Year-to-date 2011, trust bank shares are all down substantially with State Street (STT) down 26%, Bank of New York (BK) down 30% and Northern Trust shares (NTRS) down 33%. While I view the whole group as oversold and see limited downside to all three companies, I would not expect broad material outperformance until macro/market headwinds stabilize and/or the Fed starts to take measures to normalize the interest rate environment, which is hurting all the companies in this group.
Further Yield Curve Flattening to Pressure Interest Margins
The near-zero interest rate environment continues to negatively impact the trust banks in multiple ways — depressed net interest margins (given highly liquid and short-term nature of their balance sheets), the adverse impact of money market fee waivers and tighter than normal securities lending spreads. Recent trends have deteriorated — over the past quarter, the U.S. Federal Reserve has indicated they will maintain rates at low levels until at least mid-2013 and the U.S. yield curve has flattened further with long-term interest rates compressing. In the near term, I believe some of this interest compression will be offset by much better than expected balance sheet growth — I expect a good bit of this will be temporal, “frictional” deposits that exit as macro conditions stabilize.
I believe that the more important gauge for longer-term trust bank net interest margins is steepness of the yield curve at the short end given the relatively short duration of their balance sheets. I expect the recent flattening of the yield curve to hurt their business over the medium term. Specifically, average 3-year-to-3 month spread has compressed to 47 bps from 89 bps second quarter-to-date — this will likely place pressure on reinvestment yields — each of the three trust banks will see 11-20% of their earning asset base re-price within the next twelve months. This, coupled with no meaningful flexibility left in managing down funding costs, will drive net interest margins lower.
Balance sheet growth could benefit BK and STT
Similar to what transpired during the financial crisis, I expect the trust banks to benefit from a flight to safety given recent capital market deterioration. Specifically, I anticipate investor retrenchment and desire to seek safety with the best capitalized institutions to drive strong 5-6% sequential balance sheet growth, helping to buffer net interest income against continued pressures from the rate environment. As the macroeconomic environment improves some of these frictional deposits may roll off as clients re-engage in the market. While I believe that big, established trust banks could gain business in the current environment, the current Macro scenario is not good for their business models and I do not expect this to change in the medium term.
Market Correction Driving Lower Fees
Global asset prices and the pace of new business installation are key drivers in assessing growth in asset servicing and the asset/wealth management businesses. Importantly, asset mix and pricing is not uniform across the group, with State Street/Northern Trust being more equities oriented and Bank of New York Mellon having a fixed income/alternatives bias.
Global asset values are mostly lower with credit being the exception — the S&P 500 and the MSCI World are down 8% and 13% during the quarter, while trends across alternatives/fixed income were more positive. On an average basis, third quarter asset prices are tracking down from second quarter levels.
I anticipate the step back in assets prices will drive lower revenues for the custodial/asset management businesses while new business installation will provide a modest offset.
As trust banks are hurt in their interest margins, they focus on controlling expenses
In the last quarterly results, BK surprised with a positive operating leverage in the quarter. Keeping operating expenses under control is essential for improving return for shareholders, and the market was encouraged by the fact that expenses came a tad below their level in the second quarter, though still 6% higher than last year. I expect the trust banks to make more progress in the expense front in the coming quarters.
In addition to BK, State Street announced a multi-year efficiency program to save $575-$600 million (10% of 2010’s Opex) while Northern Trust continues to create a plan to “slow the pace of expense growth.”
If interest rates start normalizing, BK has the most benefit. I think this is the reason why Don Yacktman likes BK more than the other trust banks.
While higher short-term interest rates should ultimately provide a lift to fundamentals, I believe it is important to distinguish the timing and cadence of the fundamental impact as the trust banks will benefit in varying degrees. U.S. custodial bank business models are liability sensitive given their predominantly institutional client deposit base within their asset servicing franchises; this is less so the case in Europe.
As such, I would not expect a material improvement in net interest margins until several months to a year post a change in stance from the U.S. Federal Reserve. Given that, I would expect a smoother rise in U.S. Fed Funds to be more beneficial to near-to-intermediate term trust bank net interest margins.
What is more immediate in a rising rate environment will be the alleviation of money market related headwinds (alleviation of money market fee waivers, improved distribution fees) and securities lending revenues (wider spreads). I found an interesting research from Goldman Sachs that evaluates which trust bank could benefit better from a normal interest rate scenario.
Collectively, the analysts believe Bank of NY Mellon and Northern Trust should be disproportionate beneficiaries here.
■ BNY Mellon: 100 bps shock = $450 million increase in pre-tax income (interest
income $250 million and money market fee waivers $200 million). Applying BK's tax
rate and current share count, this would translate to $0.25 or 10-12% of 2011E
operating EPS. For BK fee waivers are negatively impacting earnings by $0.15
annually (approximately 60% recovered from first 25 bps move).
■ State Street: 100 bps shock = $93 million net interest revenue. Applying STT's tax
rate and current share count, this would translate to about $0.15 or 4-5% of 2011E
operating EPS. State Street does not have much in the way of a drag from money
market fee waivers.
■ Northern Trust: 100 bps gradual increase = $139 million pre tax income ($72 million
interest revenue, approximately $67 million money market fee waiver alleviation).
Applying Northern Trust’s tax rate and current share count, this would translate to
about $0.35 or 12-14% of 2011E operating earnings per share.
I believe that BK has one of the most respected franchises in the banking industry and could benefit from a more normalized environment. But I think that scenario won’t come in the near future and the stock could be affected by macro factors and potential regulations.
Looking forward, I believe if the Fed slows more than expected in normalizing rates, the industry may move to increase fee realization within the core servicing business by re-pricing and/or unbundling its services to customers. I do not believe, however, that any meaningful payoff will occur in the next few years given the lengthy contractual agreements with customers and the potential market share slippage that could come with such actions.