Valuation of the Financial Services Industry

Weekly Corporate Growth Report, Apr 7, 2008 by Dolbeck, Andrew

The financial services industry, SIC codes 60 - 62, covers banking institutions, related credit institutions, and securities brokers. Companies in the financial services sector work closely with both individual consumers and corporate clients to help them meet their financial needs. The industry is subject to considerable regulation and oversight from federal agencies.

Banking and Lending

The banking sector saw only limited profits for the final quarter of 2007, with many banks actually posting losses. Earnings in the sector were offset at many banks by the need to shore up loan loss reserves. In many cases, loan loss reserves had not kept pace with loan growth in recent years. The quality of loans to residential homebuilders has deteriorated in many markets, putting further pressure on reserves. Another factor impacting earnings in the banking sector is a general decrease in the value of securities and investments, including declines in the value of related real estate.

Consumer defaults on bank loans are likely to increase over the coining year. Many mortgages made at unsustainably low introductory rates prior to 2007 are scheduled to reprice this year. Homebuyers expected to be able to refinance their mortgages before the repricing, but the ongoing decline in home values is making refinancing difficult. With their home values low and prices for food, power, and fuel climbing, consumers feel less able to spend, limiting their willingness to pay back loans. The problems in the residential home sector appear to be spreading to other loan markets, including commercial real estate, credit card spending, and auto loans.

The banking sector is under investigation by national regulators due to the current crisis in the mortgage market. US Treasury Secretary Henry Paulson expressed sympathy to complaints that regulators are being overly aggressive in their examination of banks. He noted that regulators have a job to do and if they are being overly vigilant, it is due to the criticism that they may have missed something early on.

Mr. Paulson also stated that he opposed the idea of a government bailout of lenders and investors. Senator and republican presidential candidate John McCain also stated opposition to a government rescue of the lending industry. At the same time, the Federal Reserve Board is making a move to help stabilize the market that has come under criticism as a "stealth bailout" of government-sponsored enterprises Federal National Mortgage Association (commonly known as Fannie Mae) and Federal Home Loan Mortgage Corporation (or Freddie Mac). The Federal Reserve's plan would inject $200 million in the markets by lending Treasury securities in return for collateral including agency mortgage-backed securities.

The Federal Reserve defended the plan, saying that it was not aimed at specific firms and that it would lend Treasury securities to 20 commercial and investment banks in return for a broader set of collateral. The plan does expose the Fed to more risk, but the Fed is accepting only triple-A-rated mortgagebacked securities that are not on a watch list for a ratings downgrade.

The Investment sector

Investment banks and private equity firms provide capital, research, and advisory services to companies contemplating mergers, acquisitions, initial public offerings, and other deals.

Private equity investors contributed heavily to the high volume of mergers and acquisitions in 2006 and the first half of 2007, buoyed by readily available credit. But since the fall of the subprime mortgage market, credit for deals has been much harder to come by and high-dollar deals made in happier times are falling apart as private equity firms struggle to finance them.

The difficult market conditions are creating conflicts between private equity firms and the banks that provide them financing. Wachovia Bank, for example, recently took Providence Equity Partners to court in a move to back out of its commitment to finance Providence's purchase of 56 television stations from Clear Channel Communications.

Equity buyers have also struggled with their takeover targets, seeking to adjust deal terms after seeing company values fall. In August 2007, Lone Star Funds attempted to withdraw from a deal it struck in June with subprime mortgage firm Accredited Home Lenders, since the value of Accredited's shares had fallen about 50 percent. Accredited sued to hold Lone Star to the deal. Lone Star countered by offering $8.50 per share, about 44 percent less than its original bid of $15.10 per share. The companies finally completed the transaction in October at $11.75 per share.

There are still major deals being done in the private equity sector. Recently completed transactions include Vestar Capital's leveraged buyout of Radiation Therapy Services for about $1.09 billion. TPG Capital's acquisition of Axcan Phanna Inc. for S1.07 billion, and Veronis Suhler Stevenson's purchase of Clarion Events for $234.7 million in a secondary buyout from HgCapital. Bank of America is continuing to pursue its proposed $4 billion takeover of troubled mortgage lender Countrywide Financial, despite the company's growing foreclosure rate. Countrywide is also one of at least 14 companies under FBI investigation for possible violations related to the subprime mortgage crisis.