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United States: Financial Services
Positioning for the next leg of the rally
Fundamentals suggest further upside
We see the best opportunities in Large Cap Banks, Brokers, Asset Managers, and Homebuilders given the backdrop of low rates, higher asset prices, moderating credit costs and improving capital markets activity. Higher interest rates and regulatory overhang are the big downside risks.
Best Buy ideas
We focus investors on our top stock ideas including JPM and BAC in large-cap banks; STI, CMA, FITB and KEY in regional banks; UNM, XL PGR, and ACE in insurance; BEN and BX in asset managers; EVR, LAZ and PJC in brokers; NDAQ and CME in market structure; CBG in Real Estate and DHI in Homebuilders. In credit, we favor BAC, LLOYDS, BPCEGP, STANLN in Banks and Farmers, CNA and RDN in Insurance.
Our investment framework
Four themes guide us: (1) Potential for consumer provision leverage, (2) a focus on those companies that can return capital to shareholders, (3) improving capital market activity in 2010 and (4) stabilizing real estate prices as the hunt for yield hits real assets.
Best Sell ideas
We remain concerned on CRE given the long-tail nature of losses; avoid BRE, REG, DRE and ESS. Prime jumbo losses likely to worsen; avoid HCBK.
Jessica Binder, CFA
(212) 902-7693 | firstname.lastname@example.org Goldman Sachs & Co.
(212) 357-9981 | email@example.com Goldman Sachs & Co.
Financials as a part of your portfolio
Financials are now the second largest sector in the S&P 500 and we think there is further upside as we move towards normalized returns given attractive valuation. Investors have moved towards a neutral weighting in the sector, but are underweight regional banks. The best performers YTD have been the most underweighted sectors.
What we are watching
We highlight four sections of this report for PMs: (1) an in-depth analysis of mutual fund positioning across the Financials sector (p. 5); (2) a closer look at the idea of Financials being “cheap cyclicals” (p. 7); (3) capital management across the sector (p. 14); (4) initial thoughts around Basel III (p. 30).
(212) 855-9908 | firstname.lastname@example.org Goldman Sachs & Co.
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The Goldman Sachs Group, Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification, see the end of the text. Other important disclosures follow the Reg AC certification, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.
The Goldman Sachs Group, Inc.
Goldman Sachs Global Investment Research
Global Investment Research
April 7, 2010
United States: Financial Services
Table of contents
Portfolio Manager Summary: Life after the crisis Thinking about Financials in the context of a portfolio A return to micro from macro Theme #1: Provision leverage in consumer loan portfolios Theme #2: Capital management is beginning to be a key differentiator across the sector Theme #3: Capital market should bounce from a disappointing 4Q2009 Theme #4: Real estate prices are stabilizing as the hunt for yield hits real assets Short rates are likely to stay lower for longer, but have to go up eventually Regulatory issues likely to remain a topic for the foreseeable future Sector views: Attractive Large Banks, Asset Managers, Homebuilders and Brokers Disclosures 3 5 10 11 14 17 20 26 30 34 37
GS Financials Equity Research Team
Banks Richard Ramsden Brian Foran Adriana Kalova Quan Mai Insurance Christopher M. Neczypor Christopher Giovanni Eric Fraser Cooper McGuire Vikas Jain Asset Managers Marc Irizarry Alexander Blostein, CFA Neha Killa Market Structure & Brokers Dan Harris, CFA Jason Harbes, CFA Real Estate/REITs Jonathan Habermann Sloan Bohlen Jehan Mahmood Siddharth Raizada Homebuilders Joshua Pollard Anto Savarirajan
GS Financials Credit Research Team
Banks Louise Pitt Insurance and Managed Care Donna Halverstadt Amanda Lynam
Financials Sector Specialist Jessica Binder, CFA
Goldman Sachs Global Investment Research
April 7, 2010
United States: Financial Services
Portfolio Manager Summary: Positioning for the next leg of the rally
We remain bullish on Financials given the backdrop of low rates, higher asset prices, moderating credit costs and improving capital markets activity and see the best opportunities in Large Cap Banks, Brokers, Asset Managers, and Homebuilders. Higher interest rates and the regulatory overhang are the biggest downside risks, although appear manageable near-term.
Financials are now the second largest sector in the S&P 500, and we think there could be further upside given attractive valuation levels even after the rally. While investors have largely closed out underweight positions from last year, they remain underweight many of the regional banks. Positioning has been a big driver of returns thus far this year, and correlation across stocks in the sector has fallen dramatically since the start of the year.
We highlight four key themes for stock-picking across the sector:
Provision leverage in consumer loan portfolios: The credit cycle is moderating as non-performing asset formation is slowing and reserves are closer to peak levels. The improvement is most clear in consumer and in commercial (C&I) loans, and should current trends continue, we see the potential for reserve releases later this year. Key stock ideas: BAC, JPM. Avoid HCBK. Returning capital to shareholders: Buybacks and dividends have become a bigger differentiator across the sector. We
highlight companies that screen well on these metrics and highlight potential new entrants, which could result in significant relative outperformance. Within the banks sector, high free cash yields imply dividend yields should be attractive once regulatory pressure eases. Key stock ideas: BEN, JPM, NDAQ, UNM, XL.
Capital market should bounce from a disappointing 4Q: Trading activity was weaker than many expected in the first quarter,
but FICC should show qoq improvement. Investment banking got off to a slow start this year, but has recently started to pick up. We believe this is just the beginning of a multi-year recovery in M&A. Smid-cap brokers and alternative asset managers are well-positioned to benefit, as are some of the large-cap banks. Key stock ideas: BAC, BEN, BX, CBG, EVR, JPM, NDAQ.
Real estate prices are stabilizing as the hunt for yield hits real assets: While we may just be in the eye of the storm, low
interest rates have helped push some issues further into the future. Homebuilders are well positioned to benefit from an improvement in new home sales from the depressed levels of 2009. Shadow inventory remains a concern, but is more likely to limit the strength of the recovery rather than creating another downturn in the very short-term. On the commercial side, sentiment is better than reality; the few recent transactions that have occurred imply that prices are recovering faster than the fundamentals would suggest. Key stock ideas: BAC, CBG, DHI, JPM, MTG, STI, BX. Avoid BRE, REG, DRE and ESS.
Despite this positive backdrop, investors remain focused more on potential downside risks: Rates: Low rates have unquestionably helped to stimulate the economy, not only by lowering funding costs, but also by
supporting housing demand and boosting capital market activity. The improvement in credit can in part be attributed to low rates, given that the majority of loans in the United States are floating rate. Our economists forecast the Fed Funds rate will stay near-zero through 2011. However, even if rates were to increase, we expect money market outflows to continue. Avoid FII.
Regulatory outlook: While it is difficult to know what the exact timing and impact of regulation will be, it is clear this is an
area of focus for the foreseeable future. Banks are likely to be the most impacted across the space, and issues fall within two areas right now: the potential impact on normalized earnings, and the push for companies to hold more capital. One potential beneficiary will likely be exchanges if volume is pushed towards exchanges and clearinghouses. Other sectors where new regulatory proposals are likely to have an impact are Insurance, Rating Agencies and some Asset Managers/Discount Brokers that have money market funds.
Goldman Sachs Global Investment Research
April 7, 2010
United States: Financial Services
Exhibit 1: Top Ideas across the Financials sector
Stock ideas from the Financials business unit; priced as of the market close of April 7; $ millions, except per-share data
Upside/downside Target price to target price 20.00 130.00 18.00 18.00 17.00 40.00 54.00 25.00 35.00 26.00 23.00 25.00 10.00 72.00 21.00 13.00 33.00 7% 15% 23% 11% 42% 30% 19% 17% 23% 3% 18% -33% -23% -24% -21% -8% -13% Key Financials investing themes Provision Capital Capital Leverage Allocation Markets Real Estate
Company name Buy Bank of America Corporation Franklin Resources, Inc. The Blackstone Group L.P. CB Richard Ellis Group Inc. D.R. Horton, Inc. Evercore Partners Inc. J.P. Morgan Chase & Co. The Nasdaq Stock Market, Inc. SunTrust Banks, Inc. Unum Group XL Capital Ltd. Sell BRE Properties, Inc. Duke Realty Corp. Essex Property Trust, Inc. Federated Investors, Inc. Hudson City Bancorp, Inc. Regency Centers Corporation
Ticker BAC BEN BX CBG DHI EVR JPM NDAQ STI UNM XL BRE DRE ESS FII HCBK REG
Sector Banks Asset Managers Asset Managers REITS Homebuilders MktStructure Banks MktStructure Banks Insurance Insurance REITS REITS REITS Asset Managers Banks REITS
Market cap (current) Price 185.0 25.9 16.6 3.9 3.8 1.2 178.7 4.6 14.2 8.4 6.7 1.9 3.0 2.6 2.7 7.5 2.6 18.62 112.83 14.68 16.23 11.93 30.68 45.32 21.42 28.53 25.36 19.47 37.05 13.01 94.92 26.52 14.20 38.12
For important disclosures, please go to http://www.gs.com/research/hedge.html. For methodology and risks associated with our price targets, please see our previously published research. Source: Goldman Sachs Research estimates.
Exhibit 2: GS Financials: Summary of rankings by sub-sectors
Exhibit 3: Financials have underperformed since October
19 17 15 13 11 9 7 5 7-May-09 7-Mar-10 7-Mar-09 7-Nov-08 7-Aug-09 7-Nov-09 7-Apr-09 7-Oct-08 7-Oct-09 7-Feb-09 7-Sep-09 7-Dec-08 7-Dec-09 7-Feb-10 7-Jan-09 7-Jun-09 7-Jan-10 7-Apr-10 7-Jul-09
XLF SPX Performance 6-Mar-09 13-Oct-09 6-Mar-09 13-Oct-09 7-Apr-10 7-Apr-10 146% 7% 165% 57% 10% 73%
Equity Coverage Views Attractive Neutral Cautious Asset Managers Credit Cards Life Insurance Brokers Discount Brokers Specialty Finance Homebuilders Insurance Brokers Large-cap Banks Market Structure Mortgage Insurance Non-Life Insurance Regional Banks REITs Trust Banks Credit Coverage Views Attractive Neutral US Banks Insurance European Banks Mortgage Insurance
Source: Goldman Sachs Research.
1300 1200 1100 1000 900 800 700 600
Source: Bloomberg, Goldman Sachs Research.
Goldman Sachs Global Investment Research
which tends to have a large retail ownership base. Asset Managers. mutual funds appear to be underweight every single regional bank with the exception of Marshall & Ilsley. due largely to an underweight position in Financials. However. While funds have increased their weighting in certain regionals over the last few months. Funds are now much closer to a benchmark weight. most mutual funds remain underweight the group. they have driven them even higher. Within the Financials sector at least. CMA.3 Total Return YTD 25 20 15 10 5 0 -5 -100 Multi-line Insurance Residential REITs Other Diversified Financial Services Specialized REITs Retail REITs Industrial REITs Specialized Finance Real Estate Services Diversified Banks Office REITs Diversified REITs Insurance Brokers Consumer Finance Asset Management & Custody Banks Investment Banking & Brokerage Thrifts & Mortgage Finance Property & Casualty Insurance Multi-Sector Holdings -50 0 50 100 150 200 Mutual Fund Overweight/(Underweight) as of 12/31/09 Source: Lionshare via FactSet and Goldman Sachs ECS Research. RF. Life & Health Insurance and REITs. See Exhibits 5-8. However. think fundamentals will once again become the bigger driver. KEY and MTB. The stocks that have seen the biggest increase in mutual fund ownership are MI. those funds in the Lipper Large-Cap Core Index were trailing the benchmark by about 80 bp on average. they have not been able to keep up with the benchmark. The big increases have been in BAC and WFC. funds have largely closed out their underweights in the large-cap banks sector over the last few quarters. and as investors have increased their weights towards those sectors. we view the recent rally as largely positioning-driven and over time. an underweight position in large-cap banks. they have not fared as well this year. S&P 500 Sub-sector Property & Casualty Insurance Consumer Finance Asset Management & Custody Banks Investment Banking & Brokerage Diversified Banks Real Estate Services Multi-Sector Holdings Specialized Finance Office REITs Industrial REITs Multi-line Insurance Thrifts & Mortgage Finance Diversified REITs Insurance Brokers Residential REITs Retail REITs Regional Banks Life & Health Insurance Specialized REITs Other Diversified Financial Services Current SPX Current (bp) Current Overweight/ Weight Mutual Fund (Underweight) (bp) Weight (bp) 280 209 71 138 78 60 185 127 58 173 144 30 223 206 17 7 4 3 5 4 0 42 44 -1 6 10 -4 1 6 -4 35 40 -5 6 12 -6 1 11 -11 9 23 -14 3 19 -16 8 29 -21 74 109 -34 79 114 -35 5 48 -43 370 413 -43 Despite the outperformance of Regional banks. part of this is due to the fact that they were underweight the sectors that have performed the best. Brokers and Homebuilders. STI. See Exhibit 4. while mutual funds have taken down their exposure to JPM and C. Goldman Sachs Global Investment Research 5 . Exhibit 4: The ‘pain trade’ in Financials: those sectors that were most underweight have rallied the most year-to-date 40 35 30 Life & Health Insurance Regional Banks y = -0. including Regional Banks. Our favorite sectors are Large-Cap Banks. While a large part of this is due to an underweight in BBT. and in particular. and as of March 31. As a result.2 R2 = 0.April 7. Mutual funds generally outperformed their benchmarks in 2009.1x + 14. 2010 United States: Financial Services Thinking about Financials in the context of a portfolio This section was written in conjunction with David Kostin and the Portfolio Strategy team.
April 7. 2010 United States: Financial Services Exhibit 5: Mutual funds are still underweight regional banks 200 150 100 50 Mutual Fund 0 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Dec-08 Jun-09 Dec-09 Current SPX Exhibit 6: How mutual funds are positioned within Regional Banks Current Mutual Fund Weight (bp) BBT FITB PBCT RF CINF HCBK FHN STI CMA HBAN KEY MTB ZION SNV FNFG CYN MI 3 3 0 5 1 3 0 10 4 1 4 4 2 0 0 0 6 Current SPX Weight (bp) 21 10 5 9 4 6 3 13 6 4 6 6 3 0 0 0 4 Current (bp) Overweight/ (Underweight) -18 -7 -5 -4 -3 -3 -3 -3 -3 -3 -2 -2 -1 0 0 0 2 Change in Mutual Fund Wgt Jun-09 to Current (bp) -7 1 0 4 -1 -2 -1 4 3 1 3 3 0 0 0 0 5 Position Size (bp) 0 -20 -40 -60 -80 -100 -120 -140 Jan-06 Jan-07 Overweight/(Underweight) Jan-08 Dec-08 Jun-09 Jul-06 Jul-07 Jul-08 Dec-09 Source: Lionshare via FactSet and Goldman Sachs ECS Research Current Source: Lionshare via FactSet and Goldman Sachs ECS Research Exhibit 7: Mutual funds have largely closed out their underweight position in Large-cap banks 1200 1000 800 600 400 200 0 Jan-06 Jan-07 Jan-08 Dec-08 Jun-09 Jul-06 Jul-07 Jul-08 Dec-09 Current Mutual Fund SPX Exhibit 8: How positioning has changed within large-cap banks since last summer Current (bp) Overweight/ (Underweight) BAC WFC USB MS PNC JPM C 2 21 -15 6 -1 8 -53 June-09 (bp) Overweight/ (Underweight) -46 -2 -20 7 2 27 -10 Change (bp) 47 24 5 -1 -3 -19 -43 Position Size (bp) 0 -50 -100 -150 -200 -250 -300 Jan-06 Jan-07 Jan-08 Overweight/(Underweight) Dec-08 Jun-09 Jul-06 Jul-07 Jul-08 Dec-09 Source: Lionshare via FactSet and Goldman Sachs ECS Research Current Source: Lionshare via FactSet and Goldman Sachs ECS Research Goldman Sachs Global Investment Research 6 .
18%).4x multiple they are currently trading at. Looking at the sector. we expect banks to generate a normalized return on tangible equity of 15%. This is up from a low of 11% in January 2009. However. In thinking about the normalized return on tangible equity.5x tangible book. but it still a fraction of the 22% weight at the peak. almost half the market cap is in the Banks sector. other cyclical sectors are now back to trading at a premium to their historical valuation. and potentially even become the largest sector of the market again. Exhibit 9: Financials as a percentage of the S&P 500 25% Exhibit 10: Sub-sector breakdown of the Financials sector Insurance Brokers Discount Brokers 1% 1% Specialty Finance 1% 20% SPX Weight Market Structure 2% Asset Managers 4% Banks: Trust 4% Specialty Finance Credit Cards 4% Banks: Regional 6% LifeInsure 6% 15% 10% Banks: Large-cap 48% 5% 0% Dec-74 Dec-76 Dec-78 Dec-80 Dec-82 Dec-84 Dec-86 Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 REITS 8% NonLifeInsurance 15% Source: Compustat and Goldman Sachs Research. the sector weighting has also been boosted by the addition of Berkshire Hathaway to the S&P 500 Index. which is an increasingly regulated metric. which has led some to suggest that Financials. One pushback to this argument is that Banks should trade at a discount to history as it is unlikely that returns ever reach historical levels. We see more room to run as Financials returns continue to recover towards normalized levels and there is room for multiple expansion. While much of this increase stems from the relative outperformance of the sector since the market bottom. One of the big questions that comes up is whether Financials can outperform further. 2010 United States: Financial Services Financials are currently the second largest sector of the S&P 500. Berkshire is now the fourth largest company in the sector. which we expect to be 1. lower than the average over the last 15 years (1. and the largest company by far in Non-Life Insurance. are “cheap” cyclicals that offer leverage to the market recovery. If this were the case. Even if returns end up being below that 15% level. In comparison.5% of the total market cap. but in-line with the early-1990s. one key factor is leverage. JP Morgan and Wells Fargo accounting for 30% of the sector market cap alone. Source: Compustat and Goldman Sachs Research. but higher than the average since Goldman Sachs Global Investment Research 7 . with Bank of America. it suggests that banks should trade at 2. accounting for 16.April 7. and in particular the banks. significantly higher than the current 1. there is still room for multiple expansion. Many financial sub-sectors are trading at a discount to historical valuations (see Exhibit 11). based on our estimates. We have more comfort in our sustainable ROA forecast.1%. as Exhibit 12 shows. which is still lower than average returns in the 2000s.
banks trade at a discount to history 25% R2 = 73% Eventually should get back here 20% 2003 19941993 15% 1995 1992 1996 Normalized 2002 2000 2001 2007 2006 2005 2004 1997 1999 1998 Return on Tangible Equity Mortgage Insurance (2) Life insurance (2) Banks (1) Non-life insurance (2) Market structure Asset Managers Discount brokers REITs (3) Average 10% 1990 5% 1991 2010 2008 We may never see this again 2009 0% -5% 50% 100% 150% 200% 250% 300% 350% 400% 450% Price to Tangible Book (1): Price / Tangible Book.7x 17. Source: Goldman Sachs Research estimates.8x 16.7x 1. C is an extreme example. One other issue that investors are wrestling with is the impact of dilution on earnings.2x 11. (3) Price/FFO Source: Goldman Sachs Research estimates.5x 16.5x 13. 2010 United States: Financial Services 1934 (75 bp).4x 12. But in many cases.April 7.8x 12.9x 13. earnings per share would still be significantly depressed due to the increase in share count.4x 18. although this is clearly still an area of debate among regulators. particularly when compared to other sectors in the market.3x 17. Goldman Sachs Global Investment Research 8 .4x 15.6x 23. (2) Price / Book.2x Historical avg multiple 1.8x 13. most banks have not seen a comparable increase in earning assets.9x -Current multiple Price to Earnings Industrials Materials Discretionary Energy Info Tech Average (P/E) 17.0x 20. with most of the dilution being caused by the Banks. Citigroup exemplifies this story. we assume that banks are required to hold 8% Tier 1 common capital.2x 0.3x 18.8x 15. Despite the increase in shares. We calculate that shares are up 60% on average across Financials. Exhibit 11: Financials mostly trade at a discount to history Current multiple 1. even if pre-provision were to return to its previous run-rate.5x Premium / Discount to historical average 0% -48% -30% -43% -43% -6% 13% 30% -16% Premium / Discount to historical average 51% 39% 27% 17% -16% 24% Exhibit 12: Even adjusting for lower ROE. To get to 15% return on tangible equity.2x 1.8x 13. The dilution in Financials stocks has been extreme over the last two years.0x 18. and even adjusted for dilution.9x 1. See Exhibits 13-15.2x -Historical avg multiple 11.9x 0.7x 2. most banks are still trading at a substantial discount to the historical average. We believe the large caps are trading at a bigger discount to their long-term average earnings multiples than regionals and thus rate the large cap banks Attractive and the regionals Neutral.
Goldman Sachs Research estimates.62 3Q09 $0. Exhibit 15: Large banks and regionals are trading at a 24% discount to long-term multiples price to normalized EPS by bank.0x Difference -24% -19% -21% Note: regionals ex Northeast. Goldman Sachs Global Investment Research WAL BAC MS BK C 9 .2x 10. Long-term avg since 1985 where available.30 $3.0x 14.0x Price to Normalized EPS 12.8x 9.000 Shares (mm) 30.0x 8. Goldman Sachs Research estimates.0x 6.000 20.5x 11.80 $1.April 7.000 10.30 $1.65 2Q08 3Q08 4Q08 1Q09 2Q09 $0.000 0 1Q08 $4. GS-coverage 18.30 $2.80 $3. FNFG NTRS FITB ZION FHN PNC PBCT COF HCBK DFS WFC JPM STT STI MI RF HBAN CMA CYN USB BBT AXP KEY Source: FactSet.0x 4.0x 2.30 $0.0x 0.80 $2.5x 12.0x 10..0x Indicates "Buy" rated stock Large banks Regionals Average Price to Earnings Normalized Long-term Avg 8.30 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 Gov't announced its intention to convert into common shares * market-cap weighted Implied Normalized EPS Consumer Discretionary Information Technology Consumer Staples Telecom Services Industrials Energy Health Care Materials Utilities Financials Pro-forma for gov't conversion $0. Source: Company data.4x 12.39 4Q09 Source: Goldman Sachs Research estimates. 2010 United States: Financial Services Exhibit 13: There has been significant dilution in Financials over the last year Change in Share Count (2007-2009) Average* Median -3% -1% -3% -2% -3% -3% -1% -1% 0% 0% 1% 2% 3% 0% 4% 1% 5% 4% 59% 12% Exhibit 14: Pre-provision shrinkage and increase in share count has resulted in a big decline in normalized earning power 40.80 $0.0x 16.
33 0.65 0.32 0. Source: Goldman Sachs Research. this is not surprising.02 0. to concentrate on the fundamental issues.02 0.25 0.13 0.27 0.70 0.16 0.64 0.02 0.21 0. Goldman Sachs Global Investment Research 10 .44 0.09 0.60 0.11 0.47 0.52 0.03 0.63 0.76 Exhibit 17: Financials correlation is at the lowest level since 2006 realized correlation across stocks 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Oct-06 Oct-07 Oct-08 Feb-07 Feb-08 Feb-09 Oct-09 Dec-06 Dec-07 Dec-08 Dec-09 Feb-10 Jun-06 Jun-07 Jun-08 Jun-09 Apr-06 Apr-07 Apr-08 Apr-09 Aug-06 Aug-07 Aug-08 Aug-09 Apr-10 Jun-10 S&P 500 Financials ETF XLF XLY XLU XLV XLB XLE XLP XLK XLI SPX S&P Sector Financials Discretionary Utilities Healthcare Materials Energy Staples Technology Industrials S&P 500 Current 0.42 0.34 0. once again. While that has certainly been the case over the last few years.34 5-year percentile 0.48 0.54 0. In some ways.46 Note: The percentile is the rank of the current value as a percentage of the total observations. as regulatory fears from earlier this year dissipate.03 0.34 0. correlation across the group has started to fall dramatically in recent days (see Exhibit 17).April 7.33 0.22 0. with many of the stocks trading in lock-step with one another (see Exhibit 16).54 0.60 0. Source: Goldman Sachs Research.38 0.62 0.26 0. While we still see some key themes helping drive returns. The upcoming earnings season should provide investors with evidence as to these differentiating trends and provide opportunities for generating alpha. 2010 United States: Financial Services A return to micro from macro Financials are often considered one of the most macro-driven sectors in the market.61 0.19 0. and realize that there are many ways to differentiate across the group.38 1-year percentile 0.14 0. Exhibit 16: Financials tend to be one of the most highly correlated sectors ranked by 5-year percentile 1-year median 0.40 0.40 0.40 0.29 0.59 0. many of these are more stock-specific and cut across sectors (consumer provision leverage and capital management) as opposed to being large macro themes. investors are starting.60 0.58 0.69 5-year median 0.38 0.
S&P LCD. Trepp. Loanperformance. Loanperformance. prime jumbo is getting worse MBS (2006 & 2007 vintages) Exhibit 21: CRE delinquencies continue to trend up CMBS CMBS . Exhibit 20: Within resi mortgages. Jan 10 Oct 06 Oct 07 Oct 08 Oct 09 Source: Company data.April 7. 60+ Delinquency Subprime Op ARM Alt-A Prime Jumbo Home Equity FRE/FNM Source: Company data. 2010 United States: Financial Services Theme #1: Provision leverage in consumer loan portfolios The credit cycle is clearly moderating.8% 5. Trepp. we see potential for reserve releases later this year. S&P LCD.2% 12. Goldman Sachs Research. Trepp.MoM change.3% 6. Defaults 1Q09 2Q09 3Q09 4Q09 1Q10 TD $ 19.0% 8.7% 8. Goldman Sachs Global Investment Research Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 MayJun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 MayJun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 700 bps 600 bps 500 bps 400 bps 300 bps 200 bps 100 bps 0 bps -100 bps -200 bps -300 bps -400 bps QoQ Change in 30+ Delinquency 1Q08 3Q08 1Q09 3Q09 1Q10 TD 2Q08 3Q09 2Q09 4Q09 70 bps 60 bps 50 bps 40 bps 30 bps 20 bps 10 bps 0 bps -10 bps Avg chg in delinquency 1Q09 +19bps 2Q09 +32bps 3Q09 +37bps 4Q09 +56bps 1Q10 TD +80bps . On the other hand.4% 3. Exhibit 18: Credit card delinquencies have been better thus far in 2010 Credit Card Avg chg delinquency 2Q09 -13bps 3Q09 +4bps 4Q09 +3bps 1Q10 -12bps Exhibit 19: C&I defaults have started to slow down as well Leveraged Loans (proxy for C&I) Lagging 12-month Default Rate 12% 10% 8% 6% 4% 2% 0% Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 11 60 Month over month change 50 40 30 20 10 0 -10 -20 -30 # of defaults Ann. as non-performing asset formation is slowing and reserves are closer to peak levels. Goldman Sachs Research. Trepp.1% 8. The improvement is most clear in consumer and commercial (C&I). Loanperformance.8% 16. Loanperformance. S&P LCD.6% $ of defaults # 8. Goldman Sachs Research. Goldman Sachs Research.5% July 09 Apr 06 Apr 07 Apr 08 Jan 06 Jan 07 Jan 08 Jan 09 Apr 09 Jul 06 Jul 07 Jul 08 Source: Company data. some prime jumbo mortgages and CRE continue to get worse. S&P LCD. See Exhibits 18-21. and should current trends continue. Source: Company data.
we favor the large banks and credit card issuers vs. On this theme. BAC and JPM are our best ideas given leverage to consumer credit improvement and attractive valuation at 7X our normalized earnings estimates. Goldman Sachs Global Investment Research 12 . In particular. Exhibit 22: Scorecard – stocks with leverage to US consumer credit moderation US consumer credit cost as % of of revenue DFS COF AXP BAC JPM USB WFC Average 70% 35% 23% 6% 5% 3% 2% 16% US consumer credit cost as % of total credit cost * DFS AXP COF JPM BAC USB WFC Average 100% 85% 77% 51% 47% 40% 29% 62% US consumer credit as % of normalized earnings ** DFS COF JPM AXP BAC USB WFC Average 70% 60% 30% 30% 25% 20% 15% 28% Source: Company reports. as C&I is likely in-line with historical seasonal patterns based on commercial bankruptcies and leveraged loan defaults (although as a caveat. FactSet. in particular. We continue to believe high but stable unemployment leads to lower delinquency. Total delinquency was down 6 bp month on month while early delinquencies are down for the fourth straight month (see Exhibit 22). continues to improve. Goldman Sachs Research. See Exhibit 23. Looking ahead to earnings. and auto charge-offs have tracked down 12% using monthly data through February from Capital One and AmeriCredit. as evident in the most recent credit card master trust data.April 7. the regional banks. bank charge-offs typically fall over 20% in 1Q relative to 4Q based on data since 1985. Half of this seasonal decline is driven by declines in commercial charge-offs (C&I) with the remainder driven by commercial real estate and auto. while seasonally March to May are always strong on tax refunds and other factors. This year losses look set to fall although by a smaller degree. this regression approach tends to undershoot as losses are peaking). Delinquencies usually fall 8% over those months. early delinquencies are down 14%. Since the peak in October. Commercial real estate may be the one outlier in seasonality as delinquency data from the CMBS market implies that commercial mortgage issues are still increasing. 2010 United States: Financial Services Consumer credit.
86% 1.69% 0.71% 0.00% 0.62% 0.89% 0. left chart on dollar losses.34% 0.04% 0. 4Q -10% -20% -30% 2Q vs.62% 0.55% 0.53% 2.88% 0.91% 1.30% 0.20% 1. 1Q 3Q vs.56% 0.30% 0.75% 1.07% 1Q FY1 1.26% 1.56% 0. 4Q (bps) -61 bps -60 bps -57 bps -55 bps -51 bps -45 bps -44 bps -43 bps -43 bps -30 bps -25 bps -22 bps -20 bps -18 bps -17 bps -14 bps -13 bps -10 bps -8 bps -6 bps -6 bps -5 bps -4 bps 9 bps -28 bps 40% 30% 20% 10% 0% 1Q vs.32% 0.33% 1.41% 1. Goldman Sachs Global Investment Research Avg QoQ change since 1985 13 .65% 1.70% 0. 4Q 91) Year 1992 1990 1987 1993 1986 1991 1989 1988 1994 2006 2004 2002 2001 2003 1995 2000 2005 1999 1998 1997 1996 2007 2009 2008 Average 4Q FY0 1. 2010 United States: Financial Services Exhibit 23: The seasonality of credit – losses typically fall over 20% in 1Q vs.20% 0. with improvement in C&I.60% 0.70% 0.49% 0. CRE and auto avg quarter over quarter change in net charge-offs since 1985.58% 0.92% 0.79% 1Q vs.08% 0.76% 0.49% 0. right table on % NCOs (1992 = 1Q 92 vs.06% 0.76% 0.90% 1.86% 1.86% 0.64% 0. 3Q Source: Federal Reserve.95% 0.25% 1.48% 2.38% 0.90% 1. Goldman Sachs Research.April 7.61% 0. 4Q.65% 1. 2Q 4Q vs.64% 0.
REITs are still one of the highest yielding sectors.0% PL BXP EVR PSA CNS CLMS CBL AB 2. have already expressed a desire to increase the dividend back to a more “normalized” level. either by paying dividends or by buying back stock.0% Dividend Yield (2009) 3. USB and NTRS.0% 2. some companies (such as BAC) have expressed a desire to buy back stock and reduce some of the dilution that occurred as a result of large capital raises in 2009. The dividend yield of the sector has fallen from an average of 2. but could start to normalize in 2011.0% Market Structure Mortgage Insurance Insurance Brokers Regional Banks Credit Cards Trust Banks Specialty Finance Non-Life Insurance Homebuilders Brokers Asset Managers Life Insurance Large Banks Financials MHP TROW VR PRE RE TRV VNO CB AWH ACE 2. dividends are much more likely than buybacks.5% PTP LAZ UNM AON 1. but more recently have been closer to 45%.0% 0. but has to date largely been limited in the sector.5% Source: Goldman Sachs Research estimates. payout ratios averaged 37% since 1992.5% Dividend Yield Exhibit 25: Companies expected to grow their dividend by 5%+ this year 70% 60% Dividend Growth (2009-2010) 50% 40% DUF 30% 20% 10% MS 0% 0.5% 4. While banks are currently limited in terms of how much capital they are able to return to shareholders in the form of buybacks and dividends.5% in the years leading up to the crisis to about 1.5% 5. and are expected to increase dividends by 7% this year. Source: Goldman Sachs Research estimates.5% 3. Goldman Sachs Global Investment Research 14 . REIT and Asset Manager sectors screen especially well on this metric.0% 2.0% 4.5% 3. Exhibit 25 highlights the 28 companies across our coverage universe that are expected to grow dividends by 5% this year. we believe that once regulatory uncertainty clears. Companies in the Insurance.April 7. the potential payouts may be substantial. This implies that dividend yields could be 5%-6%. Large banks are still at the low end of the spectrum and bring down the sector average. at least initially.5% REITs 0. such as JPM. we look at historical payout ratios and apply them to our normalized EPS levels. Historically. Exhibit 24: Financials sector dividend yield 3. M&A is also a possibility.0% 1. Some banks.5% 1.5% currently (see Exhibit 24). In our opinion. In order to estimate what the yield could potentially be. That being said. many Financials have accumulated excess capital positions and are increasingly willing to put cash to work. 2010 United States: Financial Services Theme #2: Capital management is beginning to be a key differentiator across the sector While banks tend to receive a lot of focus for their inability to pay dividends.0% 1. significantly higher than the current S&P 500 average of 1.0% 0.9% (see Exhibits 26-27).
85 $6.8% 20. Inc. The PMI Group.0% 8. Life Insurance Source: Goldman Sachs Research estimates.0% 50.93 1. Arch Capital Group Ltd.0% 15.0% 4. Inc. Knight Capital Group.April 7.2% 21.41 1. Janus Capital Group Inc. 2010 United States: Financial Services Exhibit 26: Banks pay 30-40% of earnings in dividend 55.40 $4.0% 40.96 2.0% Long-term average = 37% 2004-2007 average = 45% Exhibit 27: Normalized dividend yields could be significant Div Payout Ratio* GS Normalized EPS BAC WFC JPM $2.50 Peak 45% 45% 45% 45% 45% LT Avg 37% 37% 37% 37% 37% Normalized Div Peak 1.6% 17. We highlight the groups and stocks that have the highest remaining authorized share repurchases as a percentage of market cap (see Exhibits 28-29).0% USB 25.0% Insurance Brokers Credit Cards Non-Life Insurance Specialty Finance Regional Banks Homebuilders Large Banks Trust Banks Financials Brokers Asset Managers Exhibit 29: Buy and Neutral rated companies with the largest remaining repurchase authorizations as a percentage of market cap Remaining buyback authorization / market cap 25. Exhibit 28: Sectors with the largest remaining repurchase authorizations as a percentage of market cap Remaining buyback authorization / market cap 14.08 1.35 $6. nine companies in Financials have announced new buyback programs.8% 19.3% 23.7% 17.0% 12.50 $2.93 LT Avg 0. Ltd. For these names.0% 2.0% PNC 20.0% 6.0% 45.28 2.9% 19. Validus Holdings. Platinum Underwriters Holdings Ticker TRV ACGL JNS VR MCO MTH AON PMI NITE PTP Sector NonLifeInsurance NonLifeInsurance Asset Managers NonLifeInsurance Specialty Finance Homebuilders Insurance Brokers Mortgage Insurance Market Structure NonLifeInsurance Source: Goldman Sachs Research estimates. Buybacks have also picked up recently – since the start of the year.0% Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Source: Goldman Sachs Research.05 2. Inc.89 1.41 AVG Yield on Normal Div Peak 6% 6% 6% 5% 5% 6% LT Avg 5% 5% 5% 4% 4% 5% 30.5% 25.5% Company Name The Travelers Companies.0% Market Structure Mortgage Insurance REITs 0.0% 10. Goldman Sachs Global Investment Research 15 . Aon Corp. Source: Goldman Sachs Research. Moody's Corporation Meritage Homes Corp.61 2. Market Structure and Asset Management space. completion of these programs has the potential to drive upside and significant EPS accretion. primarily in the Non-Life Insurance.0% 35.
0 Increased buyback program SFG 8% 3% 3% 07/29/2009 08/13/2009 08/28/2009 09/15/2009 09/30/2009 10/15/2009 10/30/2009 11/16/2009 12/02/2009 12/17/2009 01/05/2010 01/21/2010 02/05/2010 02/23/2010 03/10/2010 Mar. and while the two traded together for most of the year.0 UNM 2.e. Goldman Sachs Global Investment Research 03/25/2010 -1% Announces intention to resum e share repurchases 16 . Goldman Sachs Research.Apr.Feb09 09 09 09 09 09 10 10 AVG Source: Biryini Associates.Nov.0 1.0 3.5 3. 2010 United States: Financial Services Our focus on buybacks in the context of capital allocation is largely aimed at identifying supports to both the market and company stock prices. including Unum Group (UNM).Oct.Dec.April 7.Jun09 09 09 09 Jul. SFG can be shown to have significantly outperformed UNM following the announcement of its share repurchase (see Exhibit 31). UnumProvident (UNM) and StanCorp (SFG) are smid-cap life insurance companies with similar underlying businesses (i.5 2. 2010 Stock return (%) 4 day return (%) around authorization 9% 7% 6% 5% 4% 3% 2% 1% 0% 03/09/2009 03/24/2009 04/08/2009 04/24/2009 05/11/2009 05/27/2009 06/11/2009 06/26/2009 07/14/2009 Indexed Price Performance Exhibit 31: Shares have reacted favorably to SFG’s buyback announcement Stock return (%) .Aug. Source: Factset. disability insurance).. Recent analysis by John Marshall of our Cross-Product team suggests that stocks that announced buybacks during the past year outperformed the S&P 500 by 290 bp in the four days around the buyback announcement (see Exhibit 30).SPX return (%) 4. For example.5 1. XL Capital (XL) and Public Storage (PSA). There are a number of stocks that we expect will begin to buyback stock this year.Sep. We have seen this in the financial space as well. Exhibit 30: Stock reactions around share repurchase announcements Through February. With these as a backdrop we are aware of investor focus on the impact of buybacks on stocks.May.Jan.
We expect US-based M&A to increased 10-20% over 2009. using a three-factor regression model based on business fixed investment. Since 1982. and the Goldman Sachs economists do not expect much of a change over the course of 2010. However.April 7. See Exhibits 32-33. 1996. We remain optimistic that trends will improve over the course of this year. Sluggish equity volumes and low volatility has hurt commission growth. helped by rising global GDP. while F/X and commodities have lagged somewhat. Thus far in 2010. Markit. 2010 United States: Financial Services Theme #3: Capital market should bounce from a disappointing 4Q2009 While 1Q2010 did not shape up quite as strongly as many had hoped or expected. Exhibit 32: Client activity across various products remains strong in 1Q2010 AVD volumes. and in all but three of the years (1989. and unemployment trends as the input variables. the same period in 2009. but it is too soon to call it a trend. Goldman Sachs Research. with notable improvement in Asia-based activity outweighing an 11% yoy decline in European volumes. which has started to occur very recently. debt issuance for 1Q10 is quarter-ized. Low interest rates and a steep yield curve should continue to support a variety of carry trade strategies this year. Source: BATS. we remain upbeat regarding trends for the remainder of 2010. improving sentiment. 2000) the model accurately predicted at least the directionality of announced US M&A. FICC results this quarter should show a seasonal improvement. driven primarily by volume increases in rates and credit. QTD change for indices 40% 35% 30% 25% QoQ change 20% 15% 10% 5% 0% -5% -10% Debt issuance Interest Rate volumes FX volumes Commodities volumes Credit indices -4% -2% 19% 14% 17% 38% 4Q09 1Q10 Exhibit 33: Although equity trading is down year-over-year average daily trading volumes for Tape A/B/C shares in bn 12 Tape C Tape B Tape A 9 6 6% 4% 4% 1% 3 0 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 Source: CME. Dealogic. equities appear to be off to a very slow start this year despite the fact that 1Q is typically the strongest quarter of the year. real GDP. also hurting revenues. these three variables have had a 90% correlation (81% R-squared) to US M&A volumes. The big focus area is M&A. Goldman Sachs Global Investment Research 17 . Goldman Sachs Research. CEO confidence and access to credit markets. which started off the year slowly but has picked up in recent weeks. and issuance has been weaker than expected. Equities could pick up over the course of this year if we start to see inflows into US domestic funds. announced global M&A volumes are up 12% vs.
000 800. respectively) given their more diversified business models. See Exhibits 36-37. but we note that M&A has likely benefited their other businesses. with an annual CAGR of 18%. Emerging markets have also become an increasingly important area for M&A. Since 1996. and notably. Source: Company reports. as evidenced by their recently announced advisory mandates for Prudential plc’s pending acquisition of AIA.000 600. such as lending. which could come to market if conditions continue to stabilize.April 7. Asia has had the most growth in M&A volumes. and trading. Goldman Sachs Research. have less exposure to M&A as a percent of their overall revenues (6% and 3%. such as Morgan Stanley and JPMorgan. Evercore has advised on some of the largest transactions of the past year. In addition. Lazard has the largest backlog across the smidcap broker space. 2006-9 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% EVR GHL LAZ JEF DUF PJC RJF SF Average = 36% Announced Global M&A Deal Volumes ($ mn) Americas EMEA Asia-Pac Source: Company reports. Blackstone remains our top Buy (CL) idea among the alternative asset managers. and Lazard and Blackstone increased their presence as well. Larger firms.200.000 0 1Q10 (Q-ized) 1Q98 3Q98 1Q99 3Q99 1Q00 3Q00 1Q01 3Q01 1Q02 3Q02 1Q03 3Q03 1Q04 3Q04 1Q05 3Q05 1Q06 3Q06 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 Exhibit 35: …and the boutiques are the most leveraged to M&A trends advisory revenues as % of total revenues. Over the last two quarters sponsor-backed IPO filings reached $6 billion in value across 31 deals. underwriting. See Exhibits 34-35. which are the most leveraged to a rebound. including BNSF/Berkshire and ACS/Xerox.000 400.400. Goldman Sachs Research.000 1.000 1. 2010 United States: Financial Services Given our belief that we are in the first year of a multi-year recovery in global M&A volumes. JPMorgan and Morgan Stanley are among the strongest large-cap participants in Asia-based M&A thus far in 2010.000 200. BX is well positioned to deploy capital amid improving credit availability and attractive valuation prospects as it currently has $28 billion in dry powder (29% of AUM). Exhibit 34: The pace of M&A announcements has quickened in the past six months.000 1. Goldman Sachs Global Investment Research 18 .600. Alternative asset managers are also well-positioned for a recovery considering record levels of dry powder and improving financing conditions for deals. compared with 8% in EMEA and just 3% in the United States.000. sponsor-backed IPOs are likely to pick-up given the current backlog. we remain Attractive on the smid-cap brokers and boutiques. Despite a soft start to the year. led by a recovery in the Americas… 1.
Goldman Sachs Research.left axis % of total M&A . Goldman Sachs Research.right axis Source: Dealogic. 2010 United States: Financial Services Exhibit 36: Financial sponsor M&A volumes are off to a soft start in 2010 Financial sponsor backed M&A announcements ($ billions) 350 300 25% Exhibit 37: …but dry powder remains at record levels Committed but not yet invested private equity capital globally (as of Dec ’09) 600 501 462 379 163 300 186 178 280 100 259 503 62 Asia 250 200 150 100 5% 50 0 2000 Q3 2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3 2007 Q1 2007 Q3 2008 Q1 2008 Q3 2009 Q1 2009 Q3 2010 Q1 0% 15% % of total Private Equity Dry Powder ($ bn) 20% Sponsor Volumes ($ bn) 500 400 EU 10% 200 US 2003 2004 2005 2006 2007 2008 2009 Sponsor Volumes ($ mn) .April 7. Source: Prequin. Goldman Sachs Global Investment Research 19 .
Exhibit 39: Great affordability sets the stage for better sales ahead 60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 Exhibit 38: New home sales are unsustainably low Affordability = Mortgage/Income +1 SD Average . and (3) we expect stability in house prices as lenders continue to work with borrowers to avoid foreclosures. prices have recently shown more stability. See Exhibits 38-39. The strong spring selling season (late January-end of April): We expect positive macro and micro data points suggesting that the Spring. We have already heard plenty of positive micro data points and expect the macro data to reflect this soon.1 SD Source: US Census Bureau. Better industry figures and significant share shift to the large public builders and away from small. Source: US Census Bureau. On the commercial side. The brief slowdown (May-June): As the tax credit draws to a close. but there is potential for more transactions over the course of 2010 and into 2011. All in. We expect three distinct periods of sales activity for the group. private developers sets the stage for better equity prices across the builder space. Goldman Sachs Global Investment Research 20 . sentiment appears to have moved ahead of the fundamentals. when 50-60% of a builder’s annual deliveries are pre-ordered. 2010 United States: Financial Services Theme #4: Real estate prices are stabilizing as the hunt for yield hits real assets While we may just be in the eye of the storm. is going well. Residential real estate showing signs of stabilization Homebuilders are well positioned to benefit from an improvement in new home sales from the very depressed levels of 2009. The likely effect is a much strong March and April than expected but a more subdued May and June. as there is still the risk from ARM resets and CRE debt re-financing. low interest rates have pushed these issues further out into the future. aided by a lower mix of distressed sales. affordability combined with a return of jobs and confidence sets the stage for higher sales from current trough levels. On the residential side. The resumption of growth (July-December): We expect new home sales to return to positive growth as three factors drive growth: (1) the Goldman Sachs economists are expecting non-farm payrolls to begin to grow in March and to continue to do so throughout 2010. (2) we expect mortgage rates to remain low. we expect 1-2 months of pulled-forward demand due to the expiration of the government’s homebuyer tax credit.April 7.
Source: Federal Reserve. While it may seem that we have never had these levels of inventory we note that there were 16 months ahead of the 1982-84 doubling of new home sales.0 Norm al Supply 0. as rates feel in the early 80’s but are unlikely to fall from current levels. The cash on banks’ balance sheets is at much higher levels than ever before.200 US Banking Industry Cash Assets ($bn) 1. 2010 United States: Financial Services Historically. banks have not been price sensitive with delinquent and foreclosed properties but we believe this time is different. The high level of shadow inventory has the potential to make this adjustment this cycle take a lot longer.5 months of total inventory across the United States today with an approximate split of 1:2. Exhibit 40: Inventory is about 18 months. Our conversations with banks and distressed real estate investors suggest that further accommodative policies are being implemented internally. and the number of spec homes it has should enable the company to take share from other builders.000 800 600 400 200 0 01/03/73 01/03/75 01/03/77 01/03/79 01/03/81 01/03/83 01/03/85 01/03/87 01/03/89 01/03/91 01/03/93 01/03/95 01/03/97 01/03/99 01/03/01 01/03/03 01/03/05 01/03/07 01/03/09 Cash at $1.0 Foreclosures 10. Consider: There are 18. new home sales have doubled off the bottom over a two-year period. creating lower urgency to move distressed properties from a bank perspective (see Exhibit 41). After liquidating many foreclosed properties in 2008 banks are much more sensitive to home prices driving lower supply to the market than would otherwise be the case.0 15.0 90D+ 5. given the magnitude of the potential issues if a bank’s entire balance sheet had to be written down to reflect another material decline in home prices. Source: US Census Bureau. We have seen principal reductions and mortgage term extensions grow as percentage of usage in aggregate loan modifications. Historically. however.0 Mar-94 Feb-96 May-90 Oct-03 Jul-86 Jun-88 Jan-98 Dec-99 Nov-01 Sep-82 Aug-84 Sep-05 Apr-92 Aug-07 Jul-09 Note: Data based on quarterly filings. only slightly higher than in 1982 Current + shadow inventory 25. See Exhibit 40. Although we are not expecting a quick doubling of sales.5 as of 3Q09 * Exhibit 41: Cash at banks has created low urgency in moving distressed properties at lower prices 1. DR Horton (DHI) is our favorite name. It is one of the few builders that will be profitable in 2010. with 6.3TN = 11% of total assets 20. we continue to believe that these currently low levels of housing starts and new home sales will not be sustained in a growing economy.5 months of “regular inventory” and 12 months of “shadow”. Goldman Sachs Global Investment Research 21 . Within the homebuilder space.0 Total Months Supply of Home Inventory Adjusted m onths' supply w as 21.400 1.April 7. monthly data points suggest recent decline as sales have increased. One big question on this topic is what the impact of rates will be.
is whether Freddie Mac steps up its put back rate. Specifically. Exhibit 42: HAMP continues to grow which could begin to meaningfully benefit MI losses on a go-forward basis Mortgage Insurance Industry Participation in Home Affordable Modification Program HAMP Permanent Mods (# of loans) 120. the most recent data point (January HAMP report from the Treasury) suggests some early signs of success (see Exhibit 42). See Exhibit 43.444.5% of delinquent mortgages (60 day+). While not yet material to the overall 4. Fannie Mae has been driving most of the volume and the focus is still on the 2007 vintage. cumulative permanent modifications increased to 160.000 loans which have been permanently modified by the servicers and are pending final borrower approval.623 3.421 $18.000 0 Incremental 1Q2010 ► X Implied Mod Jan.265 = Implied Cure Benefit $150.000 40.150. Furthermore. Goldman Sachs Global Investment Research 22 . which are likely to be a risk to banks earnings this year.5 million borrowers behind on their payments. therefore.665. a 75% increase in one month.000. In addition. More importantly. One issue that has come up a lot more recently is rep and warranty charges. there are an additional 76. 2010 Implied Mortgage Insurers Source: United States Treasury Department. Recent data points suggest continued acceleration of put-back requests from the GSEs.936 3.000) is a mere 3. Goldman Sachs Research. this issue will likely last for several quarters / years as it’s still unclear how much ultimately gets put back at this point. it theoretically does so in part due to anticipation of successful mortgage modifications.000 MTG RDN PMI GNW Other MIs 116.465 60.498 Reserve Per Loan $26.662 4.000 20. company commentaries. 2010 United States: Financial Services While shadow inventory continues to grow.611 $19. recent news from Bank of America that they are willing to forgiveness principal for borrowers where loan-to-value ratios are above 120% imply that banks are willing to work with some borrowers.499 5.198 10.621 $76.613 $86. Mods MTG RDN PMI GNW 1.312 1.546. particularly in those circumstances where losses are likely to be significant anyway.April 7.207 MIs = 15% Mortgage Insurers 4Q 2009 HAMP 17. the rate of acceleration is meaningful.000 80.773 $19. A big swing factor.874 1. While the sum of these two (192.000 100.860 MIs = 15% HAMP Jan.116 $68.221 1.297 66.
although data is skewed by GNMA put-backs where underlying risk is guaranteed by HUD $25 bn Estimated Gov't Insured Mortgage Repurchases Estimated Non Gov't Insured Mortgage Repurchases Provisions ($mn) Reserves ($mn) 4Q09 450 400 316 220 59 1. a long-term average of 12x. 4Q08 1Q09 2Q09 3Q09 4Q09 Note: estimates based on BAC's 3Q and 4Q disclosure of gov't vs.1 bn $4.445 49% 2. That said. Capitalization has improved across the sector but on average. Similarly. properties with more challenging capital or leasing hurdles. Source: SNL DataSource.500 200 106 nr nr Amount of Mortgage Repurchases $20 bn $19. we maintain our Neutral coverage view on Regional Bank stocks. and company data. We maintain that CRE values are highly dependant on funding costs as rent and occupancy growth should be modest beyond 2010. Pricing – It has been difficult to assess a base level of CRE pricing as financing remains limited (lack of CMBS) and transactions volumes are off 80% from peak levels of 2007 (see Exhibit 44). We maintain our Neutral coverage view on REIT equities as current valuation has already discounted a robust recovery in fundamentals. the commercial real estate crisis seems to be on hold and in certain examples pricing and fundamentals have improved from the bottom. recent data points indicate that CRE prices have tightened as it seems that there is too much capital chasing too few deals for high-quality assets (see Exhibit 45). STI and FHN.3 bn $0. which make timing of CRE loan losses difficult to predict.7 bn Repuchases by Vintage * Vintage % of Total Pre-2007 2007 2008 20% 60% 20% Ticker BAC * JPM * WFC STI 3Q09 322 300 146 136 26 930 $15 bn *: based on JPM.8 bn 2006 origination share Implied market run rate *: 4Q09 estimated. REITs now trade at 17x our 2010 FFO estimates vs. $10 bn $7. data points are limited thus far as asset transaction and lease activity to date has been low. That said.April 7. 2010 United States: Financial Services Exhibit 43: Bank repurchases continue to increase. CRE as a percentage of total risk based capital remains high at 107%. CRE pricing stabilizing but on low volume. Goldman Sachs research.4 bn $0 bn 1Q08 2Q08 3Q08 $1.9 bn $2. non-gov't insured repurchases.950 Ticker JPM STI FHN FITB BAC * 3Q09 nr 123 61 10 nr 4Q09 1. “extend and pretend” loan modifications by banks remain prevalent. we believe there should be a bifurcation in pricing for Class A assets vs. *: mgmt indicated that the reserves were original established as part of the CFC acquisition and are currently "in the billions". Lastly. While this is encouraging.9 bn FHN Total $5 bn $1. refi gap remains a question In the current low rate environment.9 bn $4. Goldman Sachs Global Investment Research 23 .
a true recovery may take longer than in prior cycles. Goldman Sachs Global Investment Research 24 . Source: PPR.0% 4.9% -18.9% 2011E 7.1% -16. Fundamentals – In most markets. signs of the bottom for rents and occupancy are emerging and we expect comparisons to improve on a quarterly basis over the course of this year.7% -15. Source: Real Capital Analytics.3% 2.7% -18.4% -25.6% -29.0mn 12.0% 8.5% 4Q10E -9. Real Capital Analytics.0% J A J O J A J O J A J O J A J O J A J O J A J O J A J O J A J O J A J O J '01 '02 '03 '04 '05 '06 '07 '09 '10 avg cap rate spread (bps) 600 500 400 300 200 100 Recent CRE Transactions Asset Griffin Towers (office) Columbia Uptown (apt) The Palatine (apt) 8599 Rochester Ave (ind) Value $90.0% 10.1% 2Q10E -16.9% -20.5% Vacancy Rate.8% 5.2% -18.3% Angelo Gordon JV Van Metre Compaies Crescent Heights KTR Capital Partners Seller Maguire Properties Pennrose Properties Monument Realty Panattoni Dev'l Monthly Price Change Index Value (Right Axis) Source: Moody’s. as our economists expect the unemployment rate to pick up over the course of this year and not peak until the first half of 2011. Exhibit 46: FFO year-on-year growth comparison to improve incrementally in 2010 FFO growth by sector Regional Malls Office Apartments Industrial Shopping Centers REIT Average 1Q10E -32.3% -30. For REITs specifically.5% -12.7% -4.1% -15.6% -19.7% 2010E -18.8mn 118.4% -12. See Exhibits 46-47.7% -19. Bloomberg.5% 3Q10E -10.1% 5.6% -2.0mn 11.2% -14.5% 7.5% 2. we expect FFO growth to be flat by year-end and turn positive in early 2011.April 7.0% 4.6% -22.5% -19.0% 2. 2010 United States: Financial Services Exhibit 44: CRE values are still off 30-40% but may be inflecting indexed as of YE-2000 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 100 120 140 160 180 200 Exhibit 45: Spreads still wide but recent deals show tighter bids can be hit as of March 2010 10-Year Treasury 12. Source: Goldman Sachs Research estimates.8% 3. by sector Exhibit 47: CRE fundamentals lag the broader economy – we do not anticipate a recovery until 2012 / 2013 20% 18% 16% 14% 12% 10% 8% 6% 4% 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 M ultifamily Office CRE fundamentals typically lag the economy by 18-24 months Retail Industrial We expect FFO growth to improve on quarterly basis going into 2010 with modest recovery in 2H and 2011.6% -20.6% 3.3% -16. That being said.2% -7.3mn Date Cap rate Buyer Mar-10 Mar-10 Feb-10 Jan-10 8.0% 6.0% -41.0% 4. Market rents have started to flatten out after a period of steep declines in late 2008 and much of 2009.4% -1.
2010 United States: Financial Services Bank losses – The key concern for banks are what losses may ultimately total.April 7.0% 2. Part of the issue is persistency – given the long-tailed nature.0% 1.0% 3. To date.0% 70% 9 10 64% 69% 6. a fraction of the 7% we expect them to eventually realize. See Exhibits 48-49.0% Exhibit 49: It will take 10 years to reach cumulative default Commercial Mortgage Losses: Cumulative recognized to date by banks 4.0% 0.0% 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 GS est 60% 28% 38% 50% 40% 18% 30% 9% 20% 0% 2% 10% 0% 0 1 2 3 4 5 6 7 8 47% 57% 5.5%. Goldman Sachs Global Investment Research 23 25 99% 100% 99% 99% .0% 100% 15 16 88% 91% 17 18 93% 95% 19 20 97% 98% 21 22 Years since origination Source: PPR.0% CRE cumulative default profile 80% 11 12 74% 79% 90% 13 14 83% 85% 7. we expect it could take up to 15 years for banks to fully realize the losses on CRE. Source: Goldman Sachs Research estimates. banks have recognized losses of about 2. Exhibit 48: Banks recognized losses are a fraction of what they may ultimately end up being 8.
00% 1.00% 7. Target Fed Funds * Prior to Yesterday's Discount Rate Increase 38 bp 2 .00% Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 Oct-08 Jul-09 Oct-09 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Jan-10 1 .April 7.75% from some providers and construction loans is around 3%-4%. Goldman Sachs Global Investment Research 26 .00% 6.00% 2. debt service coverage has stayed above 1X (see Exhibit 52).5 0 2003 .0 0 1 . Over 60% of loans in the United States are floating rate. If and as rates start to increase. including increasing the spread between the discount rate and the Fed Funds rate.0 0 Febr ua ry 2 01 0 Impl ied September 2 00 9 Implied 0 . Typically. but have to go up eventually Low rates has unquestionably helped to stimulate the economy. we estimate that the rate on home equity loans is as low as 2. and reducing the outstanding balances in the Term Auction Facility towards zero. One of the big questions with regards to interest rates is whether an increase will cause a new round of credit problems. option ARMs are originated with a fixed teaser rate that is good for a defined period of time. So while many properties have loan-to-value readings above 100% as a result of falling prices. the market expects rates to start increasing as early as the second half of this year. so low rates have helped keep borrowing costs quite low. Source: CME/CBOT. Discount brokers are one of the areas that have the most to gain given their sensitivity to the short end of the curve. but investors have tempered their expectations in recent months. In addition. 2 . but also by supporting housing demand and boosting capital market activity. target Fed funds 8. Goldman Sachs Research.0 0 FEB M AR 10 10 APR M AY 10 10 JUN 10 JLY 10 A UG 10 SEP 10 OC T 10 NOV DEC 10 10 JAN 11 FEB M AR AP R MA Y JUN 11 11 11 11 11 JLY 11 AUG 11 SEP 11 OC T NOV 11 11 DEC 11 JAN 12 Source: Federal Reserve.2007 Median 100 bp *: using mid point of target ranges. Using the CME curve as a proxy. it is less likely that there will be much payment shock. 2010 United States: Financial Services Short rates are likely to stay lower for longer. they forecast the Fed Funds rate to stay near-zero through 2011. Goldman Sachs Research. See Exhibits 50-51.5 0 Exhibit 51: CBOT Fed fund futures now imply 100 bps of Fed rate hikes through May 2011 (vs prior expectations of such hikes by October 2010) Implied Fed funds rate Target Fed Funds Discount Rate Discount Rate vs. For example. While our economists do expect the Fed to reverse most “technical” factors in the near term.00% 0. Exhibit 50: Fed moving discount rate back toward more normalized levels relative to Fed Funds discount rate vs. although higher rates may hurt credit trends.00% 3. if rates start to increase because of stronger growth. outflows are likely to continue as investors move into higher risk-reward assets.00% 4. While money market funds could also gain as yields move back to normal levels. another positive impact of low rates is that as rates on option ARMs reset. not only by cutting funding costs. Regional banks will also likely see an improvement in margins. we would likely review our positioning across the sector.5 0 0 .00% 5.
April 7. After that period. there is some concern that an increase in rates may result in a new round of losses (see Exhibit 52). Goldman Sachs Global Investment Research 27 . delinquencies have picked up following the reset. particularly when the payment shock is high.8 1. Low rates imply that payment shock will fall even further to 20%-30% next year as interest rates stay near zero.4x Change % D60 6m after reset Exhibit 53: Delinquencies positively correlated with payment shock 70% 60% 50% 40% 30% 20% 10% 0% 1-25% 25-50% 51-75% 76-100% 101+% paym ent shock at reset Source: Loanperformance. When the Fed does begin to tighten its fiscal policy and short-term yields begin to shift higher. 2010 United States: Financial Services often five years. net interest margins should move back to more normalized levels. as these companies typically invest cash collateral in LIBOR-based securities but pay out Fed Funds-based rates. Given that 2010 and 2011 are peak years for option ARM resets. We estimate that the average EPS effect on the Discounters for the first 100 bp move in Fed Funds/Treasury yields will be roughly 24% on our 2011 estimates (see Exhibit 54). Similarly. Exhibit 55 summarizes how we would be positioned should rates start to increase. Currently. floating rate LIB+50bp w ith 100bp floor **Cash flow divided by debt expense Source: Goldman Sachs Research One of the biggest beneficiaries of rate increases across the space would be the discount brokers.50% 4. which is down considerably from 160% at the end of 2007. A significant amount of CRE matures over the next few years as well and likely will need to be re-financed. plus a spread. Loan to value 2007 Origination Annual cash flow Cap rate Property value Loan Loan to value (LTV) Loan rate* Annual debt expense Debt service coverage (DSC**) 5 5% 100 70 70% 5.9 1.0x -73% -39% 1.50% 2.0x Today 4 8% 50 70 140% 1. the rate is reset and then floats based on a specified index (often the Monthly Treasury Average (MTA). -20% 1. a rising Fed Funds rate should benefit security lending spreads at trust banks. Historically. payment shock is approximately 30%-40%.3x *Assume 30y amortization schedule. Exhibit 52: Debt service coverage vs.6x -50% 0% 2.
approximately 10% of total industry assets or 40% annualized organic decay. However. The yield differential between money market funds and CDs remains at the historically wide level of 125 bp. deposit mix shift from non-interest bearing to CDs becomes a headwind Trust banks benefit most in a high rate environment after the Fed has stopped rising rates.28 $0.24 ($0. Goldman Sachs Global Investment Research 28 .50 $1. what is important is what is driving the higher rates. In the first quarter. which is likely to keep pushing investors out of money funds.33 $0. But if rates rise because of better growth expectations. then money markets should see inflows as investors flock to safety.17 $0.April 7.30 $0.40 $1. money markets actually see more dramatic outflows as investors move up the risk curve. 2010 United States: Financial Services Exhibit 54: SCHW and TRAD most sensitive to a 100 bp shift higher in rates 2011E EPS Charles Schwab TradeStation TD Ameritrade optionsXpress E*TRADE Financial Average Note: TRAD estimate based on 100 bps increase in US Treasury yield $0. and is one of the key reasons behind our CL-Sell rating on the stock. While higher yields should theoretically also help money market funds given the more attractive yield. See Exhibits 56-57. money market funds saw outflows of nearly $325 billion.80 $0. This would mark a record quarterly outflow for the industry. Goldman Sachs Research.3% Regionals Above 3%.1% Cards (ex AXP) Rationale(s) Immediate leverage to higher rates Business model has become more asset sensitive but it is hard to pass on to customers with Fed funds above 1% Below 1%. Source: Company data.00) % Change 41% 41% 19% 18% (0%) 24% Exhibit 55: The outlook for different sectors when rates rise Fed Funds Best Interest Income Performance Discount Brokers 0% . regionals don't benefit much given interest rate floors 1% . Above 3% Trust Banks Source: Goldman Sachs Research estimates. FII is one of the most leveraged names to money market funds.11 Impact $0. If rates are going up because of inflation concerns. higher rates do not necessarily imply that money market outflows will reverse. The first few increases in rates are usually neutral to negative for trust banks NII.
000 1Q09* 1Q01 3Q01 1Q02 3Q02 1Q03 3Q03 1Q04 3Q04 1Q05 3Q05 1Q06 3Q06 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 -10% -20% -30% -40% 50% 40% Annualized Organic Growth Rate 30% 20% 10% Exhibit 57: The yield differential between MMFs and CDs remains wide 7-day annualized MMF yield versus 1-year CD rate 6. Goldman Sachs Research. Goldman Sachs Global Investment Research 29 .000 200.000 0% 0 -100.0% 2.000 -300.0% 4.0% 125 bps 0.0% 3.000 400. Goldman Sachs Research.0% 5.0% 1.April 7. 2010 United States: Financial Services Exhibit 56: Money market funds are on track to see record outflows in 1Q10 Quarterly money market fund flows.000 100.000 -200.0% Apr-07 Apr-08 Apr-09 Oct-06 Oct-07 Oct-08 Feb-07 Feb-08 Feb-09 Oct-09 Dec-06 Aug-07 Dec-07 Aug-08 Dec-08 Aug-09 Dec-09 Feb-10 Jun-07 Jun-08 Jun-09 Money Market Yield 1-Year CD Rate *1Q10 is "quarterized" Flows (left axis) Organic growth (right axis) Source: Investment Company Institute. 1Q2010 data is quarterized based on 2/18 data 500.000 Money Market Flows ($ mm) 300. Source: Bloomberg.
6 0.0 0.9 -0.1 0.0 PBCT 0.9 1.5 0.7 C 0.0 0.0 0.5 1.0 -0.0 -0.2 0.0 ----0.24 $0.5 0.6 1.6 1.4 PNC 0.1 --0. But.0 0.1 0.2 0.1 0. Assuming USB reports make up 80% of total repo outstanding. none of the legislation. which are currently under development.2 0.1 FITB 0.0 -0.0 Avg 3.9 3.2 0.14 $0.1 --0.8 0.6 0.0 ----0. regulation and proposals has a major impact on its own. So far.2 0.2 0.0 RF 0. (3): estimated using 15bps of Total Assets .96 $0.23 $0.1 MI 0.2 1.0 --0.3 USB 0.8 0.3 BBT 0.21 $0.1 -0.6 -0. there has been a lot of focus recently on the Basel III proposals. given a TARP tax (Financial Crisis Responsibility Fee) + CARD Act + balance sheet caps + overdraft fee limitations.2 -0.g.1 0.0 ----0.1 --0. the CARD act).7 3. (2) banks may pass on costs to customers.4 1. 2010 United States: Financial Services Regulatory issues likely to remain a topic for the foreseeable future While most of the focus recently has been on the Senate version of the financial regulatory reform bill.1 Regionals FHN FNFG HCBK HBAN KEY 0.33 $0.16 15% 23% 15% 15% 4% 7% 6% 8% 12% 8% 13% 24% 16% 5% 2% 5% 6% 6% 0% 3% 7% 7% 7% 0% 13% 7% 2% 7% 9% 2% 3% 4% 5% 1% 15% 0% 2% 8% 6% 6% 23% 2% 2% 4% 4% 3% 15% 0% 0% 9% 0% 6% 15% 2% 0% 2% 0% 0% 4% 5% 0% 2% 0% 0% 7% 4% 0% 2% 0% 0% 6% 0% 0% 4% 3% 0% 8% 0% 0% 6% 5% 0% 12% 0% 0% 5% 3% 0% 8% 0% 11% 2% 0% 0% 13% 2% 21% 2% 0% 0% 24% 0% 15% 1% 0% 0% 16% 3% 0% 2% 0% 0% 5% 2% 0% 0% 0% 0% 2% 3% 0% 2% 0% 0% 5% 4% 0% 2% 0% 0% 6% 6% 0% 0% 0% 0% 6% 0% 0% 0% 0% 0% 0% 0% 0% 3% 0% 0% 3% 6% 0% 1% 0% 0% 7% 5% 0% 2% 0% 0% 7% 4% 0% 3% 0% 0% 7% 0% 0% 0% 0% 0% 0% 9% 0% 4% 0% 0% 13% 5% 0% 2% 0% 0% 7% 2% 0% 0% 0% 0% 2% 6% 0% 1% 0% 0% 7% 3% 2% 3% 1% 1% 9% (1): estimated using 15% of annual deposit servicing charges (5% for trust banks). BAC and C.1 --0.67 $0. JPM.2 0.7 0. Also assuming 10% for trust banks as they reduce the repo books.6 1. Specifically.8 -0.0 0. On the capital side.4 5.7 0. where netting of most derivatives is no longer allowed. we estimate the cumulative impact of potential regulation actions as 9% of our normalized earnings on an equalweighted basis.9 1.10 $0.0 0.5 0. which would affect large US banks with capital market operations such as MS. (2): estimated where not provided.4 3.9 29.0 -0.1 --0. cumulative outcome.43 $0.0 0.8 0.2 0.01 $0.0 --0.0 -0.0 --0.UST Repos. Looking first at some of the proposals that would have a direct effect on earnings. We note there is still a great deal of uncertainty around many of the outstanding issues.2 -0.1 0.15 $0.04 $0.1 --0.3 0.1 0.00 $0. the cumulative effects add up quickly.0 ----0.0 0.0 -0.0 --0.3 AXP 0.2 STI 0.0 --0.2 0.0 0.00 $0.32 $0. (4) assuming 10% decline in b/s size for big 3 banks. One of the main concerns for investors has been the grossed-up leverage ratio.1 0.5 0.39 $0.39 $0. That said. (1) it is unclear which proposals will ultimately pass.4 1.10 $0.9 0.11 $0.9 0.3 0.FDIC-assessed deposits .8 1.2 0.0 -0. although one risk investors struggle with is the final.5 1.1 -0.1 -0.18 $0. and potentially more to come. there are also many regulatory and legislative proposals related to capital and liquidity levels that are likely to have an impact on the sector.1 -0. along with major Goldman Sachs Global Investment Research 30 .2 0.2 Large Banks JPM MS WFC 0.15 $0.5 1.4 0.0 5.07 $0.0 -0.0 CMA 0.2 0.05 $0.0 -0. we expect the net effect to be manageable for most banks under coverage.0 -0.9 0. and (3) some of the impact is already reflected in our estimates (e.3 1.1 -0.8 0.10 $0.5 5. Goldman Sachs Research estimates.37 $0.0 0.2 0.1 0..April 7.04 $0.0 0.0 --0.0 9.1 0.1 0.1 0. similar to banks that provide guidance. Source: Company reports.1 -0.0 0.8 0.41 $1.3 -0.2 WAL 0.9 1.3 0. Exhibit 58: We estimate that regulatory actions could negatively impact banks’ normalized earnings by 9% $bn Regulatory Impact (pre-tax) OD / NSF Fees (1) CARD Act (2) Financial Crisis Responsibility Fee (3) Restrictions on "Liabilities" (4) Restrictions on "Prop" (5) Total Regulatory Impact After-tax Impact S/O (bn) "Gross" EPS hit % of Normalized EPS Impact by Regulatory Action OD / NSF Fees (1) CARD Act (2) Financial Crisis Responsibility Fee (3) Restrictions on "Liabilities" (4) Restrictions on "Prop" (5) Total BAC 0. See Exhibit 58.2 CYN 0.0 0.5 0.0 --0.04 $0.1 --0.4 Trust Banks BK NTRS STT 0.9 0.0 0.0 0.0 ZION 0.0 ----0.5 0.7 Cards COF DFS 0.3 5.9 1.7 0.0 --0.4 0.Tier 1 Capital .0 1. (5): using disclosed % of revenue by bank where applicable.0 0.
Leverage measured using tangible co mmo n equity. banks may choose to exit this market as it becomes prohibitively capital intensive (see Exhibit 60). Goldman Sachs Research estimates. a stringent requirement would likely result in further deleveraging at large banks. non-agency RMBS capital utilization would likely increase to 33% from 5% currently under the new proposal. bank lending and securitization have shrunk by over $1 trillion. B asel III o n a pro -forma basis with no future earnings. RMBS only accounts for 5% of total trading revenue. and as a result. not bigger (see Exhibit 61). Based on our calculations. 10% 0% Revenues * excluding agency M BS Capital Utilization Source: Company data. but at the same time regulatory efforts to make banks hold more capital or to limit non-deposit liabilities both imply that the banking industry would become smaller. 2010 United States: Financial Services international banks such as Credit Suisse. In addition. etc. UBS. leverage on Basel III proposal Exhibit 60: Non-agency mortgage could turn prohibitively capital intensive under market risk proposals our estimate of non-agency mortgage revenues currently as % of total across industry. which has been offset by government lending (via Fannie. Goldman Sachs Global Investment Research 31 . So far this cycle. based on our estimates. private markets must take up the slack. and capital utilization under proposed market risk framework 100% 90% 80% 180x 160x 140x Leverage Ratios 120x 100x 80x 60x 40x Current: 19X average gross leverage ratio Basel III as proposed: 78X average gross leverage ratio 70% 60% 50% 40% 30% 20% All Other Mortgages* 20x 0x C BAC WFC JPM MS WFC C BAC JPM MS M easured as 4Q09 = current. under the proposed market risk framework. changes in b/s size etc. While the leverage threshold has not been set. Part of the reason there is such a focus is the potential impact these new capital requirements will have on credit growth. Source: Goldman Sachs Research estimates. risk weighting for most assets held on banks’ trading books would increase significantly. For the longer term. Exhibit 59: Basel III gross leverage with no netting of derivatives could quadruple leverage ratios current leverage (TCE as denominatory) vs. Deutsche Bank.April 7. Freddie and the FHA). the average gross leverage ratio for the major US banks could quadruple from the current level (see Exhibit 59). For example.
is a likely further reduction in credit availability and liquidity across markets and products. Source: Company reports. consumer and corporate credit outstanding of approximately $23 trillion Outstanding ($TN)* Non-banks + securitization Bank loans Government incl GSEs Total 9. non-banks/securitization and the government/GSEs based on total US mortgage. Forcing large banks to shrink their balance sheets would disproportionately hit consumer credit availability and would also be an issue for agency MBS demand.5 22. The unintended consequence. Goldman Sachs Research. commercial real estate. WFC and MS) have an almost 60% share of total assets and total liabilities (broadly defined) and about 40% of total loans and deposits in the United States.2 6. The top 5 banks in the United States (BAC. Goldman Sachs Global Investment Research 32 . C. in our view.2 7. Source: Federal Reserve. SNL. In addition. and C&I. other consumer. agency MBS and mortgages (see Exhibits 62-63). Exhibit 62: The top 5 banks have more than 50% share of liabilities & assets top 5 banks as % of total US banking industry 60% 55% Top 5 Banks' Market Share 50% 45% 40% 35% 30% 25% Liabilities Assets Loans Deposits 42% 40% 57% 56% Top 5 Banks' Share by Loan Type 50% 40% 30% 20% 10% 0% Cards Other (Managed) Consumer Home Equity C&I US Agency Mortgages Treasuries MBS CRE 16% Exhibit 63: The top 5 banks have large market shares across most products top 5 banks as % of total US banking industry 60% 56% 54% 51% 48% 47% 45% 43% Source: Company reports.April 7. Goldman Sachs Research. Specifically. home equity. In addition they have +40% of the banking system’s holdings in US Treasuries.9 % of US Credit Market 40% 31% 29% 100% YoY % Change -12% -7% +8% -3% YoY $bn Change -607 -552 +495 -664 Private credit is being transferred to Government balance sheet Non-banks and securitization account for biggest piece of credit outstanding and credit shrinkage *: non-financial non-government credit outstanding. SNL. 2010 United States: Financial Services Exhibit 61: Where credit comes from – banks vs. Goldman Sachs Research. JPM. the top 5 banks have more than 50% market share of total credit card outstanding. most proposed bank reforms have been targeted at the large banks.
We summarize these proposals in Exhibit 64. Currently plaintiffs must prove that rating agencies have knowingly and maliciously committed fraud in rating practices for financial gain. while various regulatory changes have been discussed in both houses of congress and by the regulatory bodies (SEC. 2010 United States: Financial Services On the derivatives side. calls for improved trading transparency should help exchanges and firms with electronic trading platforms to attract higher share from OTC markets. The probability of passing this piece of reform remains largely unknown. CFTC). in our view. or the mark-to-market value of the fund's net assets. however. Rating Agencies Financial reform and legal risk Asset Managers/ Discount Brokers Money Market Reform Source: Goldman Sachs Research. Other sectors likely to be impacted include Insurance. benefitting the exchanges or entities that control the clearinghouses for those products. pushing the industry one step closer to a floating NAV structure. rather than the stable $1.an unexpected move. In addition. there has been little actual change in the past year. should Basel III or similar measures be implemented. which has a much lower burden of proof and consequently would significantly increase legal risk for both MCO and MHP. This is not to say that all of the regulatory reforms are solely directed at the banking sector. Moreover. with any implementation of a transaction tax or curtailment of risk-taking. Possible excess capital would be free to support new business. funds now have to disclose "shadow" NAV. thereby driving up the risk weighting of non-cleared assets. Paul Volcker is pushing for higher capital requirements.April 7.00 NAV on a monthly basis . Under the proposed bill that legal pleading standard would be changed to recklessness or negligence. Goldman Sachs Global Investment Research 33 . As part of the SEC's MMF reform. Downside risk to volumes remains as well. the Rating Agencies and Asset Managers/Discount Brokers. boost investment returns or be returned to shareholders The current House and Senate versions of the Financial Reform bill have language that would negatively impact the rating agencies from a legal risk perspective. more trading assets are likely to be cleared. firm-appropriate risk management practices. rewarding those firms that effectively do so with increased capital flexibility. Exhibit 64: Current regulatory proposals likely to affect Financials Sector Insurance Topic Solvency II/International Financial Reporting Standard (IFRS) Description The aim of these proposals is to incentivize firms to use modern. However.
While we continue to believe valuing the mortgage insurers is best done on a residual value basis. b) the benefit from low rates in fee businesses . stand out as an exception as we are starting to see some price increases there. Buy: JPM*. That said. Homebuilders and Brokers Exhibit 65: Key themes across Financials (* are stocks on the Conviction List. will benefit most. and future appetite from mortgage originators for private mortgage insurance is at best unclear. The credit cycle is moderating and net interest margins are expanding. future pricing. BX* Sell:FII* Market Structure (Neutral) Dan Harris Buy: NDAQ*. Goldman Sachs Global Investment Research 34 . We have a Neutral view on Market Structure. realization of large reserve deficiencies. are potential acquisition targets. We maintain our Attractive view on the Asset managers as we believe 2010 will be a year of both retail and institutional rerisking. with a favorable bias towards NDAQ and CME. Personal lines.mortgage and capital markets. We are Neutral on regional banks. remain comfortably above last year's levels. as our thesis that high but stable unemployment = lower delinquencies is now playing out. We believe residual value represents the best proxy for potential value as the uncertainty around GSE reform. 2010 United States: Financial Services Sector views: Attractive Large Banks. the near term implications from recent proposals to incorporate principal forgiveness into mortgage modification programs has the potential to be a significant positive for the mortgage insurers. we have a positive bias toward the small and mid-cap companies. and c) attractive valuation at ~7X normalized earnings. but at the wrong time. We believe the smid-caps have simpler business models with more stable returns. trust banks are stuck with trough earnings and trough valuations. PGR. Credit quality is rapidly improving. LNC Sell: HIG Non-Life Insurance (Neutral) Chris Neczypor Buy: XL. while the big banks also provide an avenue to play the credit theme. notably interest rates and F/X. We prefer names with leverage to credit but also the ability to grow assets outside of card. In the context of our Cautious coverage view for Life insurance. Consequently. We prefer names that are inexpensive on normalized earnings and/or exposed to corporate credit which is improving quickly. though we generally believe exchanges and more specifically those with clearing houses. We maintain our Neutral coverage view for Non-life insurance as we lack conviction that the next two years will bring evidence of a turn in the pricing cycle. and thus have unwarranted valuations compared to larger peers given strong capital positions and less risky portfolios. however. The key cycle drivers-a collapse in ROEs. ACE Sell: ALL Mortgage Insurance Chris Neczypor (Neutral) Buy: MTG Sell: PMI Asset Managers (Attractive) Marc Irizarry/ Alex Blostein Buy: BEN*. while equity options and cash equities are lower. BAC* Buy: STI*. Asset Managers. coverage view for each sector is shown) Sector Equity research Large Banks (Attractive) Regional Banks (Neutral) Trust Banks (Neutral) Credit Cards (Neutral) Richard Ramsden We are Attractive on large cap banks given a) outsized exposure to consumer credit which will improve even in a high but stable unemployment environment. and a decline in cash flow-have yet to emerge. These are good businesses that generate lots of capital. loans are shrinking at over 10% per year as well making the risk/reward more balanced. future leverage.TO Source: Goldman Sachs Research. We believe the large caps face weak organic growth prospects and that investors are still focused on tail risk and capital given regulatory and rating agency uncertainties. this shift should drive higher fee rates and further margin improvement at still palatable group valuation of 17X 2010E P/E. KEY Sell: HCBK na Analyst Key Themes Top Stock Ideas Brian Foran Brian Foran Brian Foran Buy: DFS Life Insurance (Cautious) Chris Neczypor/ Chris Giovanni Buy: UNM. Our top pick in the space remains MTG where we estimate residual value to be between $15-16. Regulatory changes remain significant catalysts and overhangs. Trust banks are in the right place. but ~40% of revenues are tied to interest rates and FX volatility and right now both are a big drag. CMA.April 7. CME Sell: X. Our framework for picking stocks in a soft market focuses on finding relative value within the space. Overall. Volume trends in certain asset classes. but on the flip side loans are shrinking and valuation is ~10X normalized EPS. driving stronger flows into long-dated asset classes and away from lowering yielding money market funds. As a result. FITB.
we believe 2011 EPS estimates remain too high. We continue to highlight REITs with discounted multiples vs. We maintain a Neutral ratings for both Moody's Corporation (MCO) and McGraw-Hill (MHP) but believe double-digit earnings growth potential and highly efficient cash flow conversion are compelling drivers as the global debt markets continue to recover and grow. 2010 United States: Financial Services Exhibit 65 cont'd: Key themes across Financials (* are stocks on the Conviction List. Concerns over regulatory reform. BPCEGP. Continuing concerns include GSE-resolution (the debate is just beginning but contains potential seeds of uncertainty over the future demand for private MI). The pricing cycle remains a defining industry issue. BPO and TCO). given our 'lower for longer' interest rate view. Recent positive news include an increased focus on principal forgiveness on the part of both private and public entities and a reported jump in cure rates. We favor ETFC for its credit exposure rather than rates exposure. Focus remains on restructuring stories as liability management transactions continue and the divergence in spreads is still wider than in the US banks. 1Q earnings less of a driver of performance in our view as investors focus on the longer term reform implications. Announced M&A is up. Spreads offer better value in our view in both cash and CDS with exception of Italian and most of French banks where spreads remain tight. The investing framework within our coverage is to "Buy the Profits. LAZ. while FICC should increase up to 50% QoQ. STANLN U: ISPIM. and within our preferred triple-B p/c space we favor short-tail personal lines writers such as Farmers. suggesting advisory firms will have strong backlogs and somewhat softer results. PJC Sell: JEF Buy: ETFC Sell: na Buy: CBG* Sell: BRE* na na Buy: DHI* Sell: Louise Pitt OP: BAC U: WFC OP: LLOYDS. That said. Goldman Sachs Global Investment Research 35 . and the ability to support both embedded losses and more robust new business with current capital bases. though completed trends are lower. We are Neutral on the MI space as we see potentially positive swing factors being counter-acted by continuing uncertainties. though the leverage to rising rates is significant. Within the non-life space. One of our favorite names from a fundamental perspective has been Unum. we prefer relatively wider triple-B names to the much tighter “top of class” names. they have not disappeared. still-nascent economic and housing recoveries. Today REITs trade at implied cap rates close to 7% which we believe is acceptable given how risk free rates currently are. we view valuation as fair from an implied cap rate basis. we also maintain a Cautious outlook as we believe upside for investors remains hindered through 2010 due to unclear risks posed by potential regulatory and legal reform. CNA U: ENH Mortgage Insurance Donna Halverstadt/ Amanda Lynam OP: RDN U: PMI ** Rating Agencies and Tax Preparers fall into our Specialty Finance coverage group. Buy: EVR*. We are Attractive on the homebuilders as five factors are like to drive higher equity prices for the space: (1) a solid spring selling season (2) further stability in home prices (3) low mortgage rates (4) a return to positive non farm payrolls and (5) the share shift to large public builders away form small private developers." After 3 straight years of losses we believe that builders with 2010 profits will outperform the space. coverage view for each sector is shown) Sector Analyst Key Themes Top Stock Ideas Smid-cap Brokers/ Boutique M&A (Attractive) Discount Brokers (Neutral) Dan Harris Dan Harris REITs (Neutral) Jay Habermann/ Sloan Bohlen Rating Agencies (Cauious**) Sloan Bohlen Tax Preparers (Cautious**) Sloan Bohlen Homebuilders (Attractive) Credit research US Banks (Attractive) European Banks (Attractive) Josh Pollard Our Attractive coverage view is based on a longer term improvement in capital markets. peers as our top REIT stock picks (CBL. Our Neutral coverage view is predicated on the offset of slowing trading trends offset by the longer term opportunity for earnings improvement through interest rate changes. Both HRB and JTX have lost market share seasonto-date for various reasons but in summary we believe pricing power for traditional "brick and mortar" tax prep services has been impaired and presents potential structural challenges to the current business model. BNP Louise Pitt Insurance Donna Halverstadt/ Amanda Lynam OP: Farmers. However. capital guidelines and resulting rating agency downgrades dominate the sector once again as issuance volumes are light and spreads continue to remain firm. which has been/remains in a much more stable space compared to traditional ‘life’ names. Source: Goldman Sachs Research. though 1Q results are likely to be soft. We remain Neutral rated on REITs and while the shares seem expensive on most commonly used metrics such as P / FFO or NAV and dividend yield. While the intensity of concerns over capital and asset quality in the Life space have subsided. ACAFP. We remain Neutral rated on HRB but keep a Cautious outlook given headwinds presented by both the macro environment (high unemployment) and changing consumer preferences (shift to digital). We favor Evercore and Lazard for their opportunity to gain market share in M&A over the next year. Relatively tight spreads drive our Neutral rating on the UNM bond. Concerns over new capital guidelines also worrying investors but realization of bondholder losses in stress scenarios has been more prevalent in parts of Europe so this is less of a “new” risk.April 7. but relative to other insurance names we find it attractive in CDS. Equities trading is likely lower.
CFA Richard Ramsden Brian Foran Daniel Harris.00 Target price Upside/downside period to target price 12 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 6 months 12 months 12 months 12 months 12 months 12 months 12 months 6 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 14% -15% 7% 15% -33% 23% 11% 8% 8% 19% 5% 42% 11% 30% -21% 12% -8% -12% 2% 19% 17% 29% -14% -13% 17% 3% 29% -56% 23% 3% -5% 18% Analyst Christopher M. SunTrust Banks.7 0.00 1. Neczypor Richard Ramsden Marc Irizarry Jonathan Habermann Marc Irizarry Sloan Bohlen Brian Foran Brian Foran Daniel Harris. Fifth Third Bancorp Hudson City Bancorp. Comerica. 2010 United States: Financial Services Exhibit 66: Price target data for select financial stocks Company name ACE Limited The Allstate Corp.20 28. Inc.gs. E*TRADE Financial Corp.00 23.00 130. please see our previously published research. Inc.P.62 112. please go to http://www. CFA Marc Irizarry Brian Foran Brian Foran Christopher M.49 45.00 3.93 1. Source: Goldman Sachs Research. Horton.53 25.36 29.47 Target price 61. Inc. The Progressive Corporation Piper Jaffray Companies Inc.00 21. Comerica.00 47. Inc.0 17.8 3.31 15.67 6. Inc.7 53. Inc.7 11.0 25.81 28.00 16. The Hartford Financial Services Jefferies Group Inc. Ticker ACE ALL BAC BEN BRE BX CBG CMA CMA CME DFS DHI ETFC EVR FII FITB HCBK HIG JEF JPM KEY LAZ LNC MTG NDAQ PGR PJC PMI STI UNM X.00 55. Neczypor Christopher M.7 7. Inc.6 14.77 18.00 44. Neczypor Daniel Harris.3 5.2 1.00 17. Lincoln National Corp. The PMI Group. Inc.00 44.00 20. Neczypor Brian Foran Christopher Giovanni Daniel Harris. XL Capital Ltd.5 4.5 9.9 16. CFA Christopher M.00 10. Unum Group TSX Group.html.54 19.9 1.32 8. The Nasdaq Stock Market.4 4.90 40. CFA Christopher M.4 2.00 28.68 16. Neczypor Daniel Harris.79 314.83 37.00 35.com/research/hedge. Inc.TO XL Sector Insurance Insurance Banks Asset Managers REITS Asset Managers REITS Banks Banks MktStructure Banks Homebuilders MktStructure MktStructure Asset Managers Banks Banks Insurance MktStructure Banks Banks MktStructure Insurance Insurance MktStructure Insurance MktStructure Insurance Banks Insurance MktStructure Insurance Rating Buy Sell Buy* Buy* Sell* Buy* Buy* Buy Buy Buy Buy Buy* Buy Buy* Sell* Buy Sell Sell Sell Buy* Buy Buy Buy Buy Buy* Buy Buy Sell Buy* Buy Sell Buy Market cap (current) Price 18. Neczypor Daniel Harris. CFA Christopher M.P.6 13.9 6.R.52 14.00 28.00 27.2 3.2 6.50 25.00 25. Neczypor For important disclosures. J. CME Group Inc.00 26.30 14.05 14. KeyCorp Lazard Ltd. CFA Brian Foran Joshua Pollard Daniel Harris. Discover Financial Services D. MGIC Investment Corp.79 40.00 10.6 3.2 8. The Blackstone Group L. Evercore Partners Inc.45 42.00 26. CFA Daniel Harris.1 20.00 375.40 31.April 7.00 18.00 54.00 25. Inc.00 16. CFA Christopher M.6 185.5 1.4 7. BRE Properties. Goldman Sachs Global Investment Research 36 . Morgan Chase & Co.56 32.71 30.00 18.2 2.52 36.23 40. CB Richard Ellis Group Inc.00 20. For methodology and risks associated with our price targets.1 6. Neczypor Christopher M.42 19.9 9. Federated Investors.17 11.36 11.68 26.1 178. Inc.51 21.00 25.2 0.00 13.9 8. Bank of America Corporation Franklin Resources.
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