The Velocity of Capital

By Kenneth Cline

NationBank's James H. Hance Jr. discusses capital, stock buybacks and the advantages of purchase accounting

Capital lies at the heart of strategic thinking in the banking industry today. From San Francisco to New York, top executives debate how much capital is sufficient, where it can be deployed most profitably, and how much should be returned to shareholders. Capital also plays a big role in acquisitions, since the accounting treatment, purchase or pooling of interest, can strongly affect reported earnings and regulatory capital ratios.

All of these issues bubble on the front burner at NationsBank Corp. The $188 billion-asset superregional has always aggressively leveraged its capital. Now, it is using still-controversial purchase accounting to acquire Boatmen's Bancshares Inc., St. Louis, in the nation's third-largest bank merger. As a result, NationsBank faces a temporary decline in its capital ratios after the deal is consummated in January of next year, as well as a continuing drag on reported earnings provoked by the amortization of Boatmen's-derived goodwill.

The man best qualified to discuss the strategy behind NationsBank's capital structure, and its decision to use purchase accounting to buy Boatmen's, is James H. Hance Jr., 52, chief financial officer of the Charlotte-based bank since 1988. Hance is a certified public accountant who joined NationsBank in 1987 after a 17-year stint with Price Waterhouse. He designed the financial structure for all of NationsBank's major acquisitions of this decade: C&S/Sovran Corp., MNC Financial Inc., Bank South Corp., and now Boatmen's. He spent much of 1996 getting ready for a Boatmen's-size transaction by strengthening NationsBank's capital ratios.

In a recent interview with Banking Strategies, Hance admits that hostile reaction to the Boatmen's transaction--"investor pile-on," he calls it--caught him off guard. By agreeing to pay $9.6 billion, or a whopping 2.6 times book, for the St. Louis-based bank, NationsBank dealt its own stock a blow from which it has been slow to recover. In addition to the high purchase premium, Wall Street analysts complained about the 6% dilution in earnings per share NationsBank will incur in 1997. And amortizing the Boatmen's purchase premium, as manifested in goodwill, will penalize reported earnings by about $245 million annually for the next 25 years, which comes on top of the $160 million annual amortization burden NationsBank and Boatmen's already carry.

NationsBank's defense is the same one voiced by Wells Fargo & Co. when it bought First Interstate Bancorp earlier in the year. Forget about the intangibles, or goodwill, Hance says, and look instead at cash earnings and capital build-up after the deal. While the market is more accustomed to bank deals using pooling-of-interest accounting, which restates prior results, Hance argues that purchase accounting provides the acquirer more flexibility to manage its capital through share repurchases. Purchase transactions also permit buyers to offer a mixture of cash and stock, rather than just stock as is the case in a pooling deal. With all these advantages, Hance believes purchase transactions will eventually become standard in the industry.

Time will tell whether Wall Street and the regulators warm up to Hance's view of the world. But the Boatmen's deal clearly affirms NationsBank's status as a leading edge bank, one that is willing to push the envelope a bit further than most in terms of strategic ambition and financial engineering.

Banking Strategies: There is a great debate in the industry on the question of what capital ratios are appropriate. What is the proper capitalization for a bank having the size and risk profile of NationsBank?

Hance: There are several forces shaping capital considerations. One is that banks have more capital on hand. Earnings are rising at a faster pace than dividends, which means capital retention levels are higher (pre-buyback programs).

Two, banks are managing balance sheets more efficiently. You're seeing a much more aggressive posture than, say, five years ago. Institutions are driving out low-earning and non-earning assets. The effectiveness of capital is rising on the strength of off-balance sheet tools (such as derivatives) for managing interest rate risk, securitization, sale/leaseback transactions, and outsourcing. All of that has the effect of lowering balance sheet usage. I call this "the velocity of capital." With more efficient balance sheet management, you get a more efficient use of your capital and therefore more velocity, or return on the capital.

A third factor is a slower loan growth environment, which decreases capital needs.

Then there's the regulatory view of capital. The regulators are modifying their position somewhat. The times are good for banks. We aren't having terrible credit quality problems. The healthier atmosphere permits the regulators to become more flexible.

A counterbalancing force is the desire to please the rating agencies. Banks are interested in boosting their debt ratings. They're being run more like industrial companies: borrowing money in the capital markets, and doing other creative financings, such as preferred stock, leasing transactions and joint ventures. As a result, they want a little better rating. You need a little bit more capital for higher ratings.

So you have all these factors sort of coming together at the same time.

As to what the appropriate level is--great question. You have a huge gorilla sitting out here in the form of nonbank competition. Some industrial companies and investment banks have much lower capital ratios than any of the commercial banks. Yet banks are trying to compete against them head-up.

Banking Strategies: Do you consider that unfair competition?

Hance: That's just the way it is. Is it an uneven playing field? Absolutely.

I think the Federal Reserve in particular recognizes that and is doing what it can to enhance flexibility in the banking system so the banks can compete. The recently proposed changes in the Section 20 rules, which limit the proportion of revenues banks can derive from subsidiaries involved in underwriting securities, will help a lot. In order to meet the old threshold for Section 20, banks carried huge trading portfolios. If the Fed proposal is implemented, you're going to see a reduction in balance sheets and a reduction in the capital needed to compete. I think all of that is really healthy.

Banking Strategies: Is capital a big issue for senior management at NationsBank?

Hance: It's always been a key issue. NationsBank used to be thinly capitalized, by comparison, and now we're not. All our capital ratios--Tier 1, Total and Leverage--have come up about 100 basis points in the last year, to 7.58%, 12% and 6.64% respectively at the end of the third quarter. Meanwhile, the bank has grown and our earnings and return on equity have gone up materially as well.

I think most of the large banks are going to want to maintain Tier 1 capital ratios of at least 7% and Total capital ratios of at least 11%. I say that because most people want to have about a 100 basis-point cushion above the regulatory thresholds for well-capitalized institutions, which are 6% and 10% respectively. I think institutions also are striving for at least 6% on the Leverage ratio. I know we are. Those are all higher ratios than you would have seen in the early 1980s.

Banking Strategies: On the other hand, Keefe, Bruyette & Woods Inc. calculates that your capital ratios, following the acquisition of Boatmen's, will drop significantly below that of peers. Based on your own pro formas, for example, Tier 1 drops from 7.58% to 6.7% at the end of 1997, and the Leverage Ratio falls from 6.64% to 5.7%. Keefe further concludes that an aggressive buyback program will keep these ratios at depressed levels for some years to come. Do you agree with that analysis?

Hance: My belief is our ratios are going to be a little bit higher than we thought. The reason is, we're paring down our balance sheet a little more than we anticipated. So I think it's going to give us a cushion.

We will be down a little bit from our current levels as we go through the early period of assimilating Boatmen's, which is fine. It may put us a little lower than our peer group in some respects. But we're going to have an improved risk mix. In the case of Boatmen's, we're adding a considerable amount of consumer business and general commercial business, which lowers the overall risk profile.

We're comfortable letting our capital ratios decrease a little bit while we go through the transition. They will come back up. And what will bring them back up is earnings. The enhanced earnings power of the consolidated entity, along with tight balance sheet management and balance sheet efficiency, will bring the ratios back up.

Also, intangibles amortization makes them come back up pretty quickly. The Boatmen's amortization is sizable and is a deduction against all those ratios. As the intangibles amortize, the deductions become less and therefore the ratios come back up on their own.

Banking Strategies: How much stock will you actually buy back?

Hance: It's a puzzle, to some extent. It depends on earnings, capital levels, and balance sheet levels. Those are the key components. We've announced a continuation of our 10 million shares a year buyback program. So that's 10 million.

Second, we've announced a 60/40 payout with Boatmen's, meaning Boatmen's shareholders have the right to receive 40% of the price paid in cash. Since we're issuing about 100 million shares total of the "old" NationsBank to Boatmen's, 40 million shares, the cash part, will be bought back. So that's 40 million.

We've also announced the repurchase of 9 million shares as a result of balance sheet reduction and amortization of intangibles in 1997.

So the three repurchase programs total some 59 million shares. There's discussion about how quickly we can do it. Some have asked whether we can do more.

The question is: where are we on earnings, capital and balance sheet levels?

Banking Strategies: So you're saying you can't give a definitive answer because of all the variables?

Hance: Other than the 60 million, which is pretty definitive. Are there more shares? Is the number material? I don't know. How material can it be, against 60 million?

By the end of 1998 I think it's entirely possible that we can be back as if we had not issued the shares for Boatmen's. We'll have to see how it goes, in terms of buybacks, and whether there are other opportunities.

There are a lot of moving parts in the company, which makes it difficult to analyze. It puts the onus on us for better explanations. It's difficult because we're not a single focus company in anything we do. When you add on the expansions like Boatmen's, and the buybacks and various other things we're doing, well, there are a lot of moving parts.

Banking Strategies: Is there any danger that an economic downturn could catch you at a delicate point in your capitalization, when the ratios are down?

Hance: You always have that risk. The flexibility we have, of course, is the share buyback program. You could always suspend it in the event of an economic recession or depression that affected the whole industry.

What you have is excellent cash flow in this transaction, and that cash flow translates into higher capital. It gives us plenty of flexibility.

The operating risk dynamics are considerably less with this deal than they were with C&S/Sovran or First RepublicBank Corp. in Texas, where there was lack of net income. With Boatmen's, we are saying we're going to reduce capital levels slightly during this initial period. But the risk is lessened by the earnings flow and the improved credit complexion or profile of the combined institution.

We've also built our capital levels tremendously over the last two years, so the initial front end drop in ratios will be less than it would have been two years ago. To some extent, we were building the ratios to take on some additional risk.

One of the things that clouds the capital picture is the purchase versus pooling issue. Some of that is accounting versus reality. We're actually going to have some of the highest capital ratios around, until you take out intangibles.

From the rating agencies' point of view, equity capital improves, meaning the total equity-to-assets ratio, which goes from 7.09% currently to more than 9% by the end of March 1997. The rating agencies do not deduct intangibles in assessing capital adequacy. We look excellent from a rating agency point of view. It's the regulators who take the dim view on the intangibles and deduct it. What's influencing that is not the economics of the transaction; it's the debits and the credits, the accounting.

The industrial companies have been doing purchase transactions forever. Nobody ever asks them what their capital levels are. But the focus on tangible capital has been so heavy in the financial services industry that people have tended to do poolings even though the economics of pooling and purchase are exactly the same.

Banking Strategies: When you decided to do a purchase deal for Boatmen's, were you influenced by Wells Fargo's purchase of First Interstate? Was that a model for you?

Hance: Well, I'd say this: We've always preferred purchases here. Always. We have done poolings where it looked to be to our advantage. But we don't like poolings. We don't think a pooling depicts the true picture of what's going on, because it perpetuates the historical basis in values and disregards the fair value of assets acquired or given in a transaction.

Wells lifted the issue into greater visibility. And that was great.

Banking Strategies: Why did you let Wells take the lead?

Hance: To begin with, we didn't have something to buy. We had been raising capital levels and paring our balance sheet and preparing to take on an opportunity if we had one.

Wells paid three times book for First Interstate. The earnings dilution was deadly. But it would have been particularly deadly under a pooling, which would have prevented them from using cash flow from intangibles amortization and operations to buy back shares.

So they got everybody's attention for sure. And they had the credibility of having an established buyback program.

We think we also have credibility in terms of doing what we say we're going to do. We went to purchase accounting to give us more flexibility in the Boatmen's acquisition. It makes a difference. You have a leg up over someone who comes in and has to fight the pooling rules.

Second, it allows us to continue our buyback program and to finely tune where we want capital to be vis-à-vis our assets and our risk posture, without being hammered by accounting rules.

Boatmen's is a $40 billion bank, of which $12 billion is securities. Assuming you had no securities, why would you want to carry the capital for a $40 billion bank and be restricted by the pooling rules accordingly, if in fact you were only going to increase your company by $28 billion? If you do a pooling, and lose the ability to repurchase shares, then it becomes harder to reduce capital quickly, which in turn limits opportunities to trim the balance sheet of the acquired entity.

Banking Strategies: But investors and analysts do object to the hit NationsBank suffers to reported earnings by amortizing the premium or goodwill taken under purchase accounting, which in this case has been estimated at over 60 cents a share for each of the next 25 years. What's your response?

Hance: Counting what we have now, which is $120 million in amortization, the annual amount after Boatmen's is $405 million a year, and that is a non-cash charge.

So you do a couple of things. You tell investors what your cash earnings are. You show what your cash return on equity or cash return on tangible equity is. And you show them what you're going to do with your cash flow.

Remember, goodwill amortization is an accounting adjustment that understates reported earnings but does not actually crimp cash flow. The cash that is deducted from reported earnings can be used for any purpose, including the repurchase of shares. Therefore, we are going to use the $405 million cash flow underlying the goodwill amortization to repurchase shares.

See, what's interesting is you get a very quick ratcheting up in your capital ratios. Once that amortization is gone, it's gone. The reduction from capital is less because you've amortized some of the goodwill. So your capital ratios go up, and that gives you more flexibility for buying back shares. None of that would be true under a pooling. You'd have to wait a while, then use some cash flow to buy back shares. You couldn't do it initially.

Now do I think the industry is ready for all this? Not necessarily. I think it will take some time. But I think you'll see more and more purchases. I think the Securities and Exchange Commission's restrictions on pooling are going to be more and more onerous. You could envision a day when there won't be poolings. It goes against everything else that you see in accounting, which is heavy fair value accounting.

Now you're going to find bankers on the other side of this question. Until the analysts fully embrace it, the market's not there yet. But when that happens, the whole market is going to accept it. Because nothing has happened here except changing the debits and credits. Our Boatmen's transaction either is or is not a good transaction on the face of it. The accounting won't make a difference.

Banking Strategies: The real question is simply what you pay for the customer base, right?

Hance: Yes. In Boatmen's, our rate of growth of reported earnings per-share, that's with the accounting, and our rate of growth with cash earnings per-share both go up. And our net income level ratchets up materially. And we pick up 21Ž2 million customers. Now, from our point of view, we think that's a plus. We also think it's a plus when the return on our investment exceeds our cost of capital. We think anytime we can invest in something that gives us a return greater than our cost of capital we're ahead of the game.

Boatmen's is a yes in all of those categories.

Banking Strategies: But were you personally disappointed by the Street's reaction?

Hance: It was heavier than I expected. I knew we would have a pretty heavy reaction on the basis of pure sticker shock. You typically have a selloff with the announcement of every large deal. When we did C&S/Sovran, the initial reaction was a 7.5% drop in our stock. The initial drop here was 8.5%.

Both at the end of five days, and at the end of 10 days, we had about a 1% spread between what happened with us in C&S/Sovran and what happened to us with Boatmen's, with Boatmen's being a little bit worse. I attribute that to a couple of things. The sticker shock is bigger, just a lot of money. Two, this is a market extension, meaning we went into new territory without any major branch overlap. And three, I don't think people expected us to do anything.

I think we had sort of investor pile-on here. Interestingly, there's very little quibbling about our projected expense savings or revenue enhancements. It's all been price.

Now, could we have paid less and gotten it? No. We're talking a $9 billion price tag here for somebody, no matter what. We're comfortable other competing bids were relatively close.

Banking Strategies: Will your next big deal after this one be a purchase?

Hance: I hope so, personally. We'll just have to see. You never know what the circumstances will be. If companies continue to buy back shares like they are, you're going to have fewer pooling candidates left, by definition, because they will have tainted their own shares. So to some extent, it's going down that path on its own.

I'm a believer that the market is going to be more accepting of this. And I think the regulators will be too.

I think we would have had the same kind of stock market reaction, if not worse, had we done a pooling. I don't think the form of the accounting would have helped us. In fact, it would have hurt us because we would have had dilution that was larger and longer.

I think, in our transaction, we're mixing a little bit of the premium issue with the accounting issue.

Banking Strategies: You've already alluded to downsizing NationsBank's balance sheet. Some analysts have estimated that the balance sheet of the merged entity could decline by between $20 billion and $30 billion next year. How aggressive will you be and what will you eliminate?

Hance: I think those estimates are realistic, for us and Boatmen's together.

There are several general categories. One is just pure investment securities. There are a lot of tools now that allow you to manage interest rate risk without putting investment securities on your balance sheet. We are taking advantage of those tools, which tend to be plain vanilla swaps. The swap market is particularly liquid.

Most investment securities are on our books for the sole purpose of balancing interest rate risk--balancing out fixed rate deposits with fixed rate assets. We have been running our interest rate profile right at zero using cash instruments, but we can do that with other instruments requiring less capital.

Second, with the Federal Reserve proposing to modify the Section 20 rule to allow a higher level of ineligible income, to 25% from the current 10%, it means we can have a much lower level of eligible income. And eligible income, in the Section 20, is trading profits and spread off of trading portfolios. Trading profits and spread are so thin you must carry billions of dollars of Treasury securities to do it. So we've carried billions of dollars of trading assets for the sole purpose of having eligible income.

If the Fed goes through with that proposal, it will make a material difference. We'll be able to reduce the "carry" of the portfolio and that reduces your average capital and your period-end capital needs and frees up capital.

The third major category is securitization. That's being driven by very competitive pricing on the product that is eventually being securitzed. In order to raise the return on equity for that business--be it credit cards, mortgages, or indirect auto--you need to get assets off the balance sheet. You then have less capital in the business and a higher return on equity.

So you're seeing us move aggressively towards what I call a "commoditization" of some of these products. We streamline the form of them, stay very competitive in terms of marketing, but don't hold them on our books.

We've also turned our commercial real estate business into a conduit business, or throughput business. We're doing as much commercial real estate business with our customers as we've ever done. We're just not holding commercial realty loans. They're going into conduits and into pools. And again, that cuts down the balance sheet.

Finally, we've instituted return on asset goals for the first time. The effect of that, for all of our business executives and presidents, the people actually running the business units, is to be very selective on where we're making our money and where we're not. Our lower margin assets are slowly leaving the bank. So that gives a higher ROA, a smaller balance sheet and a lower cost structure. All of that contributes to balance sheet efficiency.

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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