BB&T merges with SunTrust

The biggest bank merger since the crisis may herald more

American banking has become a battle of scale

GIANT BANKS are made, not born. Today’s American behemoths were formed by a dizzying series of deals in the decade before the financial crisis. NationsBank and BankAmerica became Bank of America. Wells Fargo joined with Norwest. J.P. Morgan and Chase melded, and then bought Bank One. The crisis brought more mergers, but out of necessity as much as ambition: JPMorgan Chase took on Washington Mutual; Wells, Wachovia. But since the crisis hook-ups have been smaller. The very biggest banks are barred from retail acquisitions on competition grounds. Supervisors have become quicker at approving tie-ups between tiddlers.

On February 7th the big-deal drought ended. BB&T, based in Winston-Salem, North Carolina, and SunTrust, of Atlanta, Georgia, said that they would merge. The new, unnamed entity, valued at $66bn, will be far smaller than America’s biggest but far bigger than anything created since the crisis. It will be America’s sixth-largest retail bank by assets and, with $332bn, the fifth-largest holder of domestic deposits (see chart). Its business will be concentrated in the economically vibrant south-east. Both banks’ shares rose on the news.

That is unusual. Share prices, particularly those of acquirers, tend to slide when mergers are announced. On average, since 2015 acquiring banks have suffered a 3.3% decline. Yet BB&T, slightly the bigger of the pair, saw its price climb by 4.3%; SunTrust’s rose by 10.2%. (Investors are not alone: the head of another big bank applauds the extra scale.) The shares of the partners in a smaller deal unveiled on January 28th, TCF Financial, from Minnesota, and Chemical Financial, from Michigan, also went up.

Markets’ approval reflects two shifts that have made bank mergers more appealing. The first is an unwrapping of red tape. Last May Congress passed legislation to raise the asset threshold for complying with “enhanced prudential standards” to $250bn from $50bn. In October the Federal Reserve proposed raising the threshold at which it imposes its strictest capital and liquidity rules to $700bn from $250bn.

The combined BB&T and SunTrust can take advantage of this. As separate banks, both were close to Congress’s new $250bn limit—BB&T at $226bn, SunTrust at $216bn. Instead of edging over the line and facing the cost of complying with extra regulations individually, they can burst past it and share the burden. If the Fed goes ahead with its proposal the combined bank will have many years of organic growth ahead of it without needing to worry about the $700bn threshold.

The second change is that competition for deposits is heating up. Regional banks, of which BB&T and SunTrust are among the biggest, have competed with their national rivals through better local branch networks. But the giants, though banned from buying, are muscling in. Bank of America and JPMorgan Chase are rolling out around 500 branches each nationwide. Nor is physical banking the sole way to win deposits. Flashy apps and slick online banking matter ever more. This gives an edge to banks with big technology and advertising budgets. The national banks appear to be winning. The top three—Bank of America, JPMorgan Chase and Wells Fargo—snared $118bn of new deposits in 2017. Twenty regional banks attracted just $55bn.

To compete, regional banks need to bulk up. BB&T and SunTrust claim that they will lop $1.6bn, or 13%, off annual operating costs—a plausible estimate, says Keith Horowitz, an analyst at Citigroup, since a quarter of their branches are within two miles of a branch belonging to the other. The two headquarters will become one, in Charlotte, North Carolina, already the region’s banking capital (and home to Bank of America). There are sure to be lay-offs, though an elaborate executive transition has been worked out that appears to have pleased the occupants of both banks’ corner offices. These savings will release money to spend on making the merged bank fitter to compete. It will shell out an extra $100m a year on technology.

More mergers of regionals are likely. Betsy Graseck, an analyst at Morgan Stanley, notes a dearth of banks with assets between $500bn and $700bn. This leaves plenty of room for banks to merge and stay below the Fed’s putative new threshold. That said, Mike Mayo, an analyst at Wells Fargo believes there are few potential partners with an overlap that would yield the savings promised by BB&T and SunTrust.

Of course, even that deal has risks. Mr Mayo points out that attempts to merge incompatible back-office systems have proven disastrous in the past. But today’s technical challenges are smaller than those faced by banks merging two decades ago. A handful of companies now provide the technology used by thousands of banks for processing transactions and running websites. This reduces the chance of a slip-up.

Attracting new customers without alienating the old could be a higher hurdle. Both banks have a long local history. Their logos adorn sports stadiums in their home towns. SunTrust financed the international expansion of Coca-Cola, Atlanta’s most famous brand. Coke, in turn, held its secret soda recipe in a vault at SunTrust from 1925 to 2011. Customers of BB&T might be wary of a big merger. The bank saw a period of rapid growth after customers fled Wachovia, also based in Winston-Salem, after it was bought by Wells Fargo in 2008.

Elizabeth Warren, a Democratic senator and a presidential candidate for 2020—and a vocal critic of big banks—thinks that the BB&T-SunTrust deal will create another bank that is “too big to fail”. She believes that deregulation will call forth a wave of mergers that will hurt consumers.

Yet the new bank will be less than one-sixth of the size of the biggest. Though America has 5,000 banks, the top three control a big and rising share of the market. In 2007, just before politicians panicked about banks being too big to fail, they held 20% of deposits. Now they have 32%. Bigger regionals should be better equipped to take on the giants. Goliath is winning, says Mr Mayo. Time to beef up David, then.

Why ‘covenant lite’ loans are not the menace they seem

Risky debt market is dominated by contracts that have investor protections ripped out

Mark Vandevelde

The novelist Richard Ford wrote that a market economy works not by giving people what they want, but by persuading them to feel good about having whatever happens to be available. If that rueful observation hardly matches America’s self-image as the land of freedom and opportunity, it at least makes some sense of the country’s real estate agents and car dealerships, which insist on peddling “shabby-chic” apartments and “pre-loved” cars.

The $1.3tn leveraged loan market has lately developed its own peculiar quirk, which may reveal something about its participants’ material insecurities. Fully 80 per cent of the money that changed hands there last year was extended under what are known as “covenant lite” loans, a polite term for lending contracts that have had most of the investor protections ripped out.

The safeguards in question are legal clauses that once enabled investors to grab the wheel if a company missed its financial forecasts or made other wrong turns. In the credit market frenzy that preceded the financial crisis, private equity firms were briefly able to negotiate exceptions, winning notorious “mulligan” clauses that allowed the company to drop the ball once without consequence. Such permissive deals vanished for a few years when credit markets seized up. But during a decade of expansive monetary policy and loose lending, they have returned to become the norm.

The Bank of England and former Federal Reserve chair Janet Yellen are among the policymakers now sounding the alarm about disappearing covenants and other signs of careless lending. When billionaire investor Howard Marks asked colleagues at his firm Oaktree to dish the dirt on their rivals’ most imprudent deals, they returned with a bulging catalogue. In a letter to investors, he told of one highly indebted company that earned more than half its revenue from a single fickle customer. Another colleague told of a banker who said he had more to fear from losing business to competitors, than from losing the bank’s money on a risky deal.

For asset managers who earn a living channelling cash from pension funds and insurance companies into corporate loans, there is little alternative but to try to make clients feel good. Dwight Scott, president of Blackstone’s GSO credit platform, argued in the Financial Times last week that if a company’s condition deteriorates, investors could in some circumstances forget the covenants and instead sell their loans. That is unlikely to reassure veterans of the long months in 2008 when it was impossible to put a price on many financial assets, let alone find a buyer.

The strongest argument for embracing covenant-lite loans is one the lenders themselves would blush to make: they are often not the best people to run troubled companies. When researchers at S&P Global Market Intelligence tracked down defaulted loans that were issued before 2010 with weak covenants, they found creditors had recovered 78 per cent of the money they originally lent. Loans with traditional protections barely fared any better, suggesting there is little to be gained from parachuting rescue teams in early. The difference is much starker for loans written after 2010, when lenders recovered about half of their original outlays — but the data is too thin to draw firm conclusions.

Blackstone’s private equity business, itself a major borrower, has flirted with disaster and lived to tell the tale, delivering creditors a payback they might not have managed alone. The company’s $26bn acquisition of hotel chain Hilton Worldwide, sealed in 2007, required about $20bn of debt from more than 20 banks and other investors, including Bear Stearns, the doomed investment bank that ceased to exist by 2009. The global recession wiped one-fifth off Hilton’s revenues and an industrial espionage lawsuit from rival Starwood threatened to burn a hole in the company’s balance sheet.

Lenders took some pain, selling back a portion of their Hilton debt for less than the company had originally borrowed, in a rescue brokered by Blackstone that also saw the private equity firm put up more cash. The creditors had few options because Blackstone had insisted on covenant-lite debt. But it is far from clear that loan officers could have obtained a better outcome if they had held more of the cards. By the time Blackstone sold its final Hilton shares last year, it had turned the deal into one of the most profitable private equity trades in history.

While creditors may overrate the usefulness of taking over an ailing company, loose lending hurts them in less dramatic ways. An absence of covenants means missed opportunities to charge fees for waiving violations, shaving a few points off expected returns at a time when debt is already cheap. And bankruptcy lawyers say sloppy drafting has allowed some teetering borrowers to spirit valuable assets beyond the reach of creditors, reducing likely recoveries when they eventually fail.

But with too much capital chasing too few deals, and the Fed shelving plans for interest rate rises that could have given lenders more power to dictate terms, covenant-lite loans remain the only loans there are. Perhaps investors can learn to feel good about them.

The Federal Reserve Seems Oblivious to a Coming Crisis

By Avi Tiomkin

The Federal Reserve Seems Oblivious to a Coming Crisis
Illustration by James Yang

The Federal Reserve recently suggested that it was finished raising interest rates for now, and might even stop shrinking its post-financial-crisis balance sheet sooner than expected. Even so, in delivering numerous upbeat assessments of the U.S. economy, Fed Chairman Jerome Powell is continuing the regrettable tradition set by his predecessors, Alan Greenspan and Ben Bernanke: that of blatant detachment from the real economy. This isn’t merely aloofness, but deliberate disregard of increasingly clear signals that point to a looming recession, including a dramatic slowdown in housing, stagnating car sales, declining retail sales, and economic weakness in China and Europe, accompanied by the dismissal of those who warn of an imminent crisis.

When we read through the transcripts of Fed deliberations on the eve of megacrises such as 2000 (Greenspan) or 2008 (Bernanke), and follow Powell’s statements of the past year, it is hard to believe the Fed’s inability to read the state of the economy or understand its decision-making process. Only when reality struck in the past, when the ship smashed into the iceberg, was there a willingness to admit to analytical flaws, recognize errors of judgment, and craft a recalibration of policy.

In the Fed’s defense, leading bankers and economic forecasters were also on the same page on the verge of the 2001 recession and 2008 financial crisis. In December 2000, during a meeting of the policy-setting Federal Open Market Committee, Greenspan mocked the technology industry, commenting that executives’ alarm about diminishing orders and production demands was really a concern about the value of their companies’ stocks and their personal wealth. His audience laughed.

Two weeks later, in a conference call between meetings, the FOMC enacted an emergency federal-funds rate cut of 50 basis points (half a percentage point).

Greenspan’s Fed began raising rates in 2004, and Bernanke, who succeeded Greenspan in 2006, continued this policy, raising rates three more times until it became clear in mid-2007 that something awful was unfolding in the subprime-debt markets. Bernanke then predicted that any crisis would be contained, and wouldn’t trickle down to affect the broad economy. After he declined to lower rates at the August 2007 FOMC meeting, he reportedly was lauded by former U.S. Treasury Secretary Robert Rubin, then chairman of Citigroup, for doing the right thing.

Powell proclaimed just a few months agothat the current U.S. business cycle could go on indefinitely. He called the economic outlook bright, and said rates were a “long way” from the neutral rate at which the economy is in equilibrium. At the time, major investment banks and several prominent hedge-fund managers were predicting additional rate hikes up to 3.5%, and a rise in long-term bond yields to 5%. A fellow at the Milken Institute told CNN that the U.S. economy “is firing on all cylinders.”

Yet, while the Fed and others proclaim the economy’s health, signs of stress abound. China’s Shanghai Composite is back to 2006 levels. Japan’s Government Pension Investment Fund, the world’s largest public pension fund, reported a loss of $135 billion for the December quarter. Europe’s economy offers little to cheer.

In the U.S., corporate profit growth is decelerating, and stock buybacks, once a major source of stock-market support, appear to be diminishing as funding becomes more expensive, or disappears. Repatriation of corporate cash due to changes in tax law helped fund buybacks in 2018; it doesn’t exist to the same degree this year. Buybacks also were funded by low-cost debt, some $3 trillion of which was issued in the past five years and now sits on companies’ balance sheets. A recession would substantially reduce companies’ willingness to authorize additional aggressive buyback schemes. At the same time, the Fed has been shrinking its balance sheet by $50 billion a month, which has drained liquidity from the financial system.

There seems little doubt that the world economy is sliding into a recession—or, minus unprecedented action by the authorities, a crisis that could be much worse, led by China, Europe, emerging markets, and other troubled economies. Individual-country data suggest as much, as does the decline in global trading and exports as evidenced by the Baltic Dry Index, a measure of global dry bulk shipping costs that has plummeted since the middle of 2008. The U.S. trade battle with China only compounds the problem.

Keep an eye on falling banks shares, too. Those in Europe, Japan, and China are sending clear signals of trouble, and U.S. bank stocks can’t be far behind. A blow to the global real estate market, coupled with a severe recession, conceivably could cause irreparable damage to the global banking system.

Central banks eventually responded to the last crisis by cutting interest rates to zero, or below, which boosted asset prices, fueled debt accumulation, and encouraged savings over the spending that spurs economic growth. Ultralow rates also harmed insurance companies and pension funds, which couldn’t earn sufficient investment returns. Even though rates have risen some in recent years, central bankers have too few tools left to deal with another global crisis. They eventually will reverse course and resume quantitative easing.

Global sociopolitical unrest is rampant. The only effective measure to stave off a crisis is budgetary and fiscal expansion on a dramatic scale. This will be achieved as central banks fund the monetization of ballooning government debts. But making government the solution to all economic crises is a dangerous step that would not merely threaten asset prices but also hasten capitalism’s unfortunate end. 

Avi Tiomkin is an adviser to hedge funds. He previously managed money for several large hedge funds and specializes in global macroeconomic analysis.

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