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The 2017 Forecast On Financials: A Conversation With Community Bank Analyst Chris Marinac, Part One

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The 2017 Forecast On Financials: A Conversation With Community Bank Analyst Chris Marinac, Part One

The massive post-election rally experienced by the big banks last year, as well as the continued suggestion of impending banking reforms under the Trump administration and republican-dominated congress, has many people curious to see what role smaller banks will play in the coming years.

Marketfy Maven Tim Melvin recently had the opportunity to speak with Chris Marinac, co-Founder and Director of Research with FIG Partners—a community bank specialist research and investment firm—to get his thoughts on the future of the country's financial institutions with the looming prospect of reform, acquisitions, and cyber security.

Below is part one of their conversation, slightly edited for length and clarity. You can find part two here.

Tim Melvin:  We're on today with Chris Marinac of FIG Partners. Chris, thanks for spending a little time with us. As we all know, the community banks have been pretty exciting since the election. What do you see as we go into the New Year in the community bank space?

Chris Marinac: I think the companies are very healthy from a fundamental perspective. The capital is strong. They do have loan growth. The deposit growth for the most part it has been solid. We think the liquidity of these companies is very good. In many respects these companies have more money to lend and that we can see the cash and securities balances coming down and loan balances go up. That is going to be positive for revenue and positive for margins. So I think it is a pretty healthy time. As I mentioned, credit is in very good shape. I think that is always important because credit tends to be what hurts the banking industry the most and right now we are in a pretty good spot.

Melvin: Do you see credit possibly worsening in 2017? Bankers keep telling me that credit can’t possibly get any better and then quarter after quarter it keeps getting better.  What can happen economically to change that?

Marinac: Banks are a mirror of the communities they serve. If local economies were to deteriorate, then credit will get worse. I think the attitude among businesses is stable-to-improved, and I think that actually is going to increase spending. As businesses increase spending and potentially change hiring plans, even if it is modest, it should actually spill over to more loan demand, which actually would spill over to better credit.

I think on a selective basis you’re always going to have flareups that happen. There are individual situations where companies or borrowers have one off incidents that occur. Sometimes those get extrapolated. I think we had that happen with Opus Bank (NASDAQ: OPB) in the past quarter or two, where some credit issues were extrapolated into a much bigger issue than probably exists. That company will most likely create stability in the next quarter or two and prove that out. 

I think in other instances we’ve seen a lot of energy related issues that are now going to get cleaned up. In terms of the initial recognition, that has already been done as long as energy prices stay where they are now.

The ongoing incremental problems just aren’t out there. The level of past dues, the level of substandard loans for those banks who report that information are very low. The charge offs, most importantly, are very low. I think it will take time for that to develop. If it does become more of a credit cycle, it will occur more in 2018 and 2019 than in 2017.

Melvin: I take it you’re not seeing any bankers make what I call 2006-brand—or stupid—loans at this point in the cycle, are you?

Marinac:  Well, stupid is always a relative term. If anything we see more examples of banks taking undue risk in terms of interest rates where they’re fixing loans for 5 to 8 years. Sometimes they’re properly hedging those loans, perhaps with a federal or home loan bank instrument or other long-term CD, but typically they’re not, so that would be the only example of sort of stupid that I feel is out there.

We’ve seen those terms and structures sort of weaken and lessen over the last couple of years. It will probably just take another 2 years to fully develop into issues. The good thing is the banks have earnings. They have capital. They can handle those issues. We are seeing that. Again, I use the Opus incident. Opus can handle the issue and address it and move on.  That’s a sign of health. That’s a sign of strength, even though it is unfortunate those things happen. They can handle it and move on.

Melvin: Now of course the big question on everybody’s mind, and really the driver of this rally since the election, is how does the regulatory environment change next year?  What are your thoughts on that?  Because I have heard everything from, "things probably aren't really going to change much at all," to, "they’re just going to rip Dodd Frank up and throw it away." Where do you come in on that one?

Marinac: Regulatory change took a long time to be implemented, and I think it will take a long time to be broken down. I think that this will be a year where the regulations are known, that there are no new rules that are put on, with maybe a couple of exceptions which I’ll talk about.

I think it is going to sort of be steady as she goes. I think the big picture question, which has engaged investors because we do look out longer than the next 6 to 12 months, is that the direction of regulatory is toward reform. It is toward reducing Dodd Frank. It is toward perhaps rethinking how we treat the whole regulatory process, which I think will be changed in 2018 or 2019. It will be a lot more subtle than it is direct.

Melvin: Does the changed perception of the regulatory environment perhaps see the return of de novo banks?

Marinac: I think the regulatories have already been becoming more open toward a handful of de novos. Even if the election didn’t change the attitude of regulation, I think these de novos were going to happen. If anything the regulatory bodies wanted to demonstrate that they’re at least willing to do a couple. I still think a couple is the operative word.

The attitude toward new de novo banks is definitely much different than it was in 2003 to 2006, that era when we had hundreds of new banks. I just don’t see it coming back to that. The capital might be there, but I think the structure of what regulators want, and sort of the straight jacket that they put new banks under is going to make it more conducive for existing banks to recapitalize or reset their business plans, and that become the de facto de novo.

Melvin: How about your outlook for M&A activities? M&A has been very strong in the last few years, with regulatory costs with the smaller banks often cited as a reason. Does M&A slow down if there is some sort of regulatory reform, or is this more of a secular trend that is just going to keep going?

Marinac: I think it’s definitely a secular trend. I think, if anything, M&A accelerates because of higher prices. Currencies really drive M&A. What happens over time is that stock prices tend to have wider dispersion in terms of their valuations that is beginning to develop, and I think it will continue to occur as 2017 unfolds.

What that means is that there is a bigger spread on the price to tangible book and as that happens the buyers distinguish themselves from the sellers and more transactions can happen. There are still many boards of directors who I would say are tired by the environment. They certainly were scared by what went on during the financial crisis years and they remember what it felt like and when they’re given an opportunity to come out at a reasonable price, particularly when they can take strong currencies from the buyer, I think there are enough banks who will say yes, and take that on.

This is still an ego game. The egos don’t like when they have to take a low price and something that has seemed to be less than a real market bid. Now that pricing has come back, I think egos can very much be massaged into feeling good about a particular M&A transaction and that the pricing is much better.

Melvin: Regulatory cost has been cited as one the big issues in the industry, but more and more it looks to me like a lot of banks are facing some serious technology spending challenges. Can you comment on that?

Marinac: The concept of cyber security in the regulatory framework is awfully important. In fact, I would say that cyber might drive certain companies out of the business because the regulators are as serious as a heart attack about banks and boards of directors being all in on cyber.

I feel like the cyber and the tech spending is still a real topic and, if anything companies might be investing savings that they’re getting on taxes.  So you might see companies taking the revenue from a better margin, and perhaps stronger net income because of taxes and reinvesting some of these profits back into technology spending to not only make sure that they’re in line with the rest of the Joneses, but also that they can sort of anticipate the problems.

I mean, the cyber issues, large and small, are still out there. I hate to say this, but I believe it’s going to be proven true. It’s going to take an incident of public knowledge, knowing that banks had issues and that they had to respond. It’s always worried me that only BB&T Corporation (NYSE: BBT) and JPMorgan Chase & Co. (NYSE: JPM) are the 2 most vocal banks about cyber. We haven’t seen enough banks being vocal about what they spend and how they do it. I think unfortunately an incident is going to have to change that. I hope it doesn’t happen, but history suggests that is the type of thing that creates change in the industry.

Melvin: You talked about the banks needing to disclose it more, do you think this is much more widespread than people realize?

Marinac: It is, and I think that the email fraud is rampant as well. There is not a CEO or CFO who hasn’t told me that they get emails all the time requesting to wire funds. It’s almost become comical that their internal people know that we have to follow up with a phone call and multiple ways to get money wired internally to pay vendors. It just doesn’t come because a CEO asks via email to wire somebody X dollars. That unfortunately continues to be a good example if incidents that are occurring in the industry.

Melvin: As long as we are on technology, the fintech threat, how real is it?  Are they really going to make banks obsolete?

Marinac:  I don’t think so. I think we see banks who continue to be focused on branches because it’s the center point of how they do business. A branch is not just a place to go in and get a cup of coffee and a donut and to make a deposit. It’s really a way that you know a bank is in your neighborhood. I think we are going to see banks in 2017 really use the branch for a very strong purpose, which is as a marketing tool in the area, having it be a first class facility on a first class street corner, but using that as the epicenter for their own calling effort when they’re going out calling on people individually. 

The focus of branches is changing, but it’s going to be a blend of technology and physical infrastructure that gets it done.  I mean, every bank in the country is finding ways of doing more with less, and that will continue to play out in 2017. 

To your earlier point on technology, companies are spending money. They have to. I recently had a CFO tell me pretty directly that I’ll spend a dollar all day to make $2 or $3 of revenue. I think that is where we are heading. Most investors and analysts are probably tired of hearing the term operating leverage, which is really getting revenues growing faster that expenses, but  it is real important that it happens in a positive way at banks. I think that is going to become one of these terms we hear often just like we hear ROA, price to book, and return on equity and margin, we’re also going to hear about operating leverage and whether a bank does or doesn’t do that over time.

To read more on what Chris Marinac thinks banks will do in 2017, including the role fintech and deregulation might play, click here to read part two.

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