Financial Services Industry

Banks in Asia, Europe and Canada are growing more active in underwriting the debt that companies raise to finance buyouts, the Daily Deal reported, mentioning HSBC, Royal Bank of Canada, Barclays Capital, Société Générale and Bank of Ireland.

The non-U.S. banks are handling a larger share of the biggest underwriting deals, although mid-tier U.S. banks such as Wells Fargo and PNC Financial are active in some of the smaller ones.

Bob McCarrick, a senior managing director of corporate finance at GE Healthcare Financial Services, said at a healthcare conference that a weak dollar was helping the non-U.S. banks. The Deal also noted that,

some bankers and private equity sources said the new prominence of the EAC institutions in the U.S. mergers and acquisitions market is because they do not share the balance sheet problems of their U.S. brethren, and do not rely so much on structured financing tools.

None of this is surprising in that stronger players will naturally take on business when weaker ones are struggling. But it could mean that, once U.S. banks turn their situation around, they will still face an uphill battle in regaining the market share they lost during the hard times.

Bill Miller famously outperformed the S&P 500 for the first 15 years he managed Legg Mason’s Value Fund. Almost as famously, he has underperformed that benchmark for the last two years. Now he’s sticking his neck out and saying the worst is likely over in the financial sector.

For planning purposes, here is my forecast: I think we will do better from here on, and that by far the worst is behind us. I think the credit panic ended with the collapse of Bear Stearns, and credit spreads are already much improved since then. If spreads continue to come in, the write-offs at the big financials will end, and we may even have some write-ups in the second half instead of write-downs.

Write-ups? Now that would be refreshingly new. Miller argues that valuations are attractive, and that once momentum begins to fade from the market, value investors can start scavenging. He said some housing and financial stocks have hit bottom, suggesting many believe they have seen the worst.

There is one factor that could undo this optimism, and it’s commodity prices. If commodities break, or even just stop their relentless rise, equity markets should do well. If they continue to move steadily higher, they have the potential to destabilize the global economy.

No one wants that dire scenario. But despite the past two years underperfromance of his fund, it’s interesting to see a big name coming out and arguing that the bottom is near for financial companies. Not quite persuasive, but interesting.

Union Bank of California has fared much better than many larger banks in the face of a souring mortgage market, but that hasn’t kept it from taking a more cautious approach. So it’s selling its insurance subsidiary, Union Bank Insurance Services, to BB&T Insurance of Raleigh, N.C.

Terms of the deal weren’t disclosed, but Union Bank said it would record an $11 million after-tax net gain from the transaction.

The San Francisco Business Times pointed out that Union Bank credit is actually faring relatively well.

The bank’s credit quality was another bright spot. The bank charged off as uncollectable $12 million in loans. Non-performing loans stood at 0.23 percent of total loans. In the bank’s $14 billion residential mortgage portfolio, only $18 million worth of mortgages were in foreclosure.

The deal was announced on Wednesday, when the bank’s parent company UnionBanCal reported earnings that were down from last year. CEO Masaaki Tanaka took a guarded tone in discussing the company’s outlook.

“We have faced a tougher economic environment than had been anticipated 90 days ago… In these unpredictable times, it is difficult to determine the future and we have chosen to proceed with a cautious outlook.”

Chief operating officer Philip Flynn, meanwhile, suggested that even the bank’s careful approach up until now didn’t foresee the softness in the market.

“Deterioration in our homebuilder portfolio was more rapid than anticipated and we are beginning to see weakness in related sectors … Given our current economic outlook we have adopted a guarded outlook for the remainder of the year.”

If you wasted as much time watching Gilligan’s Island reruns as I did, you might remember the (now prescient) episode where the island was running dry of drinking water.

The Skipper assigns Gilligan the task of guarding the water well. While Gilligan sleeps on the job, the other castaways fetch out water to drink. When they are caught by the Skipper, he says they should be ashamed of themselves. Mr. Howell replies,

“I’m ashamed we got caught.”

Mr. Howell’s words came to mind as Nomura, Japan’s largest brokerage, was caught red-handed involved with insider trading. A Nomura trader bought $114,000 worth of Fujitsu Devices, later bought by Fujitsu in a deal Nomura advised.

But the real news isn’t that a Japanese investment bank was involved in insider trading, but rather that one erred in an unknown manner that angered bureaucrats enough to slap it back into line.

With Japanese finance, you have to read between the lines. Let’s look at Bloomberg’s coverage (I used to cover Nomura and other brokers for Bloomberg years ago).

Nomura … fell for a second day in Tokyo on concern it may lose customers after an employee was arrested in connection with alleged insider trading.

Japan’s Pension Fund Associates, which manages 13.2 trillion yen ($128 billion), said yesterday it stopped doing business with Nomura. Daiwa Securities SMBC, the nation’s second-largest investment bank, was forced to suspend some operations for a day after two former bankers were indicted for illegal trading in 2003.

Everything rides on that phrase “was forced”. But unlike some free-market paradise that would bring a smile to Adam Smith’s face, this force was an unseen hand that had nothing to do with markets and everything to do with bureaucracy. The government is punishing Nomura, as it did Daiwa.

It’s not that insider trading is more rampant in Japan than in other developed markets. Rather, companies don’t get punished unless they color outside lines that are drawn to benefit all players. We may never know Nomura’s real transgression, but whatever it was it’s now paying a dear price for it.

Anyone who’s ever been through a bad breakup has got to give credit to Alliance Data Systems. The Dallas-based credit card transaction processor ended its $6.4 billion agreement to sell itself to affiliates of Blackstone Group. And it added this message: “It’s not me, it’s you.”

To drive home that point, ADS is asking Blackstone for $170 million.

The two companies agreed on a deal last May. A month ago, ADS sent notice that Blackstone, which has been battered about by the market turmoil and seen its stock decline 40 percent since its IPO, was in breach of the terms of the acquisition and wasn’t using its “best efforts” to complete the transaction.

This is just the latest legal salvo that ADS has fired across Blackstone’s bow, in a courtship that long ago went sour. As the Daily Deal points out,

Alliance Data first sued in January to bring Blackstone back to the negotiating table after the New York-based private equity firm said it did not expect the deal to go through due to onerous federal regulatory requirements. Blackstone balked at demands from the Office of the Controller of the Currency that it provide a $400 million guarantee of credit support to an Alliance banking subsidiary that the OCC regulates.

The damage to banks caused by underperforming or defaulted mortgages is well known. Now there is starting to be evidence that banks are getting hurt by another big area of the real-estate industry: development.

Builders have taken out loans for developments in what had been some of the country’s hottest real estate markets. But falling home prices and rising default rates among homeowners is leaving those new housing projects in the lurch.

As companies report their financial conditions for the first quarter, there is mounting evidence that the builder loans are not only dragging on business, but may force some to raise loan-loss reserves, the American Banker said.

KeyCorp and Comerica were among the companies that cited deteriorating loans to home builders in Southern California when they showed worse than expected conditions.

BB&T Corp. said it tripled its loan-loss provisions. PNC Financial cited slowness along the mid-Atlantic seaboard. And Zions Bancorp. pointed to weakness in the Southwest.

PNC Chairman James Rohr put it bluntly in a conference call this week:

“We are in the worst housing market in recorded history of the United States.”

Comerica, which saw its net chargeoffs rise nearly six times over (and raised its loan-loss provisions in tandem) expects more. Its CFO Beth Acton told the Banker that she expects more of the same through the fall at least.

Eric Upin, who left his post as Chief Investment Officer for Stanford University’s investment group, has resurfaced at VC shop Sequoia Capital.

He’s not going far: moving his desk a mere four miles as the crow flies. But there are whispers that, what this job jump lacks in geographical shift more than makes up for it in the strategic shift of his new employer. Private Equity Hub’s Dan Primack, who broke the news, mulled its meaning.

Details are a bit sketchy as to what he’ll be doing, but sources believe that this could be the beginning of Sequoia’s long-rumored hedge fund practice. The Menlo Park-based firm has not yet discussed Upin’s role with all of its limited partners, although a few are being used as sounding boards.

This could be a case of rumors getting ahead of themselves. Upin, who covered enterprise software at Robertson Stephens before heading up its research desk, has no hedge-fund experience but deep connections in the Valley.

What’s more, as the Daily Deal observed, a representative of the VC industry testified last autumn before Congress that venture shops were more interested in building companies than “financial engineering.” But Sequoia may be an exception.

Well, at least the first exception. The Deal’s Alan Sherter wrote,

Sequoia isn’t your average venture firm. VC blue-bloods such as Michael Moritz and Roelof Boetha and a history of splashy exits have made it an industry bellwether. If Sequoia really is jumping into hedge funds, other VCs will be be tempted to follow suit. Their “unique argument” would look all too common.

One of the scary things about the Great Credit Crunch of 2008 is that the contagion of lending fear could spread from mortgages to other activities dependent on debt - such as credit cards, home equity loans and even student loans.

And now, halfway through April, exactly that seems to be happening.

We’ll allow the analysis to the students who have the most at stake in this news:

The drought in capital markets for student loans may affect the ability of financial institutions to offer federal and non-federal loans, but will likely hit private lenders like Sallie Mae - who rely on the capital market in order to secure loans - the hardest.

And now the Student Loan Corp., a publicly traded company that is 80 percent owned by Citigroup, is suspending lending to students whose educators it deems as unworthy. It’s also planning to withdraw from the Federal Consolidation Loan markets.

Why? Because near-term profits are more important than financing the education of a new generation who could generate new profits.

SLC said that beginning May 1, it will withdraw from the Federal Consolidation Loan market and will stop lending at schools where loans with lower balances and shorter interest-earning periods are less profitable.

Is this is the worst possible time to be cutting back on student loans? Probably. But if those students were thinking hard about their futures, they might be putting some of their money in the stock of Citigroup. The majority owner of Student Loan Corp. rose almost 3% today. And SLC itself rose more than 10 percent!

If that keeps up, students won’t have to take out loans. They will just have to buy stock in a company controlled by one that has made so many mistakes in the mortgage market that it is willing to deprive students of an education they deserve.

The big loss at Wachovia yesterday may have been a surprise, but according to the company’s hometown newspaper the writing had been on the wall all along.

Charlotte Observer writer Rick Rothacker took a long hard look at the spoke that got stuck in Wachovia’s wheels - Oakland-based Golden West Financial, a seller of non-traditional loans (and home of the “Pick-A-Payment” loan) that Wachovia bought for $25.5 billion in 2005, just as regulators were increasing scrutiny of high-risk loans.

There’s lots of good insight in the piece. Executives stitched the deal together in just 11 days, hardly ample time for due diligence, and then hailed it as a perfect fit.

Cultural differences became clear to some at a one-day training session in Delray Beach, Fla. At a Golden West facility there, one of the company’s executives explained how Pick-A-Payment loans were the answer seemingly to every borrower’s needs, executives recalled.

“We’d call it drinking the Kool-Aid,” said one of the former executives. At least a half dozen top Wachovia mortgage executives would begin leaving after the deal closed in October 2006….

Some Wachovia loan officers have told the Observer that if they didn’t meet certain minimum sales goals, they faced discipline, including termination. The company says it hasn’t fired employees over Pick-A-Payment loans specifically and no longer has goals for selling just that product.

Ironically, when Wachovia CEO Ken Thompson took the reins in 2000, his first major decision was to shut down The Money Store, a troubled California lender acquired under the previous CEO. There were lessons there about trying to mesh a high-risk lender with a more conservative bank. For whatever reason, Thompson quickly forgot those lessons.

Private equity makes up a sizable and growing share of the $53.4 trillion in global assets under management. Yet the private-equity investor remains a faceless if formidable player in the financial markets. The prospectus for Apollo Global Management, filed last week, gives a few interesting glimpses.

Private equity funds– which make up three quarters of the $40 billion in Apollo’s assets under management — seek to build controlling interests in companies, usually through buyouts. If nimble, they can thrive in good times and bad. Apollo, for example, seeks out distressed or underpriced companies in bear markets.

According to Apollo’s filing, if you had invested money the top performing private-equity funds in 1986, you’d have beaten the S&P 500 by 9 percent a year, even after factoring out fees and expenses. Forgetting for a second the other 75 percent of those funds, that kind of statistic draws in big money. Private equity funds raised $282 billion last year, up from $73 billion in 2004.

And who gave them all that money? Apollo’s disclosure on that front is interesting. It’s not just wealthy individuals or corporations, which accounted for only 10 percent and 9 percent, respectively, of its private equity investments. Public pension funds contributed 33 cents on every dollar raised, and endowments another three cents. Foreign governments, however, made up a quarter of the money in Apollo’s funds.

Apollo, in turn, has invested that money in some brand-name companies, Harrah’s Entertainment, Smart & Final and Norwegian Cruise Lines. Some made last year, though, are looking more distressed these days: including real-estate firm Realolgy and troubled mortgage lender Countrywide.