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Vol. V, No. 48


Financial Services Insights and Intelligence

FIRST WORD: Catching up with PNC’s Bill Demchak. One of the few people in the financial services industry who may look back on 2020 as actually being a good year for his company is PNC Financial CEO Bill Demchak, whom I talked with this week. In May, PNC announced the sale of its minority ownership position in BlackRock, which generated cash proceeds of $11.1 billion. Then earlier this month, the company announced the purchase of BBVA’s U.S. banking assets for $11.6 billion. The BBVA deal will boost PNC’s assets by $104 billion, to $560 billion, and will represent another big step in Demchak’s plan to build PNC into a national banking franchise that will compete with JPMorgan Chase, Bank of America, Wells Fargo, and Citigroup.

I have long been a Demchak fan. He became PNC’s president in 2012 and CEO the next year. He’s led the company through a period of significant positive change, including a major technology upgrade, a significant branch network reconfiguration, and de novo branch expansion. Demchak’s view of the future banking environment has become more dim, especially in view of the prospect of zero interest rates for an extended period of time. Rather than be defensive in this environment, he has decided to go on offense through these two significant transactions. BBVA is attractive to PNC for a number of reasons: it is large, it moves PNC into new geographic markets (the company will operate in 29 of the top 30 MSAs after the deal), and BBVA’s U.S. franchise has been underperforming and presents the opportunity for improvement, especially since the unit’s problems appear to be relatively easy to fix.

Demchak’s plan is to cut $900 million, or 35%, of BBVA’s expense base, which would result in 21% earnings per share accretion in 2022 and a 19% IRR. But there’s more: Demchak said that due diligence revealed significantly more than $900 million in cost saves, but the company used that number in its investor presentation because “no one would believe a number over 35%” of BBVA’s expense base, given the limited footprint overlap. He gave me two examples of obvious cost savings. BBVA invests around $65 million annually in its fintech subsidiary, Simple, that loses over $25 million a year and has no path to profitability. The other example is that BBVA has seven layers of management in commercial banking, versus only three at PNC. The cost saves, if achieved, will provide the E.P.S. accretion and the attractive IRR, but Demchak is most excited about the longer-term revenue enhancement opportunities, because he has been through situations like this before.  After PNC bought the U.S. operations of RBC, for instance, it was able to increase commercial fee revenues from less than 20% to over 50% by arming the former RBC calling officers with PNC products. Demchak sees the same opportunity with BBVA over the next five years.

Financial impact. PNC received $11.1 billion from the BlackRock sale and invested $11.6 billion in BBVA. The company’s tangible book value per share was $85.52 before the Blackrock sale, and will be $87.59 after the BBVA purchase closes. BlackRock provided 20% of PNC’s earnings before the sale, while BBVA should provide 21% of PNC’s earnings in 2022.

Investor reaction. From the closing price on the last trading day before the BBVA announcement, PNC’s stock is up 13% while the KBW Banking Index is up 8%, which indicates a positive investor reaction, but it wasn’t as large a response as I would have expected. Demchak put a lot of excess capital to work quickly, buying a good franchise and assets at a reasonable price given the upside potential. In this environment, investors are skeptical that managements can deliver on their promises because, so often, they have not done so in the past. I am expecting that Demchak and this deal will add value for PNC’s shareholders.

COUNTERINTUITIVE: Here’s how crazy this year has been for the stock market. For only the sixth time since 1933, stocks will generate a positive return for the full year despite having endured a drawdown of 25% or more.

PLEASANTLY SURPRISED: This is definitely a good thing. The graduation rate for NCAA Division I athletes hit 90% this year, including a graduation rate for black athletes of 80%, up from just 54% in 2002.

OUT AND ABOUT: How strong is the housing market? This strong: even now—the time of year when prospective buyers historically head back to the sidelines for a while—sales are still surging. Here, for example, are existing-home sales, not seasonally adjusted.

Crazy. It’s as if the summer selling season never ended.

ANOTHER WINNER: OK, I admit it. I didn’t see this coming. The traditional 60-40 stock-bond portfolio—which plenty of skeptics have lately argued is obsolete, since interest rates have fallen so far that the bond piece of the portfolio no longer provides a meaningful stream of income, and because stock and bond prices seem to be more correlated to each other than they once were—has pretty much knocked it out of the park again this year. A surprise, right? In particular, while the 60-40 didn’t fall nearly as much as the stock market overall during the market’s big selloff this past March, it has still returned 13% so far this year, basically in line with the S&P 500.

Then again, long-term interest rates will presumably begin an extended and meaningful rise at some point, right?

NOT TOO SCARED: Further evidence that investor sentiment is discouragingly, and extremely, non-bearish. Short interest on the typical stock in the S&P 500 is at record lows.

UNBELIEVABLE. LITERALLY: Claptrap alert! On Monday, Morgan Stanley equity strategist Michael Wilson told clients that he expects the S&P 500 to rise by 10% over the coming twelve months—but not before it falls by 10% in the interim because “the [Covid] vaccine won’t be ready for mass distribution for another 3-4 months as case counts and deaths increase.” Got it! Reasons this is total nonsense: 1) Over any given twelve-month period, the stock market rarely fluctuates by just 10%. It’ll either go up by 25% or more, or go down 15% or more, to average out to a long-term return of around 8%. Sorry. 2) Trust me, the market as a whole has a much better sense than Michael Wilson does as to when any vaccine will be ready for wide distribution, and 3) Anyone who believes he can predict every zig and zag in stock prices over a given twelve-month period really is delusional. I mean, who pays for this stuff?

PUMPED WAY UP: “Twenty-one percent of all U.S. dollars were printed in 2020.” I mean, what can go wrong?

LINKED: Meanwhile, the people at Pantheon Macroeconomics say that money growth is not a reliable indicator of inflation. Really? Are we all looking at the same chart?

So let’s see: from 1960 until the mid-1970s, the annualized rate of M2 growth rose from the low single digits to 15%, while over that same period the inflation rate jumped to 12% from around 3%. Then from the mid-1970s to the mid-1990s, M2 growth declined to zero from 15%, and inflation fell back to around 2%. Then after that (until this year), the rate of M2 growth never topped double digits. I think I’m seeing a pattern.

AGAIN AND AGAIN: Is the market’s new high this week a sign that stock prices are making a top? Probably not. Fisher Investments’ Ken Fisher makes the point that, historically, once the market hits a record high, it tends to keep on rising in the year that follows:

PURCHASING MANAGERS BUSY: I’m starting to get the impression that the nation’s economy-watchers haven’t yet gotten their hands around the possibility that GDP growth could be pretty darn strong in coming quarters. Markit’s preliminary composite purchasing managers survey for November, out this past Monday, seriously topped expectations and now is at its highest level since March 2015.

STRONGER: Meanwhile, Atlanta Fed’s GDPNow real-time economic model, said to be among the most accurate of such models, now says that the economy is set to grow at a 5.6% real, annualized rate in the fourth quarter, or slightly ahead of the top range of consensus forecast.

GIVING BACK: Money talks! Corporate America seems to be starting to do things that hint that it suspects that the end of the pandemic might be in sight. From the Wall Street Journal, on Monday:


After scrambling to hoard cash in the spring, some large U.S. companies that halted their dividend payments are reversing their decision, a sign that their leaders believe the worst of the crisis is behind them.

Earlier this year, when much of the country’s economy shut down in the first waves of the coronavirus pandemic, companies withdrew cash from credit lines, stopped repurchasing stock and halted dividend payments amid the uncertainty. . . . [M]any businesses—from factories to law firms—have learned how to operate during the pandemic. Retailers, fast-food restaurants and car makers are doing better, and there is hope among executives that any new restrictions to battle the latest U.S. surge in cases won’t be as severe.

“Multinationals are beginning to exhale,” said Mark Zandi, chief economist at Moody’s Analytics. “The resumption of corporate dividend payments is an encouraging sign that executives believe that the pandemic will soon be behind us.” [Emphasis added.]

 Well, good. This is consistent with why, against anyone’s expectations even six months ago, the stock market keeps on making new highs.

HIGHER AND STRONGER: Ed Yardeni makes the entirely sensible point—and one I don’t think I’ve heard anyone else talk about—that despite all the moaning and hand-wringing surrounding this latest slowdown, it hasn’t been nearly as devastating to either the financial system or the economy broadly as the financial crisis twelve years ago was, in large part because, in contrast  with what happened last cycle, this time homeowners’ equity (and home prices) haven’t collapsed, but have surged, instead.

I’d also add (and would even include a chart if I could just remember where I put it) that this cycle, mortgage borrowers have skewed heavily to upper prime, unlike (ahem) what happened the last time around.

UNFORTUNATE TIMING: Do these people not know there’s a pandemic on? On November 19, New York City began requiring  that merchants accept cash—even as the use of contactless payments rather than cash is seen as an effective and convenient way to slow the virus’s spread.

NEW YORK OFFICE WORKERS NOT COMING BACK SOON: Things are apt to get back to normal more slowly for office workers in New York City than they will for workers in the rest of the country. Just 10% of office workers in New York polled by the Partnership for NYC say they’re back working in their office, and just 15% say they expect to be there by yearend.

TECH FUND FLOWS: Here’s one reason that tech stocks have been running rings around the rest of the market over the last few years: fund flows into the sector have been absolutely monumental.

PROGRESS AT FIRST HORIZON: Bryan Jordan became the CEO of First Horizon in September of 2008, the week before Lehman Brothers failed, and now, a dozen years later, he sought regulatory approval for a large merger of equals (with IberiaBank) in the midst of a pandemic. Jordan has done a great job as CEO despite the challenging environment in which he has had to operate. He’s a down-to-earth, strategically thoughtful CEO who rose through the financial ranks, which gives him a particularly strong grasp of the numbers and how they are derived. I was able to talk to Jordan this week; here are some highlights of our chat:

New three-year plan. The company is just completing its latest three-year plan. Jordan says he thinks he’s participated in 13 of these. This one is different, though, since it was started in May in the midst of the pandemic, but before the merger was completed. Jordan said the planning process was more granular this time, with markets like Atlanta and Dallas developing their own plans based on their markets and then those individual plans were rolled up to the corporate level. The plan highlighted some businesses at First Horizon where the company must distinguish itself, and others where the company needs to remain competitive. A few businesses were given a profitability “up or out” connotation. Jordan did say that the planning process during the merger and pandemic led to more discussion among people from both companies in different areas of the bank. That should help as the two banks are integrated.

Credit knowledge. I mentioned to Jordan that he must have an incredibly detailed understanding of the company’s commercial loan portfolio, given the credit concerns created by the economic shutdown, plus the fact that the Iberia loan portfolio, which makes up 45% of total loans, had to be marked to market as a result of the merger, and he agreed. Every bank CEO is in an unusual position this credit cycle because of the slow development of the credit problems this recession.

PPP loan forgiveness. About $2 billion in PPP loans were originated on Iberia’s system, and the same amount on First Horizon’s, which means the merged company will have to use two systems to help their clients through the loan forgiveness process.

System integration. The actual conversion of the two companies’ systems was postponed by two months to enable First Horizon to make some upgrades to the system that Iberia will be converted to. Jordan said this delay was not really pandemic-related, but was made more to ensure a better customer experience.  By not paying a big premium to merge, the banks have less pressure on the timing of expense savings, and everyone benefits.

Loan demand. Jordan wouldn’t say that loan demand had started to improve, but he did say clients are becoming more optimistic about the economy, which should eventually result in demand for loans to expand businesses.

MIDWEST ONE UPDATE: MidWestOne is a $5 billion, five-state banking franchise headquartered in Iowa City, Iowa. Charlie Funk has been the company’s CEO for the last 20 years. In July, Funk brought in Len Devaisher to be the company’s new president and COO. This week, the two provided me an update on what’s going on at the bank. Some highlights:

Digital banking investments. MidWestOne is in the midst of completing three big tech investment projects. The largest, most important, and costliest is the installation of a new digital banking platform, which brings significant enhancements to customers and bank employees. Funk has long been outspoken about his dissatisfaction with the banking industry’s three large core processors, but he was quite complimentary regarding Fiserv’s help rolling out this new platform. The second project is a new small-business loan application process that incorporated DocuSign software, which is being installed now. Finally, the company will roll out a contactless chip card in early 2021. Funk mentioned in his 2019 letter to shareholders some impressive metrics related to MidWestOne retail customers’ adoption of digital banking technologies last year. The pandemic has pushed those numbers meaningfully higher, particularly among some of the bank’s older customers.

ATBancorp acquisition. In May of last year, MidWestOne completed the acquisition of ATBancorp, which had been delayed by some divestiture requirements. After the closing, several of the calling officers of ATBancorp left, taking some good business with them. Despite this disappointment, Funk still points to the bump the acquisition gave the company’s trust and mortgage businesses, as well as the good cultural fit as being important positives from the acquisition.

Goodwill writedown in the third quarter. As with Equity Bancshares, the weakness in MidWestOne’s stock price in the third quarter required a $31.5 million writedown of goodwill. And as with Equity, this didn’t affect any of the company’s key capital ratios or affect its dividend or share repurchase plans.

PPP loan program. The company made $340 million in PPP loans; the process was greatly aided by the licensing of software from Newgen during the second tranche of the program.

Loan demand remains weak, largely as a result of PPP loans. Loans were down a little in the third quarter, with paydowns in Iowa and the Twin Cities only partially offset by growth in Denver and the southwest of Florida. Funk mentioned on the third quarter earnings call, and he repeated to me this week, that there are signs of a pickup in loan demand.

Credit is stable. Funk mentioned that the company’s ag loan portfolio is in as good of shape as it has been for the last seven years, thanks to higher corn and soybean prices.

NEXT WEEK: On Monday, October Pending Homes Sales will be released. The consensus expects a monthly change of +2.0% vs -2.2% in September. Then on Tuesday, October Construction Spending will come out. The consensus expectation is for a monthly change of +0.8% vs +0.3% in September. Finally, on Friday, we’ll get the November Employment report. The consensus looks for a change in nonfarm payrolls of +500,000 vs +638,000 in October, and an unemployment rate of 6.8% vs 6.9%.

THE LAST WORD: As I sat down last night to think about what I should be thankful for this year, I at first figured it would be a challenge on account of Covid and the recession, but I quickly realized that that was crazy. I have more reasons to be thankful than I can count. In fact, I concluded (again) that this is my favorite holiday, because it brings together just about everything that’s important in life: patriotism, family, faith, friends, and food. Also football. Plus, it’s the unofficial beginning of the Christmas season. For me, Covid and the market’s dramatic decline in February and March have presented big challenges, but all that has been overwhelmed by good times with family and friends. We will have our Thanksgiving dinner on Friday with a smaller group than Amy would like, and then Saturday we will all head outside to put up the Browns’ version of the Griswolds’ Christmas lights. Our plan, as usual, is to make it the best light show yet, and we will not let Covid deter us. We will have numerous laughs along the way, all the time being thankful for all we have and for living in the greatest country on earth, thanks to the efforts of those who came before us. I hope you have a terrific Thanksgiving with your family and friends.

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Edited by Matt Stichnoth.

Copyright © 2020, Second Curve Capital LLC

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