August 01, 1998
When, in the space of a single week, two monumental and very different bank mergers were announced, each possibly foretelling the future direction of banking in the United States, bankers throughout the United States were transfIxed. What does it mean that Citibank, the largest banking company in the United States, is proposing to merge with the giant fInancial services provider Travelers? And what about Bank of America, arguably the most valuable banking franchise in the country, undertaking a so-called merger of equals with NationsBank? Yet these two proposed mergers are merely the most visible of the hundreds of bank mergers that are proliferating throughout the country. Understanding the motivations and trends of recent mergers is critical to evaluating strategic alternatives that are available to banking institutions and in providing leadership to them as it confronts the Twenty First Century.
Evolution of Bank Mergers
To understand the factors driving bank merger mania it is necessary to examine the evolution of the banking cycle that has brought us to this point. During the 1970s and early 1980s, many banks and savings and loans were formed for varying reasons. In some cases the banks were seen as status symbols for those who organized them. Others organized for more venal reasons such as to benefIt their personal businesses or those of friends. Some looked at investing in a bank or thrift as a reasonably safe way to obtain a fair return on investment. The large banks and thrifts were fIxtures; they had existed for decades largely unchanged. Banking was highly regulated and competition was (to use a term that reflected the gender composition or the industry) gentlemanly. Mutual funds and money market accounts offered by brokers were not very prevalent and certainly were not available to the average consumer. Capital markets as a method of funding the monetary needs of corporations were limited. Finance companies and mortgage brokers were not the choice of mainstream Americans. Generally people turned to their banks and savings institutions for their deposit and borrowing needs.
A series of developments through the mid -1980s caused rapid change. As a result of hyper-inflation in the late 1970s, all Americans sought ways to increase the earnings on their savings.
Banks, because of regulation, were unable to respond and mutual funds and brokerages began to replace banks as the guardians of their savings. Similarly, new consumer lenders and corporate capital markets began significantly to attack the traditional supremacy of banks as lenders. Then through the effects of inflation, savings and loans were brought to their knees in the mid-80s and the real estate market recession of the late-80s virtually fInished them off. Commercial banks survived these moments in shaky condition only to have the severe recession of the late-80s and early-90s strike them. During this period weak banks and thrifts sought stronger institutions as acquisition partners. Bankers and board members, tired of being bullied by regulators, sought reasonable exit strategies through mergers. Thus the beginning of the merger trends of today.
While these factors formed the genesis of merger mania, they only hint at the rampant merger and acquisition trends that we are currently witnessing. Healthy institutions with fully developed strategic plans are being sold. In-market combinations abound. Acquisition multiples are in the stratosphere: Deals in the past were usually between one to two times book value. When Wells Fargo paid almost three times book value for First Interstate it was one of the highest premiums ever paid. Now an average bank transaction is hovering around three times book value and we are witnessing deals at four and even five times book value. The number of transactions is escalating at a brisk pace. Why is this and what is driving this frenzy? Where will it stop? What institutions will be left after the carnage ceases?
Primary Reason: Sustainable Earnings Stream Growth
The prime reasons for merger mania are directly related to the evolution that has been outlined: the changed competitive climate and the earnings prospects for banks. For years bank profits had stagnated as institutions simply played the same old garne. As a result, bank stocks were dormant. But, with the changing role of non-bank competition, banks could no longer remain docile; they needed to find ways to improve their profit picture. New products, new delivery systems, different ways of doing business were needed.
As the 90s proceeded, the economy certainly helped the profitability picture and many innovative bankers, through creative uses of technology, found the products and delivery systems that have captivated consumers and returned banks to being relevant competitors. As a result, the stock market, which was enjoying its own renaissance, began to recognize and reward performance in the banking industry. A graph of bank stocks from the mid-90s to present would demonstrate how significantly the market place has rewarded this performance. In fact, the banking segment of the market has out-performed the general market during this period.
The problem, however, is that consistent and dramatic earnings growth is almost impossible to sustain long-term. Therefore, other ways to improve performance needed to be identified. Enter mergers. An obvious way for a bank to improve its earnings is to purchase the earnings stream of a competitor, both eliminating competition and adding the former competitor's earnings to its own. If the purchase price for the acquired earnings stream can be offset by cost reductions resulting from the combination, the acquirer has solved some of its problem of sustaining earnings growth.
At this point the next problem surfaces: How do we get the competitor to sell? This answer is bifurcated: First there is the need for the directors of the target institution to create shareholder value; second is the use of an attractive market premium. During the early 90s bank stocks were trading at or below book value of the institutions. An acquirer could offer a small premium to book value (say 1.25 times book value) and the premium above the capital of the target could be absorbed by the synergies of the transaction (for synergies, substitute fired people). The target's shareholders were happy having received a premium and the resulting institution improved its earnings stream thus creating the likelihood of greater market support for its own stock. This is the simple theory of bank mergers and it has accelerated at the speed of light.
Basically, the marketplace has recognized this trend and has rewarded banking stocks accordingly. Some stocks are viewed as good bets because they will add remarkably to their earnings through successful mergers (witness Washington Mutual's stock trading at 3.8 times book value) or because they are probable takeover targets. Bidding up bank stocks in this fashion has had a dramatic effect on merger transactions. The normal currency of bank mergers (the stock of the acquiring bank) is inflated. Therefore, it is cheaper for the acquirer to pay a higher premium for the target using its inflated currency. In the early 90s a bank whose stock was trading at book value was paying much more for a target when it paid 1.25 times book than is a bank currently whose stock is trading at 3.8 times book when it offers a target institution 3 times book value. As the marketplace rewards the stock price of the acquirers in this type of transaction, higher and higher premiums are perpetuated. Currently, bank stocks are trading at the highest mUltiples in history, with banking companies trading at an average of more than 2.5 times book value and 20 times earnings. Thus, institutions that are underperforming the market are vulnerable and there is virtually no defense against an offer from an institution that is outperforming the market.
With this in mind let's look at some of the specific trends that have created a thriving merger market.
Financial Services Expansion
First, there is the desire of banks to diversify their revenue sources and to get into businesses that are less capital intensive than traditional banking. We find our largest institutions seeking to improve their income streams by diversification into fmancial services products through the acquisition of investment banking companies such as the NationsBank acquisition of Montgomery Securities or Bank of America's purchase of Robertson Stevens. Banks are investing in leasing companies, factoring companies, consumer finance companies and the like. They are seeking origination sources for loans that can be packaged and sold into the secondary market. From a banker's perspective, these types of acquisition have the double benefit of adding to earnings while greatly leveraging the institution's capital providing a greater return on equity.
Bigness for Relevance
Then there is the old-fashioned reason for mergers, simply to get big enough to remain a relevant competitor. In the past there were numerous institutions with assets of $100 million or less. These institutions are fmding it difficult to remain competitive. Moreover, small bank transactions are becoming less attractive since the costs and the pain of a small merger are disproportionate to the rewards for the acquirer. Therefore, small institutions are seeking merger partners just to stay relevant as competitors and possible acquisition targets. Moreover, these types of mergers are necessary to justify an independence strategy for banks that are intent on fighting it out. in the marketplace. This is because standing still right now is seen as a sign of weakness and vulnerability. So, in a sense, in addition to all of the other factors that we have discussed, fear is also a driving element of merger mania.
Next, we are observing the realignment of branch banking by the sale and purchase of branches. Recently we have observed large institutions selling branches in outlying areas, because they are expensive and not proportionately bottom line oriented. But, and here is the magic of this marketplace, small community banks have voraciously grabbed up these branches for reasonable premiums to fill in their market areas and to expand their organizations rapidly so that they can stay relevant. And, as large mergers are approved by banking regulators and the Justice Department, branch divestitures are required and other institutions are given the opportunity to expand through acquisition of location and deposits.
Mergers of Equals
Another trend in mergers is the so-called mergers of equals-that is, mergers of similar-size banks that have compatible cultures and strategic visions. Social issues are the driving force behind these transactions and they are recognizable because of the absence of a significant merger premium, with the exchange of stock usually being on a book to book basis. These types of transactions create greater liquidity for the stock of the combined institution and some relative cost savings, usually in the back room operations. There are significant obstacles to mergers of equals since they require enormous compromise by the respective boards of directors and managements. Neither party to the merger should appear to be a seller and the composition of the surviving board and management becomes a delicate balancing act.
Another factor that is a prevalent force in bank mergers is the prospect of a double-dip. This concept, simply stated, is the target's selection of a merger partner based on the prospect that the acquiring institution will itself be acquired. In this instance the target will get first a premium for its sale to the acquirer and then a further merger premium when the acquirer is sold. A classic example of the double dip was California Bancshares (CBI), a holding company that had come into being through the acquisition of 11 independent banks. In this example, 11 separate institutions received a reasonable merger premium and acquired the liquid and very attractive stock of CBl. When CBI then sold at a very handsome premium to U.S. Bank, an even greater premium was achieved. Finally, U.S. Bank was sold to First Bank of Minneapolis with an even greater premium yet. This triple dip has created expectations for this model that has made it very attractive indeed.
Pooling versus Purchase Accounting
No discussion of merger trends would be complete without reference to pooling versus purchase transactions. These concepts are truly arcane-belonging to the accountant's world--but their impact is tremendous. Essentially a pooling transaction must be all stock and meet various other technical requirements, in which case the resulting institution is treated as if it always existed and the merger premium is absorbed into the normal capitalization of the company. In a purchase transaction, which is any merger that involves payment of cash in the purchase price or fails to meet the technical requirements for pooling, the accounting treatment must reflect the premium as goodwill and the goodwill is offset against future earnings for a period of years. Perhaps the height of the debate over this issue took place when Wells Fargo used purchase accounting in acquiring First Interstate. The gurus of the merger zeitgeist pronounced the death of pooling transactions because, according to the then-prevailing theory, the marketplace was going to look beyond accounting devices to the "real" earnings of the institutions and would disregard the enormous drag on earnings created by the amortization of goodwill in a purchase accounting transaction. In fact, this simply has not happened. And the murderous effect of purchase accounting on future earnings can be devastating, especially in light of the monstrous premiums that are being paid.
While this survey of bank merger trends has not dealt in depth with the technical aspects of bank mergers, it provides a context in which to evaluate merger mania.
* James M. Rockett is a partner in the firm of McCutchen, Doyle, Brown & Enersen, LLP, in San Francisco, where he specializes in bank mergers. He is also Vice-Chairman for Membership of the Financial Institutions Practice Group. This article is adapted from a speech Mr. Rockett recently gave to the 1998 Bank Directors Symposium.