Drip
Portfolio Report
Thursday, March 26, 1998
by Dale Wettlaufer
([email protected])
ALEXANDRIA, VA (Mar. 26, 1998) -- Banks and financial services companies aren't just retail institutions. The wholesale part of the business is extremely important. By wholesale, I mean interaction with other financial institutions in data services, securities transaction processing and securities markets, institutional asset management, highly leveraged transaction lending, and merchant banking. The Federal Reserve defines, in short, a wholesale bank as, "A bank that is not in the business of extending home mortgage, small business, small farm, or consumer loans to retail customers." Another Fed definition of a wholesale bank's activities includes "acceptance of wholesale deposits, commercial lending, trade finance, and mortgage finance."
Wholesale deposits are deposits made by one large bank in another or the purchase of deposits, such as brokered jumbo CDs. Trade finance is issuance of letters of credit, which are presented by one party in a transaction to another and represents the credit of the issuing bank, not the merchant presenting the letter of credit. Bankers' acceptances can be issued against letters of credit.
To explain a few of these terms:
1. Securities transaction processing -- the business of keeping straight the trades of billions of shares of stock each week on exchanges around the world, keeping track of bond trading and money market transactions, and providing these services to correspondent brokerage firms. Banks also act as trustees and securities registrars, making sure transactions are effected properly. Chase Manhattan (NYSE: CMB), Citicorp (NYSE: CCI), Harris Trust, in which a subject of our study, Bank of Montreal (NYSE: BMO), owns a substantial stake, and State Street Corp. (NYSE: STT) all have substantial presences in this business.
2. Highly leveraged transactions -- include providing bridge loans in buyouts or other acquisitions. Bridge loans are short-term arrangements used until permanent financing is secured. This is also syndicated finance, in which a number of banks provide transaction financing for larger acquisitions, such as the multi-billion-dollar syndicated loan to WorldCom (Nasdaq: WCOM) for its acquisition of MCI Communications (Nasdaq: MCIC), led by NationsBank (NYSE: NB). These banks participate, or keep on their books, their part of the loan and then sell the loans off to other banks other institutional investors, with smaller banks down the food chain. The "bridge" to longer-term financing, or mezzanine finance, is what got Citicorp and Chemical Bank (since merged with Chase) into trouble and was the watershed event in the collapse of the high-yield (or junk) bond market in 1989.
3. Merchant bank -- a company that finances highly leveraged transactions and takes an ownership (or equity) position in companies. Among U.S. financial services companies, Donaldson, Lufkin & Jenrette (NYSE: DLJ) is well-known (as are most of the New York banks and brokers) for its larger-scale merchant banking activities.
The reason banks engage in these risky activities is that they are highly profitable. Not only are the assets generated in such deals higher yielding than others (and hence, higher risk) while being funded by short-term paper (debt) that banks can issue at a much lower interest rate, but banks doing these deals can collect very large fees for facilitating the transactions.
The return for very well-run banks specializing in securities transactions, merger and acquisition activity, and merchant banking can run at twice the middle-of-the-road bank's and broker's measures of capital efficiency. This allows a company to use less debt if it so chooses and still generate the same return on equity that a more highly leveraged financial services company can achieve. Or, with more leverage, the company can do a greater number of deals and still generate a higher return on equity. Whatever the preference of the bank's management, the higher returns available in the venturesome areas of banking allow for a great amount of financial flexibility when things are running well.
In securities transaction processing, trust and asset management, or bank card merchant processing (providing credit card terminals for merchants and effecting credit transactions), less absolute amounts of capital can be achieved to generate the returns on capital seen elsewhere in banking. Whereas the average return on assets (ROA) for a bank or large integrated financial services firm runs from 1.2% to 1.6%, these wholesale services can generate ROAs north of 2%, or about 30% higher than the rest of the industry.
Going back to our formula for return on equity (ROE):
Earnings Revs Assets
ROE = ------------- x --------- x -------------------------
Revs Assets Shareholder's Equity
or
ROE = Net Margin x Asset Turnover x Leverage
Which shows us the way to ROA. ROE can also be expressed as:
ROE = ROA x Leverage
Cutting leverage out of the two expressions, ROA is then:
ROA = Asset Turnover x Net Margin
The ROAs generated in the transaction processing, asset management, data services, and securities markets lines of business, then, are a function of faster asset turnover and/or better margins, which is just another way of saying these are less capital-intensive businesses than the lending business. With better asset turnover and margins, a financial services company can cut back on leverage and achieve the same ROE result as the rest of its business lines, or the company can increase leverage on top of these already superior economics to achieve excess returns on capital. For companies like J.P. Morgan (NYSE: JPM), State Street Boston (NYSE: STT), American Express (NYSE: AXP), Mellon Bank (NYSE: MEL), the super-regional banks, Fifth Third Bancorp (Nasdaq: FITB), Norwest (NYSE: NOB), Synovus Financial (NYSE: SNV), and myriad other quality companies, the higher value-added, less capital intensive portions of wholesale banking is where excess returns, or maintenance of returns, have come from or are planned to come from.
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