February ’18

The BAN Report: Boards Under Fire at Wells & Wynn Resorts / Has the Regulatory Pendulum Swing? / The Return of Volatility / To Zero, Says Goldman Sachs-2/8/18

Boards Under Fire at Wells & Wynn Resorts

We’ve seen two prominent and recent examples of Board of Directors under attack for failing to do their jobs at both Wells Fargo and Wynn Resorts. On Janet Yellen’s last working day as chair of the Federal Reserve, the Fed sanctioned Wells Fargo.

Responding to recent and widespread consumer abuses and other compliance breakdowns by Wells Fargo, the Federal Reserve Board on Friday announced that it would restrict the growth of the firm until it sufficiently improves its governance and controls. Concurrently with the Board’s action, Wells Fargo will replace three current board members by April and a fourth board member by the end of the year.

In addition to the growth restriction, the Board’s consent cease and desist order with Wells Fargo requires the firm to improve its governance and risk management processes, including strengthening the effectiveness of oversight by its board of directors. Until the firm makes sufficient improvements, it will be restricted from growing any larger than its total asset size as of the end of 2017. The Board required each current director to sign the cease and desist order.

“We cannot tolerate pervasive and persistent misconduct at any bank and the consumers harmed by Wells Fargo expect that robust and comprehensive reforms will be put in place to make certain that the abuses do not occur again,” Chair Janet L. Yellen said. “The enforcement action we are taking today will ensure that Wells Fargo will not expand until it is able to do so safely and with the protections needed to manage all of its risks and protect its customers.”

The Fed also released a letter to its former lead independent director.

You were made aware of sales practices and other compliance issues while you were lead independent director. However, you did not appear to initiate any serious investigation or inquiry into the sales practices problems or put a proposal to do so to the WFC board. In addition, you did not appear to lead the independent directors in pressing firm management for more information 2 and action, even after you were aware of the seriousness of the problems.

That’s the crux of the matter, folks. If Boards become aware of a serious matter at the Company, they are pretty much forced to investigate it. Board members though are often chosen by the very management they need to oversee, and they often enjoy the perks of being on a prestigious board. The correct approach is to hire an outside law and/or consulting firm and have them report directly to the Board. We see the same issue at Wynn Resorts, even after the resignation of Steve Wynn this week.

But at a meeting Wednesday, gambling regulators in Massachusetts, where Wynn Resorts is planning a $2.4 billion casino, raised pointed questions with implications for directors and executives who could have been in a position to know about Mr. Wynn’s alleged misdeeds and didn’t report them.

Stephen Crosby, chairman of the Massachusetts Gaming Commission, zeroed in on an allegation that Mr. Wynn in 2005 paid a $7.5 million settlement to a manicurist.   Mr. Crosby said a central question is what the Wynn Resorts board of directors and executives knew about the settlement and associated allegations, and when they knew it.

Massachusetts regulators have stressed that they are closely investigating not just Mr. Wynn but also his board and the company, and that they are investigating the group’s broader pattern of conduct as opposed to any one specific allegation.

The Wynn Resorts board has consistently received low marks from outside proxy advisory firms for what they have called poor corporate governance practices and its “excessive” executive compensation policies. Half of Wynn Resorts’ independent directors have had seats for more than 10 years, a tenure investors often criticize as being too long.

In addition to an independence problem, there are simply a lack of good board members at many institutions, some of which is by design.    Often, management teams prefer a passive know-nothing board. And, the unintended consequences of regulatory and legal actions against boards is to drive many good board candidates away form serving on boards.

Has the Regulatory Pendulum Swung?

The Trump Administration has now replaced the Comptroller of the Currency, the chair of the Federal Reserve, nominated a new FDIC Chair, and replaced the head of the CFPB, as part of a deregulation agenda. With these changes, have you seen evidence that the regulatory and compliance burden has changed?

For those of you who work at banks, we ask you to answer this brief 6-question survey. It should take five minutes and we will be publishing the results later this month.

The Return of Volatility

Stock market volatility has increased exponentially this month, culminating in a 1,275 drop in the Dow Jones average on Monday, which wiped out all the gains in 2018. The market rebounded in subsequent days, but the increased volatility has rattled investors, while benefiting many trading firms that benefit from increased trading and volatility. Ruchir Sharma of Morgan Stanley believes that this is the new normal.

The fear generated by Wall Street’s sharp fall in recent days had been greatly magnified by the calm that preceded it. Before the 8 percent decline in United States stocks over the past week — which was followed by a bounce back of nearly 2 percent on Tuesday — the S. & P. 500 had gone two years without suffering a drop that large. Spoiled by this unnaturally placid stretch, many Americans had forgotten what a routine market setback even looks like.

They better get used to this. In a typical year, according to data going back three decades, the market experiences a correction of about 10 percent. What Americans are witnessing now is thus a return to normal market behavior, which has never followed a straight line.

This year could be pivotal, because the conditions that underpinned the steady upward march of stock prices are now likely to deteriorate. In the United States and around the world, stocks have been buoyed by the trifecta of accelerating global growth, low inflation and loose central bank policies, all of which are now poised to turn against the bubbly market.

There is a spirited debate right now regarding growth and inflation. So far, there is no evidence that inflation is or will exceed the Fed’s targeted 2% annual increase. But, Mr. Sharma predicts that inflation and tighter money are around the corner.

Fewer workers also means labor shortages and higher inflation. Unemployment rates are close to a 40-year low in developed economies, including the United States. If the United States economy keeps adding 200,000 jobs per month, as it did in January, the unemployment rate could fall below 3.5 percent by the end of the year. And a rate that low has never been sustained in the past.

This looming shortage of workers is now putting upward pressure on wage growth, which has been steadily rising in recent months. And historically, wage growth has been a strong driver of inflation, as workers use their expanded paycheck to bid up prices for goods and services.

Many companies have announced bonuses and wage increases following the tax cuts enacted late last year, so there is certainly anecdotal evidence of wage pressure. But, there is also some heavily stimulus going on from the tax cuts to increased spending in Washington. It is healthy that some irrational bubbles have been pierced, especially the nonsense in cryptocurrencies.

To Zero, Says Goldman Sachs

This week, Goldman Sachs predicted that most cryptocurrencies are likely to fail with their value falling to zero.

Steve Strongin, head of Goldman Sachs global investment research, said in a note dated Monday, that cryptocurrencies don’t have “intrinsic value” adding that it’s “unlikely” whether any of today’s digital currencies are likely to survive in the long run.

“People seem to be trading cryptocurrencies as though they’re all going to survive, or at least maintain their value. The high correlation between the different cryptocurrencies worries me. Contrary to what one would expect in a rational market, new currencies don’t seem to reduce the value of old currencies; they all seem to move as a single asset class,” Strongin said.

“But if you believe this is a ‘few-winners take-most’ situation, then the potential for retirement depreciation should be taken into account. And because of the lack of intrinsic value, the currencies that don’t survive will most likely trade to zero.”

The Goldman research note comes after a violent sell-off in the cryptocurrency market over the past few days, which at its lowest point on Tuesday, saw over $550 billion of value wiped off the market. Bitcoin even dipped below $6,000 for the first time since November.

Most cryptocurrencies are not currencies, in the sense that they are used for transactions. They are merely speculative vehicles and volatile pricing makes them poor substitutes for traditional currencies.   For example, let’s suppose you signed a contract and were paid in Bitcoin. If the price of Bitcoin fell dramatically, would it make sense to perform? We do think there is future in this market, as the currencies market might be the most rigged market in the world. But, a successful cryptocurrency needs to be stable, and widely adopted.

The BAN Report: Crisis at Wynn Resorts / Regional Bank Earnings Roundup / New Tax Law Impact on Banks / Homeownership Rises Again-2/1/18

Crisis at Wynn Resorts

Steve Wynn is perhaps the most important figure in the modern history of Las Vegas, and maybe even the most important person in the history of the state of Nevada.   So, when the Wall Street Journal published an explosive report last Saturday, alleging sexual misconduct, it put the Board of Directors in a terrible position.    Mr. Wynn is involved in all aspects of his hotels with his namesake and signature on the marquee.

The company’s stock dropped 10% on Friday after an article about the accusations in the Journal and shares fell a further 9% on Monday.

But will he be pushed out? The board and investors will weigh whether keeping Mr. Wynn would be better for the company’s long-term value than firing him, and whether any value that is created is worth the hit to its reputation. In a securities filing before the Journal’s report, the company cited the loss of Mr. Wynn as one of the biggest risks to the business: “If we lose the services of Mr. Wynn, or if he is unable to devote sufficient attention to our operations for any other reason, our business may be significantly impaired.” It is hard to say whether casino-goers will shun Wynn properties if he stays; these are casinos, after all.

The Wynn situation is also unique because the casino industry is so heavily regulated. Nevada gaming regulators have typically focused more on historic risks such as mob influence or corruption than on sexual harassment. But a recently appointed top regulator there has said the Nevada Gaming Control Board is “reviewing the information.” Under state regulations, she could cite character as a consideration in the granting of casino licenses, though that would be an unusual step.

Massachusetts may be more important. Following the Journal’s report, the Massachusetts gambling regulator, which granted the company a casino license in 2014, has opened a regulatory review of Wynn. The company has said it “will be fully cooperative with any review the commission chooses to undertake.”

Currently, the Wynn Boston Harbor is under construction, and its gaming license may be in jeopardy.   The property is half-built and is scheduled to open sometime in mid-2019.   Additionally, they are planning on building two new casinos in Las Vegas, developing the old Wynn golf course and building a property across the street on land recently purchased.

The Board has formed a special committee to investigate these allegations.     It should be noted that Mr. Wynn effectively controls 20% of the company, so it wouldn’t be difficult for him to assemble a few large blocks to maintain control.    Clearly, at least some of the Board of Directors (certainly Mr. Wynn and his ex-wife) knew of the $7.5MM settlement paid to a manicurist and failed to disclose it to any regulators or the investing public.

The allegations are very serious and troubling but outing the CEO from a namesake company carries its own set of risks.   There is an easy way out here, if Mr. Wynn decides to leave quietly, but early evidence suggests that will not happen.    Ultimately, the public will vote here as we will soon find out if his situation has an impact on reservations.

Regional Bank Earnings Roundup

In the past, we have analyzed the earnings of the largest four banks, but we thought we’d change things up and look at the ‘Q4 earnings for three representative super-regional banks, BB & T, Fifth Third Bank, and Zions Bancorp.

BB&T Corp.

BB&T Corp. had a solid fourth quarter, earning an adjusted net income of $671 million and adjusted earnings of 84 cents, versus analyst estimates of 80 cents.    Actual earnings were reduced by two one-time events, a $43 million charge related to tax reform, and $22 million in merger and restructuring charges.

“We had a very strong fourth quarter with record revenues and good expense control,” Kelly King, BB&T’s chairman and chief executive, said in a statement.

King has said a heightened focus on expense control, such as the decision to close 147 branches in 2017, for a current total of 2,049, is helping the bank “optimize our structure.” Branches in Denton, Lexington and Whitsett were affected by the decision.

King told analysts during a conference call that the bank expects to close another 150 branches in 2018.

“We’ve still got a lot of small branches in a lot of rural areas, and we’re being much more aggressive in terms of rationalizing that structure,” King said. “You can expect to see that continue for a number of years.”

King said BB&T remains in its self-imposed hold on bank purchases while it is “tightly focused on organic growth and flat expenses.

The one-time charge related to tax reform was interesting, as it was comprised of a reevaluation of deferred taxes and investments in affordable housing projects, a one-time bonus, an increase in philanthropy, and a rise in the minimum hourly pay rate from $12 to $15 per hour, effective January 1, 2018.     They decided to expense certain items in 2017 under the higher tax rate, versus waiting until 2018 when the rate will be lower.  It is also interesting how aggressive they have moved to close branches, especially in rural areas, in which branch utilization is a bit higher.

Fifth Third Bancorp

Fifth Third beat analyst estimates on earnings (52 cents versus 47) but missed on revenue by about 1%.

Fifth Third gained a whopping $220 million from a tax reduction due to a change in how deferred tax liabilities are measured. And it gained $20 million from selling Vantiv stock during the quarter. Those were partly offset by a loss of $68 million resulting from impairment in affordable housing investments and other costs.

The affordable housing impairment, along with one-time employee bonuses and a contribution to the Fifth Third Foundation that combined to cost $30 million, caused noninterest expenses to rise 12 percent from a year ago. Excluding those items, expenses barely budged from the prior quarter, but they rose 2 percent from a year ago.

Net interest income of $956 million rose 6 percent from a year ago. Fee income totaled $577 million. Excluding special gains, it rose 3 percent from the prior quarter.

Rising interest rates helped Fifth Third’s net interest margin of 3.02 percent widen from 2.86 percent in the year-ago quarter.

So, banks that have deferred tax liabilities will see one-time windfalls, versus the one-time expense of a deferred tax asset.     It’s also noteworthy that they are seeing a big benefit from rising interest rates, as their net interest margin expanded.

Zions Bancorporation

Zions released its fourth-quarter results, earning 80 cents per share, surpassing estimates of 73 cents.

Harris H. Simmons, Chairman and CEO, commented, “We are pleased with the results of both the quarter and the year. Fourth quarter earnings per share increased to $0.80, a 33% increase over the prior-year period, when adjusted for both the deferred tax asset revaluation and the larger charitable contribution expense, which were directly related to the passage of tax reform legislation. When adjusted for these items, the efficiency ratio improved materially to 59.8%, and the return on tangible common equity rose to 10.9%, up from 8.4% in the year-ago period.”

Zions saw a one-time charge of $47 million due to the reduction of its deferred tax asset.     They had some interesting commentary on the impact of higher rates.

The net interest margin remained at 3.45% in the fourth quarter of 2017 when compared with the third quarter of 2017. The rate paid on total average deposits and average wholesale borrowings increased by 1 basis point and 9 basis points, respectively. The rate earned on average available-for-sale securities decreased 8 basis points due to increased prepayments of Small Business Administration (“SBA”) backed securities. These changes were offset during the quarter by an increase in the average loan yield (3 basis points), primarily on commercial real estate loans (8 basis points) and commercial loans (4 basis points).

It appears, at least in Zions case, that higher rates will benefit commercial real estate loans yields the most, and funding on core deposits will rise less than wholesale funding with rate increases.   As rates rise, banks with stronger core deposit franchises will see more benefits, especially if they have more floating-rate loans.

New Tax Law Impact on Banks

Last week, the banking Agencies published new guidance to all banks with respect to how the tax reform will impact accounting and reporting.  Not surprisingly, the big impact will be on deferred tax assets and liabilities.

ASC 740 requires DTAs and DTLs to be measured at the enacted tax rates expected to apply when these assets and liabilities are expected to be realized or settled.   As a result of the change in the federal tax rate effective for tax years beginning on or after January 1, 2018, institutions would remeasure their DTAs and DTLs for purposes of reporting as of December 31, 2017. When remeasuring these accounts, institutions would apply the newly enacted federal tax rate to those temporary differences expected to reverse in tax years beginning on or after January 1, 2018. A reduction in the federal tax rate alone would result in decreased DTAs (and a corresponding increase in income tax expense) and decreased DTLs (and a corresponding decrease in income tax expense). The effects of these changes are to be reported in Schedule RI, Income Statement, item 9, “Applicable income taxes (on item 8),” in Call Reports and in Schedule HI, Consolidated Income Statement, item 9, “Applicable income taxes (foreign and domestic),” in FR Y-9C Reports filed as of December 31, 2017. Under ASC 740, institutions that do not use a calendar year tax year may need to schedule reversals of temporary differences at the various applicable enacted federal income tax rates to remeasure their DTAs and DTLs.

Yes, this is highly technical, and these interagency statements have helped many bankers improve their sleeping, but this tax law change will have a significant impact on short-term reporting.

Homeownership Rises Again

For the first time in 13 years, the US homeownership rate rose in 2017, rising to 64.2% in the first quarter.

The homeownership rate rose to 64.2% in the fourth quarter of 2017 from 63.7% a year earlier, according to data released Tuesday by the U.S. Census Bureau. The share of Americans who own a home has been on the rise since the first quarter of last year, indicating a reliable upward trend.

The homeownership rate among households headed by someone under age 35 rose to 36% in the fourth quarter from 34.7% a year earlier. That was by far the largest increase of any age group during the period.

“This is happening because young households are buying homes. Full stop,” said Ralph McLaughlin, chief economist at home listings provider Trulia.

Millennials are entering the market after years of stagnant wages and widespread wariness about the pitfalls of homeownership. After the housing crash that nearly brought down the global financial system in 2008, young people were hampered by tight credit and lackluster wage growth, along with anxiety over the possibility of getting trapped in homes worth less than they paid, as waves of previous home buyers had.

Wait – we thought real estate developers in their 50s and 60s understood these millennials?   They don’t want to own their own home, we were told?   As we have been forecasting for a while, the housing supply in the US is imbalanced with too many apartments being built and not enough condos and single-family homes.

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