The Road Immediately Ahead with Tom Michaud

Hey, I’m Al Dominick, and welcome to Plugged In. I’m in our Scottsdale DJ booth with my good friend Steve Williams.

I was listening to some classic rock, and it inspired today’s conversation. So I’m going to pull some tracks off the proverbial shelf to get our conversation with Tom Michaud, the CEO of Keefe, Bruyette & Woods, really cranked up for this special edition of Plugged In.

Tom, welcome. Thanks for doing this.

Thank you. It’s great to be with you both.

I was walking over to our Scottsdale offices this morning listening to U2’s “One” from their Achtung Baby album. Great album. Tom, that song starts with the lyrics, “Is it getting better, or do you feel the same?” I thought those little words put together really allow you to talk about the current earnings season and some of the observations that you have.

Sure thing. Again, thank you very much. It’s great to be with you both.

For earnings, we’ll talk about the banking industry’s third quarter of 2022. We’ll start with the core regional banks. I think there are four things you need to know about the quarter, and then we can think about how they fit into the bigger story that’s unfolding.

The first is net interest income growth. Net interest income growth for a core commercial bank was up 20% year over year. We think we’re in the second quarter of a four-quarter run of accelerated growth in net interest income.

The second thing that’s important to know is that credit quality is still pristine. I’ll say it again because I’ve said it many times: when credit costs go up, we should not be surprised that they go up. We should be surprised that they were so low for so long.

I know in our earnings models for the next couple of years, we’ve got provisions being bumped up every quarter, even though right now we’re modeling a soft-landing scenario.

The third thing that’s important is that we’ve had bond market moves like we’ve never seen in our careers before. That has put a lot of pressure on tangible book value and tangible capital ratios.

I’d say the typical regional bank has had more than a 10% decline in tangible book value this year. We’ve also seen the industry get more levered on tangible capital. It’s actually back to the same ratio that we saw at the end of 2007.

The reason that’s happened involves both the numerator and the denominator. The industry has been swollen with excess deposits, and tangible capital has been clipped because of the bond markets.

The good news is that we think, over the next couple of years, that’s all going to burn off as bonds get closer to maturity, the industry remains profitable and deposits shrink. It’s going to self-correct.

Hopefully, there’s no credit event in the meantime because that’s the bear narrative for this group. If you get a credit event while that’s happening, it could lead to a capital-raise cycle. For those who are more cautious on bank stocks, that would be something they might point to.

Then the fourth thing is deposits.

We’ve run a trend line for where we think FDIC-insured deposits should be today. We think there are $2.6 trillion of excess deposits in the banking system.

Remember, JPMorgan said not too long ago that they think they’re going to lose $400 billion of deposits over the next year. I think they said that maybe six months ago. As deposits leave the system, that alone would be the 10th-largest bank in the nation.

We’ve never had banks in a position where they have to surf this moment, and not every bank is going to surf this moment successfully.

We’ve seen in the stock prices that the profile of a bank matters to share performance. In particular, deposit betas are a big driver. Companies that have lots of non-interest-bearing liabilities and companies that are well core-funded are the ones doing better because the view is that they’re going to be able to navigate this moment more successfully.

I would say those are the four big takeaways.

I know we often talk about the regional banks, but I would like to spend a moment talking about the big universal banks because they’re having the opposite happen.

While they’re getting the net interest income bump that regional banks are getting, investment banking is essentially already in a recession. Mortgage banking is essentially already in a recession.

What you’re seeing is that a company like Bank of America could have 20% net interest income growth but only 4% revenue growth because of its business mix.

We’ve done a study where we looked at how long the capital markets have been closed for equities over time, and 10 months is the longest period we found. We’re about to enter the 11th month in November of that bear market for that business.

It’s going to turn one day, and when it does, we think it’ll come back strong. It’s a matter of when, not if. But the big banks are navigating their way through that moment.

You asked a question about where we’re headed. That’s what happened in the third quarter.

My view is that we’ll still be talking about what we just talked about in the third quarter. Maybe capital markets for universal banks get better, but I think we’re going to be talking about credit more over the next six to nine months.

I don’t think it’ll be as pristine. It’ll still be excellent, but credit has to move higher.

We talk about, “When’s the shoe going to drop?” You mentioned deposits. That was a dirty word to use a year ago. Now it seems to be back in vogue, if you will.

Steve, what are your thoughts as you listen to Tom talk?

It sounds, Tom, like that margin expansion is the good news. What’s interesting is that it hasn’t really been dialed into stock appreciation. Is that because of the potential on the credit side or the funding side? What’s holding back some really nice appreciation, given that margins are going crazy right now?

It’s a couple of things.

First of all, investors aren’t willing to give certainty to the earnings estimates out to 2023 and 2024 because they believe there’s risk on credit and risk in managing this deposit moment.

I’ve had really smart investors tell me they’d rather pay 10% more for bank stocks with certainty than buy today when they just don’t know.

The other thing I’ll tell you, and I’m surprised the market hasn’t talked more about this, is that we just came out with our 2024 estimates. We think earnings estimates are going to be flat. There’ll be no earnings-per-share growth, and I think the market is not going to love that when we get to that moment.

That won’t be true for all banks. Really, what’s happened through this whole period with COVID and provisioning is a lot of pulling earnings forward and pulling them back into different periods.

We’re probably overearning right now because of this margin. At some point, the margin is going to flatten out. We’ll probably have much slower loan growth because of a weak economy. We’ll have higher provisions, and we have inflation.

It doesn’t take much for all of that to eat up a lot of earnings-per-share growth.

The industry will be more profitable. Growth is just going to slow a lot in 2024, we think.

That makes sense. If you’re stepping up provisions, if the beta is starting to go up on funding, and you’ve got a little bit of growth pressure, the math works.

Right. Remember, whenever we and others talk about deposit betas, we typically talk about them over the cycle.

We’re enjoying the low numbers of the cycle. We get into the fourth quarter and first quarter, and then we’re going to have the above-cycle numbers.

If we think it’s 35 to 40 basis points for the cycle, that means we have a few quarters of 60 to 65 basis points.

Tom, you talked about surfing the moment. I think you’re doing a great job of helping set the table for what people need to be talking about and preparing for.

Steve, I want to ask if you recognize some music that came out of the state right across the way from where you are. If I was in New York looking down to New Jersey, there are some lyrics that go a little bit like this: “There’s a dark cloud rising from the desert floor. I packed my bags and I’m heading straight into the storm. It’s going to be a twister to blow everything down that ain’t got the faith to stand its ground.”

Does that ring a bell?

Yeah, it’s “The Promised Land,” a great Springsteen song.

I think we wanted to get into credit, and Tom kind of hit on this, that there probably could be some credit challenges ahead.

My question, Tom, is where do you see that? Is there a sector? Is it the real estate side because people aren’t coming to work? Is it consumer credit because that got overbid? Where do you see the first cracks in credit?

There are a couple of things we could do right now.

First of all, there’s a lot of credit that trades in the market, so we can follow market spreads to see where we might go.

If it was my bet, levered and leveraged lending would probably be one place.

Remember, we’ve also gone through a special moment where the shadow banking industry has undergone tremendous growth. Zero interest rates were the rocket fuel for shadow banks. Seeing how credit quality plays out in that vertical is one thing I’m watching.

The second is subprime lending, which, again, is not really a core bank product. Interestingly, banks do lend to subprime lenders, but they don’t really make the subprime loans themselves.

I keep watching consumer confidence and unemployment because those could be early indicators for what may play out there.

I mentioned that we took a few songs off the playlist for today’s Plugged In, and I also want to tie it into a movie that I think most of us enjoyed this summer.

I’ve got a need, a need for speed.

You guys know that’s a Top Gun reference. Talk to me, Goose.

If you want to talk about Top Gun and we’re talking music, Kenny Loggins is getting some good royalties off “Danger Zone.”

If we’re talking about franchise reboots like that movie, we should also be thinking about banks. Maybe we look at the community bank sector and think about how they’re trying to position themselves for their next great run.

You talked about the regionals. You talked about the big banks. Could you give us a little take on those proverbial troublemakers that are a little bit smaller in asset size but are doing some pretty cool stuff?

I’ll tell you the interesting thing that we see happening, and I’m going to flip to fintech in the conversation here.

Fintech and digital engagement came on really strong during the COVID period. I have not seen any relenting on the part of banks in terms of staying on that path.

There’s also a view that the big banks were able to take a lot of share during big moments in the industry’s history. When there were bank failures during the global financial crisis, the policy was to take big banks and sell them to even bigger banks.

The big banks can afford a lot of investment in fintech. There’s also a view that the consumer banking business has, by and large, set itself up where you already know who the long-term national leaders are going to be. That’s late in the game.

For smaller banks, their bread-and-butter business is commercial lending. I’m seeing a lot of intensity around making sure community banks don’t get disintermediated by the bigger banks or by shadow banks in commercial lending.

There’s a lot of investment activity happening with fintechs, and it’s kind of like conducting an orchestra. When you conduct an orchestra, you have to have all the pieces moving together.

With these smaller banks, they need to have their core processor on board. They need to have the ability to onboard fintechs that can help them pioneer in this area or build out their digital engagement.

I’m seeing a lot of smaller banks take on that challenge and execute plans in that area. I think that’s actually very exciting.

We’re seeing that as well with all the different fintechs that are out there.

It kind of neatly ties into a song that I wish we had the marketing budget to actually stream as we’re talking. We don’t have it in the budget, but we can talk about Men at Work because, if we’re talking about something coming from the land down under, it was just August of last year that Square paid something like $29 billion for the buy now, pay later behemoth Afterpay.

In the period since, we’ve seen a tremendous cooling. Valuations of fintechs have gone anywhere from one-third to one-half of what they were.

We’ve heard and talked a little bit about some of the cool stuff from last year really not having the same appeal at the moment. That’s crypto, AI and machine learning. Things people were getting excited about are slowly fizzling for some.

But you and I, Tom, have talked over the years about fintech and your fascination with it. What gets you excited and amped up on the fintech side of the world right now?

I think number one is something we just talked about, which is having community banks be able to get in the game and hopefully have partners that can help them do that.

I think payments are so important to the banking industry. Whoever emerges as the long-term big player in payments could be the winner, or there could be a group of winners.

We’re doing a lot of work in the blockchain area, where there has been some blockchain development to bring payments to a closed loop for the banking system.

Real-time payments are in a variety of places. The Fed is working on the FedNow plan. You’ve got The Clearing House working on a plan. You have our effort using blockchain inside the space.

I think that’s one area where there’s a lot of energy and excitement.

Remember, a lot of the systems that banks use today were built in the ’70s. I know you’ve been quoting songs. You could probably find a few good songs from the ’70s to quote, but I like some of the songs you mentioned better. Maybe those were the ’80s.

The other thing with fintech that I would bring up is that the gap between innovation and regulation is the widest I’ve ever seen it in my career.

I think the next Congress is going to do a lot of work on that. You’re going to start to see a lot of regulation and legislation put in motion, whether it’s cryptocurrencies, digital assets or crypto exchanges.

I think we’re going to get more regulation.

The good news for the banking industry is that I think the banking industry is still going to be at the center of a lot of it. The regulators, I think, have been very disciplined about not giving charters out or granting access to the payment system easily.

Bank regulation is going to be a very dominant part of the future, and I think that’s really good for banks.

With that complexity to sort through and what’s happened with valuations, you’ve got more humble fintechs, maybe not as frothy with valuation. We call it playing the long game, Tom.

These ideas aren’t going to go away. The use of blockchain is going to be there. It’s just going to be more about rolling up your sleeves and getting to work together.

Yeah. You see companies like Figure Technologies doing some really cool stuff with blockchain technology to create smarter contracts and look at industries that are ripe for disruption.

The whole title space is very manual and process-oriented. We heard from the founder of QED that anything analog will be digitized. The big challenge is figuring out how you create business cases and business opportunities around that very thought.

Tom has been very generous with his time. He’s probably recognized a theme here at Cornerstone: we love music.

I want to take us home with this quote: “You’ve got to find a way to bring some lovin’ here today.”

That’s the ’70s.

That is the ’70s, and that’s Marvin Gaye. It’s all around “What’s Going On.”

We think it would be appropriate to quickly touch on what’s going on with ESG. We’ve been trying to talk about depoliticizing ESG as a conversation and taking the temperature down a little bit.

I’d be curious, Tom, if you could weigh in on ESG activism versus shareholder activism and the power structure that you’re seeing right now.

Sure. I think, number one, the difference between ESG activists and traditional activists is being blurred. The dividing line between the two is really going away.

What’s really interesting is, I don’t know if you saw it last year at Exxon, but a hedge fund that owned 0.2% of the company led a campaign that replaced three of the 12 Exxon directors.

Yeah, pretty mind-blowing.

The entire campaign was built around Exxon not keeping up with its peers in the area of ESG. That was the epicenter.

We actually think there’s not going to be a big difference between the types of activism, and you’re likely to see that many activist campaigns will include ESG.

We meet a lot with our clients and talk a lot about what to do with ESG and where it’s headed.

The way we think about it is that there are offensive and defensive reasons to be aware of what’s happening in this market. There are going to be business opportunities around ESG. Then, like I just mentioned, there are risks around how your shareholders think about ESG, especially if they’re not aligned with your views.

The advice we give to our clients is to make sure they’re engaged, especially with their biggest shareholders, about how ESG has been incorporated into the work that they do.

Then companies will be able to gauge how active they should be in that space, how important it is and how it could be woven into their business plans.

That’s generally how I think about it and how our firm thinks about it.

We appreciate that.

I am going to ask a little bonus question because it would be unfair for me not to ask the CEO of one of the best investment banks in terms of doing bank deals over the years to weigh in really quickly on the M&A space as you see it now, heading into the first quarter of 2023.

The first thing is that bank M&A has been very robust since the 1980s, since the laws were changed.

We do get moments where it slows, and right now we’re in one of those pause moments. I think it’s for two primary reasons, plus one minor reason.

The primary reason is that when things are disorderly in the economy and in the markets, bank M&A tends to slow, unless it’s rescue M&A. That’s natural.

If you think about it, selling your company is one of the most important things you could ever do. You’re not going to do it when your stocks are flying all over the place or when you really don’t know where the economy is headed. You need to feel comfortable with both companies to do a deal like that.

The other thing is that we have had a change in mentality in Washington. The length of time for many of these bigger deals to get merger approval has essentially doubled.

It seems like we’re getting more clarity, which is good. I think that’s going to have the impact of really slowing things down at the largest-bank level.

But I think you will see midsized regional banks continue to emerge.

Another item I would point to is that, until you get to $1 trillion, the bigger you are, the higher the valuation tends to be on a price-to-tangible-book basis for your stock price.

That is a really big driver. I believe economies of scale are working. Investors are rewarding it, so M&A is going to come back.

Lastly, I’m really focused on the class of 2021. These are a bunch of MOEs that came together, with a lot of excellent management teams combining forces.

I’m really eager to see how these companies perform relative to their peers over the coming years. I think it’ll be an interesting lesson for the industry.

Maybe what we’ll do is bring you back in nine months. We can take a look back at that class and see how they’re doing.

Tom, we really appreciate you taking a little bit of your time to get Plugged In with us here at Cornerstone.

I think I might toss up a shadow playlist on Spotify. You talk about shadow banking, so I’m going to do a shadow playlist for this Plugged In episode. We’ll have those five tracks that we covered with Tom ready to roll.

Steve Williams, Al Dominick, we’re just sending our thanks to Tom Michaud and the team at KBW.