody seems to think that it needs to happen at their firms. So if some big

changes do come at Salomon, they will be readily followed. Having said that, the compensation managers at some of the major firms are having a tough time scaling back now because profits are so high and everybody is accustomed to being paid well. Thus, new policies will be hard to implement.

Uss: Managements have tried for years to come to grips with the issue of payout versus profitability. Internal books are twisted by the internal politics of allocation and of capital costs. Profit judgments made after payouts is something the Street has moved to change. From a shareholder's perspective, the change should be viewed positively. The idea of running a brokerage firm with a fixed payout relative to revenues, as Bear Stearns and Morgan Stanley have tried to do, does not sound like a bad way to run a service-driven business. Question: Who are the shortterm and long-term winners as a result of the Salomon difficulty? What are the implications for the industry? Keefe: I think nobody wins. I doubt that any tremendous shift in business will occur. It is a pothole for Salomon, but I do not see it as being disruptive to the rest of the industry. It has been handled entirely differently from Drexel's situation. Some internal changes have taken place within Salomon, but as far as having a big chunk of business flow to one company or another, I doubt that will happen. Longer term, there may be structural changes in the Treasury bidding process. Question: How do you view long-term investment prospects

for Salomon? On one hand, it has a greater shareholder orientation than previously, but will it be willing to take the risks that earned it big profits in the past?

Keefe: We cannot tell what Salomon will do. Having articles in major newspapers is

nice, but that needs to be translated into real behavior this month, this year, and for several years down the road. What has happened so far has not been life-threatening. Hang on for another 6 or 12 months, and we will see the lasting effects of internal motivation.

Uss: I would close by suggesting we not believe all that is written in the press. We view our clients as central to our business. Salomon will continue to emerge from this process as more customer oriented.

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The Impact of Market Value Accounting on the Operation of Financiallnstitutions 1

Martin Mayer Author

Market value accounting is on the horizon for three reasons: the merger and acquisition boom, the rapid growth of techniques to value bank portfolios, and the demands of accountants.

Market value accounting is coming, but it will not come as fast as it should, even though the Financial Accounting Standards Board's feet are being held to the fire. That is because our banks are still in very bad shape. An eminent young economist said, on the basis of an analysis he is doing for an even more eminent consulting firm, that he thinks no creditworthy companies remain that expect to borrow from banks. He is looking at it from a national perspective. From a local perspective, banks still have lots of business to do with good companies. The current drive to establish nationwide banks is outrageous. Professor Martin Shubick of Yale University has suggested a way out of this dilemma. He would be willing to support nationwide branching if, as part of the law, each branch manager were required to stay in the branch for at least 10 years. I suspect a lesson was learned by the 1991 credit card flap, in which the suggestion that a lid be put on credit card interest rates sent the stock market reeling. Banking analysts learned that eventually, with or without government intervention, the credit card business will become a commodity business at very low margins. Because banks are our only transmission belt for monetary policy-and we are so deeply in the hole we cannot use fiscal policy to stimulate the economy-the Federal Reserve will move heaven and earth to create profits for the banking system, even when its actions are counterproductive. For purposes of monetary policy, the Fed would find very useful a credit card cap law that said banks could not charge credit card rates of more than 10 percent over the London Interbank Offered Rate. This would l This presentation is based on a paper the author wrote for Peat Marwick.

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make consumer credit automatically countercyclical, forcing extra expenses on consumers in a boom and relieving them of interest costs in a bust. But banks do not want it, so the Fed is opposed. The banking regulators also will vigorously oppose market value accounting for banks; in fact, they already have. The regulators solemnly wrote in 1990 "market value accounting could have a significant adverse effect on the safety and soundness of the banking system." Last winter, Richard Breeden, Chairman of the Securities and Exchange Commission (SEC), said, "Bank regulators are inducted into an order of secrecy soon after their employment. We have had 1,100 bank and thrift failures. I want to know how much investors lost in those failures. None of the bank regulators had those records. I asked our economists to go out and look at the situation, and in 20 institutions they found investor losses of more than $8 billion-and climbing." Breeden, being at bottom a political animal, will not in an election year with a panicked president continue to stand quite so tall for market value principles. Nevertheless, they will come. About a year ago, then-SEC chief accountant Edmund Coulson wrote a letter to the American Institute of Certified Public Accountants (AICPA) arguing that "accounting standards ought not to conceal the reality they are established to portray. Certainly, financial statements should not ignore the reliable valuation furnished by liquid markets.,,2 Back in 1982, then-chairman of the Federal Deposit Insurance Corporation (FDIC) Bill Isaac told an AICPA meeting, "The historic cost accounting sys2Letter of September 13, 1990, from Edmund Coulson, SEC chief accountant, and Robert A Bayless, chief accountant of the Division of Corporate Finance, to Jack Kreischer of AICPA.

tem does not reflect reality." I sent Isaac a copy of that clipping the other day, because he is now on the other side. His office at the Secura Group warns against judging bank portfolios by their "liquidation" value. Market value accounting, however, is not liquidation accounting; it is merger-and-acquisition accounting. A lot of mergers and acquisitions are going to take place, and nobody ever bought a bank according to the historic cost of its portfolio. Historical cost accounting in bank examination goes back to 1938, when bank regulators, seeking to evade the effects of the economic relapse of 1937, gave banks permission to carry loans and securities-then 43 percent of bank portfolios-at historic cost whatever their delinquencies or the current market, as long as the case could be made that ultimately the loan would be paid back and the securities would be redeemed. Professors Donald G. Simonson and George Hempel of Stanford wrote, "By focusing on loans' ultimate collectibility, this provision ignores the fundamental economic tenet of the time value of money. . . . The historical cost accounting framework conceals the true value of the institutions' net worth.,,3 Twenty-five years later, the Financial Accounting Standards Board (FASB) validated this neglect of the time value of money by approving FAS No. 15, a rule permitting financial institutions to carry restructured loans at par on their balance sheets so long as all payments on the loan-principal and interest together-would total more than its face value. Under the shelter of this rule, regulators allowed banks to carry their obviously impaired loans to lesser developed countries at full book value, even though these loans were being traded for less than half that value on an active international market, which moved an annual dollar volume considerably greater than the dollar volume of all trading on the American Stock Exchange. FAS No. 15 also gave some color of justification to one of the early acts of Comptroller Robert Clarke, who in 1987 changed the rules to let banks use their own appraisers rather than independent outsiders when judging the value of real estate loans. He also restricted "loss" classifications to "loan exposures exceeding the undiscounted future market value expected to be realized within a reasonable period, normally not to exceed five to seven years." This circular was one of the reasons the Senate Banking Committee rejected Clarke's reappointment. The Federal Reserve Board staff, trying to fight 3Donald G. Simonson and George Hempel, "Running on Empty: Accounting Strategies to Clarify Capital Values," Stanford Law and Policy Review, (Spring 1990):92-94,96.

off pressure to mark to market, noted that market value accounting on loans would be difficult to do, because a bank would not "reveal its private information. . . when estimated values are low relative to public information. Because of incentives to overstate values that are relatively low. . . market value accounting proposals ... do not improve on current accounting practices.,,4 In the case of the savings and loans (S&Ls), bad accounting practice-much of it validated by the Federal Home Loan Bank Board-enabled the huge pileup of losses to go undetected for so long. For the S&Ls, "gains trading" was legal; that is, an S&L could buy a lot of paper from a Wall Street house, sell what went up in price and put the profits in the S&L owner's pocket, and continue to carry what went down in price at historic cost. Indeed, if getting new deposits was a nuisance or the examiner thought he could make himself a hero by worrying about net worth, the depreciated paper could be taken back to the house that supplied it originally and pledged in a reverse repossession to get cash to buy more of it and play the game again. For banks, such behavior is forbidden. The Treasury department report that backed the banking bill noted "large depository institutions typically evaluate and compensate the managers of their investment securities portfolios on the basis of earnings calculated using MVA [market value accounting] concepts, rather than on the basis of generally accepted accounting principles accounting profitability. The market price of a security represents an institution's actual opportunity to convert that instrument into cash, which can then be distributed to owners and creditors or redeployed within the organization.... Prudential asset/liability management techniques may require the selling of investment securities prior to maturity as part of an overall business plan or to effectively manage liquidity and interest rate risk."s These things do not affect only securities these days. As a cynical FASB accountant puts it, "The badly documented loans are the only ones banks really intend to hold to maturity." The regulators warn that marking the bond portfolio to market might dissuade banks from holding long-term Treasuries. Omitting the fact that banking students in business schools spend 69.7 percent of their time learning the second-order partial differential equations that are supposed to show them how 4AIIen N. Berger, Kathleen A. Kuester, James M. O'Brien, "Some Red Flags Concerning Market Value Accounting," Board of Governors of the Federal Reserve System, Washington, D.C. (August 1989):22. 5Department of the Treasury, Modernizing the Financial System, Chapter XI (February 1991):30.

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to hedge portfolios of long-term Treasuries, the Treasury department study for the banking bill notes dryly that"a shift to less risky portfolio strategies by depository institutions-such as a reduced willingness to fund fixed-rate, long-term assets with shortterm deposits-should be interpreted as an intended and beneficial aspect of MVA,,6 As a practical matter, the big banks rely increasingly on off-balance-sheet assets for their profits, and just about everybody marks swaps to market"not," according to one banker, "as a matter of principle, but simply because you lose money if you don't do it." The one irrefutable argument against market value accounting I found in the literature was a statement in a Federal Reserve research study that markto-market accounting fails to value "the put option on the bank's loans which is issued by the deposit insurance agency and is held by the bank." 7 That put option becomes increasingly valuable as the bank's capital diminishes through losses on bad loans. In the end, market value accounting is on the horizon for three reasons. The first is the merger and acquisition boom, of which we have heard only the first thunder. The second is the rapid growth of techniques to value bank portfolios, partly to serve merger and acquisition efforts and partly as an offshoot of the mathematical gaming that the best bond houses use. Bloomberg Financial Information is collecting huge data bases on the trading of loan participations and establishing Bloomberg fair value curves for generic loans and for generic bonds. Term loans, to quote Joe Grundfest when he was SEC Commissioner, are "nothing but illiquid junk bonds." The regulators now so anxious to avoid market value accounting need it worst of all, because deposit insurance, which we cannot escape, will never again be a viable government program if what is insured is what Lowell Bryan calls "a blind pool of assets." Traditional bank examination, obviously, will not be good enough. Between now and Thanksgiving, Congress has to appropriate $150 billion for the Resolution Trust Corporation and the FDIC$600 for every man, woman, and child in the United States-because the bank and thrift examiners and regulators goofed. The third reason market value accounting is inevitable is the most important. The accountants are going to demand it. They are being sued in connection with S&L and bank failures, and they are losing money. The most important single source of the 6Modemizing the Financial System, Chapter XI, p. 10. 7Berger, Kuester and O'Brien, p. 6.

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credit crunch was a letter the Public Oversight Board of the SEC Practice Section of the AICPA sent on January 2,1991, to all accountants with a depository institution practice. "We have observed with considerable concern," wrote AA Sommer, Jr., the distinguished chairman of a board that includes Melvin Laird and Paul McCracken, "the attacks on the accounting profession resulting from the savings and loan debacle and the ensuing litigation, which in the estimation of many threatens the profession's very existence. . . . In the next few months, your firm and those of your colleagues will be performing audits of virtually all the major banks in the system. . .. If, as happened with respect to many savings and loan audits, these audits are followed quickly by bank failures or disclosures of previously undisclosed write-offs which imperil the viability of the institutions, we may expect a new wave of litigation against auditing firms and renewed public criticism of the profession. . . . We fully realize the restraints imposed upon auditors by generally accepted accounting principles and the difficulties of urging upon clients disclosures that may not be technically required but which do contribute to an understanding of the financial affairs of the client." In short, what the examiner says does not much matter. The accountant in his own self-interest is not going to let the bank get away with anything like the hanky-panky that was commonplace only a few years ago. Companies are providing some pretty good 10-Qs, but the 10-Ks, when the accountants have their say, are going to be a lot less enthusiastic. A General Accounting Office study showed that as banks get deeper into trouble, their call reports become more inaccurate. 8 This industry still suffers from egregious overcapacity, and the government's favorite solution-bringing new capital to a condition of overcapacity---eannot be done honestly. So beware. One aspect of the credit card interest flap does not seem to be getting any attention: Lowering rates would not disrupt the economy. The most interesting story I have worked on in recent years is the Johnson & Johnson management of the Tylenol disaster. At one point in the first week after the discovery of the cyanide-laced capsules, the government urged the company not to recall the product. It was known by then that the contamination physically could not have occurred at the plant; the cyanide used was hygroscopic and, within a matter of weeks, would have destroyed the water-based capsule coating-and these capsules were manufactured six 8Ceneral Accounting Office, Bank Insurance Fund, Report No. AFMD-90-100, Washington, D.C. (1990).

months before. The Food and Drug Administration argued that recalling this product would show that a nut or a terrorist could force a great company to swallow hundreds of millions of dollars of loses by tampering with a product on the shelves. The U.S. distribution system is based on open shelves; we could not go back to a time when you ordered something from someone behind a counter. This was a tough debate that was not publicized. At the end of the debate, news came of an incident of strychnine in a Tylenol capsule in Oroville, California, so Johnson & Johnson pulled the product. And this did not damage the distribution system. The financial system of the United States rests on the willingness of households to be intermediaries. Many middle-class Americans have $10,000 in a bank or a certificate of deposit, and they also have credit card loans and car loans outstanding of $8,000. These households are receiving 5 percent or less in interest on their certificates of deposit, and they are paying 19 percent or more in interest on their credit cards. We have given households an incentive to

shrink their borrowings-at the expense of shrinking the cash position that makes them feel well off and willing to spend. This was a very dangerous thing to do, and it may well be one of the reasons the current recession is so intractable. A lot of cheap wisdom and propaganda from theoretical and self-interested sources have railed at the suggestion that something be done to require banks to bring credit card interest rates down when their cost of funds comes down. My own reading of the history of the Fed is that Bill Martin or Arthur Burns would have made them do it. The argument that banks need to make huge profits from their good customers to permit them to loan money to bad customers is not a very strong one. It is the sort of thing that has brought the banks to their present sorry pass, with their good commercial and industrial borrowers leaving them. There are lessons to be learned from our recent experience, and bankers had better learn them. Analysts are, for better or worse, about the only people who can teach them.

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Question and Answer Session Martin Mayer Question: At a point when the economy is under considerable attack and consumer confidence is dead, why is revolving credit the only part of consumer credit outstanding that is growing? Mayer: Revolving credit only represents some of the outstanding consumer credit, although not much. Automotive credit is down because automobile sales are down. Personal loans are taken out on a credit card because the banks have offered them. Credit card debt is up because of indiscriminate and irresponsible marketing campaigns. 60 Minutes reported that Southern Methodist University hired a special counsellor to assist kids who abuse the credit cards they automatically receive when they enroll for college. This is a particularly cruel way to run the country-to offer credit to people who cannot pay it back. It is a worry on a financial basis, but what about on a human basis? What about all the lives being ruined because they have been offered credit they should not have been offered? Banks have a social responsibility not to make bad loans, whether it is to real estate developers who are borrowing 105 percent or to college kids who will abuse the privilege. Question: How can someone put a current market value on a small local commercial loan?

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Mayer: The techniques for making such valuations will be finely honed during the next five years, with the help of data bases like Bloomberg's. All of our proposed legislation assumes that people are going to buy those banks, and the guy who buys the bank must know the market value of its loans. Although people are trying to make those judgments, it is very expensive to do with diligence, so people are saying it cannot be done. Within 5 or 10 years, because of experiences like Bank of America's, these techniques will be marketable, and you will be able to do much closer analysis of the value of bank portfolios. Question: What developments in financial intermediaries do you think will surprise people most during the next five years? Mayer: The strength and resilience of the smaller banks will be a big surprise. Credit quality is the fundamental question, and smaller banks will have it. Also, the Federal Reserve figures do not show any economies of scale in banking. Crowley's figures show that the banks with assets of between $5 billion and $10 billion are the most profitable. Our experience in New York state, when the big banks were first allowed to branch outside New York City, is that they came back with their tails between their legs.

The resilience and profitability of the middle-sized bank will be the great surprise. Question: As we enter the era of big monolithic banks, why are we seeing continuing chartering of small banks? Mayer: Small banks are being chartered because those are the ones that will make profits. The monolithic banks are not going to make any money. National banks were built to serve national borrowers. Big banks were built to serve big borrowers who no longer need banks because they can borrow directly from the market. Big banks do not have a future without government support. Small banks have a comparative advantage in the commercial and industrial lending the United States needs, and they have profitability and potential. The government is supporting and subsidizing the big banks so it can pay a guy double his book, get him out of business, and then go in and run the business badly. The farther you get away from what you know, the more trouble you are likely to get into in banking. There will be monolithic banks that operate nationwide only if the government backs them; the problem is the government may back them.

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