Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
Regional banks have been in focus recently, and I am here with Jim Leonard, a senior securities analyst at Morningstar, to get his take on the industry and the best way to play it.
Jim, thanks talking with me.
Jim Leonard: Anytime.
Glaser: So, let's take a look at regional banks as a whole. How they are performing and how has that been different than some of the larger banks that we might hear about more often?
Leonard: Well, I think what we've seen since the credit crisis--and this has been a theme from us for a while--is that regional banks have continued to improve, have continued to do better, and really stabilized themselves. If you look at some of the credit metrics from the credit crisis--and let's call that, let's say 2008--most of the nonperforming asset reserves are back to where they were at the beginning of the crisis; nonperforming assets to total assets have just about gotten back to where they were pre-crisis.
But one of the critical issues is that tangible common equity to tangible assets, which we can think of as their capital base, has actually improved since the credit crisis. So, for the average regional bank, you would be looking at tangible common equity to tangible assets of, let's say, just over 7%; where nowadays the average bank is almost 9%.
Glaser: These regional banks don't necessarily have the same international exposure, or have some of the same worries that you might have with the J.P. Morgans or the Citigroups of the world?
Leonard: Exactly, it's just complete play on what you would think would be a normal standard bank, which is, they make loans, they take deposits, and they run just a nice, healthy, clean business.
Glaser: So, what's the best way to invest in this sector?
Leonard: Well, one of the things we've noticed, specifically in the credit space, is that there are two types of banks. One bank, where you see the regulator, the FDIC, is happy with the bank, and the bank is at the right capital levels, and that bank is allowed to release reserves to its shareholders, whether it be through dividends or whether it be through share buybacks.
The other type of bank is obviously a bank that can't do that. But what you're seeing is those banks that can't are slowly working their way up to being a bank that can. So, what we are telling investors, specifically on the credit side, is look to banks that are the banks that can't release capital now, but have a positive credit trend. Therefore, you are getting a much higher spread from their debt. Their ratings are much lower, but they will work their way up so that one year or two years down the road, they will look like one of the bank that is allowed to release capital and will have much better capital levels.
Glaser: So, what's one of your favorite banks that isn't allowed to release capital yet?
Leonard: Well, it's a bank that can release capital, but just very small amounts, and that bank is Regions Financial. If you look at Regions Financial, obviously, it's one of those banks that went through the credit crises in poor way, but recently it has been able to repay its TARP, and it's got its nonperforming assets to a level of about under 3%. Now, we would like to see that to 1.5%, but it's much better than the 5% that they had in 2010. And also, like I mentioned before, we see the capital increasing, and they're on that positive trend that we talk about, and they're exactly the type of bank that we'd like for credit people that need a little more spread and need to go out the credit spectrum, but expect that bank to do much better in the next couple of years.
Glaser: So, what's your favorite investment in Regions right now?
Leonard: Well, … one of the things that we have to tell specifically our institutional investors is that the bank is split rated. So, … Moody's rates them high yield/yield junk, and S&P rates than high grade. Now, we rate them BBB-, and so, we would be about the same as S&P. And so, if you're an institutional player, you have to be little careful and make sure that you can invest if you're high grade because you have one of the rating agencies [has a] non-high grade [rating on Regions].
However, we expect that over time, if our thesis is right, they should be investment grade in the future, and some of the institutional players can play down there. But one thing we would say, though, is … we like investors to look at the bank's sub-notes, which is, there is a parent [holding company] and then below that is this bank, and they issued bonds, and we like those bonds, and they have a spread of about 250 basis points, where a normal regional bank would have a spread of about, let's say, 60 basis points. Now, some of that spread is coming from the fact that it is a bank sub-note, where generally that would trade 50 to 75 basis points wider. So, the short story when you add it all up is you're picking up probably about a 150 basis points over a normal A- credit in the regional bank space.
Glaser: Well, Jim, thanks for your thoughts on this space today
Leonard: Thank you very much.
Glaser: For Morningstar, I'm Jeremy Glaser.