banking primer 1

7/27/2019 Banking Primer 1

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E Q U I T Y R E S E A R C H

Andrew B. Collins

Senior Research Analyst

212-284-9310

Steven M. Truong

Research Analyst

212-284-9307

R. Neal Kohl

Research Associate

212-284-9455

LARGE COMMERCIAL BANKS

T H E 6 0 S E C O N D B A N K S T O C K P R I M E R

A P R I L 2 0 0 3


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E Q U I T Y R E S E A R C H April 2003

THE 60 SECOND BANK STOCK PRIMER

The Basics Of Banking Remain UnchangedOver the last 12 months we have witnessedsignificant turmoil within the financial services sector, primarily reflecting severedeterioration in the equities market. We can now revisit the basics of bank stockinvesting within the context of a completely new, lower valuation environment.

The Economy Is 80% Of The Call On Bank StocksWe must make certain assumptions

regarding the U.S. economy to consider investing in bank stocks, and those include thatthe U.S. consumer will remain somewhat healthy, while the corporate environment willslowly stabilize after wringing out the severe excesses of the late 1990s. Key economicdrivers of bank stock price performance are explored.

Credit Quality Can Cut Hard Both WaysUnquestionably, the biggest swing factor inbank stock earnings remains credit quality. We do not foresee a double-dipping U.S.economy; however, under such a scenario we might witness another round of corporatebankruptcies and a weakening consumer. We have provided the key dials and needlesin bank stock financial statement analysis.

Consolidation And Nonbanking Remain The Mega TrendsIn our assessment,consolidation has been one of the big trends in commercial banking for the last 15 yearsand may resurface as a support for stock valuations under a scenario of increased earningsstress. Another mega trend that has turned increasingly detrimental to earnings over thelast two years has been the single-minded focus on fee-based revenues, which dominatedthe mid-1990s.

Risks to achievement of our 12-month price targets include, but are not limited to,deterioration in the broader market; significant weakness in the U.S./global economy; orspecific unforeseen fundamental company-related events which may result in failure toachieve our EPS estimates.

L A R G E C O M M E R C I A L B A N K S


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2 | Large Commercial Banks U.S. Bancorp Piper Jaffray Equity Research

Viewpoint .................................................................................................................... 4Economics And Bond Market Indicators ....................................................................... 5Deals And Needles What Is Really Important When Modeling.................................... 8Loans And Credit Quality .......................................................................................... 11Revenue Components................................................................................................. 15Noninterest Expenses ................................................................................................. 16Capital ..................................................................................................................... 18

Valuation Methods .................................................................................................... 21Price-To-Earnings ................................................................................................ 21PEG Ratio........................................................................................................... 22Price-To-Book ..................................................................................................... 22Some Attractive Yield Opportunities .................................................................... 23

Mega Trends Consolidation, Credit Quality, And Nonbanking ................................. 27Consolidation...................................................................................................... 27Credit Quality ..................................................................................................... 28Nonbanking Trends ............................................................................................. 30Investment Banking ............................................................................................. 30Asset Management .............................................................................................. 31Processing ........................................................................................................... 31Credit Cards ....................................................................................................... 32Mortgage Banking ............................................................................................... 33

Technology And The Evolution ............................................................................ 33

History of Banking .................................................................................................... 34

Definitions ................................................................................................................. 36Index ......................................................................................................................... 46

T A B L E O F C O N T E N T S


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U.S. Bancorp Piper Jaffray Equity Research Large Commercial Banks | 3

Exhibits

1. The Primer Pyramid .............................................................................................. 42. High Yield Spread Versus Bank Stock Index ........................................................... 63. Equities Fund Flows Weekly Change ................................................................... 74. Money Markets Fund Flows Weekly Change .......................................................... 75. Taxable Bond Fund Flows Weekly Change ............................................................. 76. Bank Deposit Flows Weekly Change ....................................................................... 77. Example 1: Balance Sheet....................................................................................... 88. Example 2: Average Balance Sheet .......................................................................... 99. 3-Month T-Bill Versus 10-Year U.S. Treasury Historical Spread............................. 1010. Example 3: Income Statement .............................................................................. 1111. Example 4: Credit Quality ................................................................................... 1212. Total Home Equity Outstanding And Committed With Growth Rates................... 1413. Revolving Consumer Credit Outstanding ............................................................. 1414. San Francisco Bay Area Unemployment Rate ........................................................ 1515. Example 5: Noninterest Expenses ......................................................................... 1716. Regulatory Capital Requirements ......................................................................... 1817. Example 6: Components Of Capital ..................................................................... 1918. Benchmark Averages ............................................................................................ 2019. 2003 Historical Consensus Estimates ................................................................... 2120. Fastest And Most Consistent Earnings Growers .................................................... 2221. Top-50 Banks Price To Book And ROE ............................................................... 23

22. Bank Stock Dividend Yield Versus 10-Year U.S. Treasury ...................................... 2423. Top-50 Banks (By Market Cap) Dividend Yield .................................................... 2524. Top-50 Banks (By Market Value) 2002 Dividend Payout Ratios ............................ 2525. Dividend Payout Top-50 Banks ............................................................................ 2626. Bank And Thrift M&A Activity ........................................................................... 2727. Industry Net Charge-Off Ratios ........................................................................... 2928. Large-Cap Banks 2003E Earnings Mix ................................................................. 3029. State Street Investor Services Competitive Wins And Losses ................................... 3130. U.S. Credit Card Industry Overview..................................................................... 3231. Top-10 Residential Servicers ................................................................................. 3332. Top-10 Residential Originators ............................................................................ 33

T A B L E O F C O N T E N T S C O N T I N U E D


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Viewpoint In our judgment, investing in bank stocks is highly dependent upon a healthyunderstanding of U.S. economics, bank accounting, and key industry trends. Bank stockinvesting can entail sorting through large databases of historical and valuation

benchmarks. We have attempted to simplify these investment factors into a short primeron bank stock investing (see Exhibit 1).

The Economy - We think U.S. economic growth determines 80% of the success in bankstock investing. Among key economic indicators we pay particularly close attention to arethe following: personal unemployment, purchasing managers index, bankruptcies, loangrowth, and demand levels and money flows. Using these statistics, our current macroview on the U.S. economy includes: limited interest rate movements over the next 12months, low single-digit GDP growth, and a continued healthy consumer, despite potentialfor a near-term uptick in unemployment. We view this as a solid environment from whichto invest in bank stocks.

Fundamentals And Accounting From a fundamental standpoint, we monitor credit

quality statistics closer than any other category of fundamental analysis, given a historicaltendency for credit to generate enormous swings in earnings. We also constantly monitorinterest rates and loan growth as a basic function of banking profitability. In ourassessment, credit quality in 2003 may finally stabilize after three years of weakness, whilebasic banking trends may suffer from deteriorating optics, reflecting the uniquephenomenon of market rates declining too much.

T H E P R I M E R P Y R A M I D

Exhibit 1

Source: U.S. Bancorp Piper Jaffray

History Regulation Legislation

Mega -Trends Consolidation Credit Quality Nonbanking

Valuations Price-to-Earnings Price-to-Book PEG Ratios

Fundamentals Credit Quality Net Interest Margin Fee Revenues Investments Loans

Economy GDP Growth Interest Rates Unemployment Bankruptcies Purchasing Mgrs. Loan Aggregates


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Economics And Bond

Market Indicators

We monitor seven or eight key economic/bond market data points when following bankstocks including the Treasury market rates (3-month and 10-year maturities), high-yieldcredit spreads, loan market aggregates, unemployment, purchasing managers index,money flows, and GDP growth.

In our assessment, the state of the U.S. economy is probably 80% of the call on traditionalbank stock price performance. Under a scenario of 3.0% GDP growth or more, investorsoften become concerned with higher interest rates and seek out faster-growing areas withinthe investor spectrum (i.e., technology), often ignoring financials in the process. If GDPgrowth drops below roughly 1.0%, investors should be concerned with slowing loangrowth and potential for weakening credit quality. So far, the consumer who makes uptwo-thirds of the U.S. economy has held up remarkably well while large corporate

America has suffered. In our view, somewhere between 1.5% and 3.0% GDP growth isoptimal for bank stocks on a relative basis.

The absolute direction of interest rates signals the level of demand for funds within thevarious markets. The Federal Reserve has a direct impact on the shorter end of the yieldcurve through the Fed funds rate, which can be adjusted at each of the FOMC meetings,whereas longer-term rates are primarily a function of the markets. We think the FederalReserves significant campaign to lower the Fed funds rate by 525 basis points to itscurrent level of 1.25% has had little impact on the corporate side to reaccelerate corporatedemand and capital spending, primarily due to the massive bubble created by over-investment in the technology sector throughout the late 1990s.

Valuations We view bank stock valuations primarily within the context of the broadermarket, focusing on relative price-to-earnings (P/E), price-to-book (P/B), and return onequity (ROE) throughout a full cycle. Although P/Es and P/B ratios appear to be at the

high end of relative historical ranges at 75%, ROEs are higher than normal, and a lotdepends on earnings expectations for the broader market. We think the broader marketmay be subject to more severe downward earnings adjustments in 2003. Traditional bankstocks or spread banks tend to trade as a group based on interest rate developments,whereas the conglomerates are generally more sensitive to equity market fluctuations.

Mega Trends Consolidation, credit quality, and fee-income business developments havebeen the biggest trends to impact commercial banking over the last 20 years. Althoughindustry consolidation grinded to a halt in 2002, we would expect some catalyst to lead toan acceleration in activity within the next two years. Further, while the push into non-banking business has also slowed due primarily to significant deterioration in marketsensitive revenues we think banks will once again focus on fee-based businesses by 2004.Diversity of earnings and capital has proven extremely useful during times of stress, while

many larger banks attempt to cross-sell products through healthy distribution networks.

History And Regulation On a historical basis, we think regulatory and legislativeoversight of the financial services space is currently in an expansionary phase, asexemplified by the global settlement with investment banks, recent initiatives to curtail thesub-prime consumer markets, and regulation of the asset-backed finance market (VIEs).Most of these moves have not severely impacted banking profitability, unlike somehistorical negative regulatory efforts. We are waiting for a true litmus test regulatory orlegislative event.


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450bps

500bps

550bps

600bps

650bps

700bps

750bps

800bps

850bps

900bps

5-Ju

l-00

17-Aug-0

0

29-Sep-0

0

13-Nov-0

0

29-Dec-0

0

13-Fe

b-0

1

28-Mar-

01

10-May-0

1

22-Jun-0

1

6-Aug-0

1

19-Sep-0

1

31-Oc

t-01

14-Dec-0

1

31-Jan-0

2

15-Mar-

02

29-Apr-

02

13-Jun-0

2

30-Ju

l-02

11-Sep-0

2

24-Oc

t-02

5-Dec-0

2

21-Jan-0

3

HighYieldSprea

d

600

650

700

750

800

850

900

950

1000

Ban

kStoc

kIndex

High Yield SpreadBank Stock Index

Negative 0.6Correlation Coefficient

Dec-2

Enron files

Ch.11

May-21

Merrill settles$100 million

Jan-3

Fed 2001 rate cut

campaign begins

Sep-11WTC Attack

Avg.

Spread

616 bps

Oct-8SNC Results

Nevertheless, lower short-term rates probably led to lower long-term rates such as the 10-year Treasury, which has declined by roughly 115 basis points over the past 27 months toa current yield of 3.94% as of March 26. And since this rate has a high correlation with

mortgage rates, we have witnessed a dramatic strengthening in the housing market asmany Americans have refinanced at lower interest rates.

Further, interest rates have a significant impact on net interest revenues at U.S. commercialbanks. A steep yield curve, i.e., a big difference between short-term and long-term interestrates, is usually very favorable for bank stock net interest income and thus earnings asbanks tend to lend longer term and borrow shorter term.

H I G H Y I E L D S P R E A D V E R S U S B A N K S T O C K I N D E X

Exhibit 2

Source: U.S. Bancorp Piper Jaffray, ILX and Bloomberg

Note: As of March 13, 2003.

High yield credit spreads tracked against the 10-year Treasury can often signal increasedcredit concerns in the marketplace and thus potential systemic disruptions. Prior to Enron

declaring bankruptcy during the fall of 2001, and then again leading up to the sharednational credit results in October of 2002, credit spreads widened dramatically. In sum,these measures track credit fears as well as reality (see Exhibit 2).

We generally view consumer and corporate loan aggregate trends as early indicators ofeconomic growth. Although corporate loan shrinkage appears to finally be slowing afterseveral quarters of deterioration, consumer loan growth has continued to expand, albeit atmuch slower rates over the past six months.


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We are also closely tracking unemployment trends, which have a significant bearing on thelevels of unsecured consumer net charge-offs. With the unemployment rates trending up,we would expect to witness an increase in credit card delinquencies and potentially net

charge-offs. Nevertheless, recent credit card master trust trends (which are reported on amonthly basis) appear to have been somewhat benign with limited increases inbankruptcies and net charge-offs.

Purchasing managers index remains important to gauging potential expansion within thebusiness sector and thus the potential for increased loan demand. In our assessment,overcapacity remains high within the corporate sector, thus corporate demand is hard torecognize. The most recent ISM Manufacturing data was very weak at 46.2, indicatingcorporate contraction.

M A R K E T F L O W S

Exhibits 3,4,5,6

Bank Deposit Flows Weekly Change

4 Week Moving Average (Billions)

($100)

($50)

$0

$50

$100

$150

2/2/00

4/2/00

6/2/00

8/2/00

10/2/00

12/2/00

2/2/01

4/2/01

6/2/01

8/2/01

10/2/01

12/2/01

2/2/02

4/2/02

6/2/02

8/2/02

10/2/02

12/2/02

2/2/03

Source: U.S. Bancorp Piper Jaffray and Federal Reserve. As of February 26, 2003.

Taxable Bond Fund Flows Weekly Change


($1.0)

($0.5)

$0.0

$0.5

$1.0

$1.5

$2.0

$2.5

$3.0

$3.5

8/2/00

10/2/00

12/2/00

2/2/01

4/2/01

6/2/01

8/2/01

10/2/01

12/2/01

2/2/02

4/2/02

6/2/02

8/2/02

10/2/02

12/2/02

2/2/03

Source: U.S. Bancorp Piper Jaffray Fundamental Market Strategy Group and AMG Data. As of March 5, 2003.

Money Markets Fund Flows Weekly Change4 Week Moving Average (Billions)

($30)

($20)

($10)

$0

$10

$20

$30

$40

$50

1/26/00

2/26/00

3/26/00

4/26/00

5/26/00

6/26/00

7/26/00

8/26/00

9/26/00

10/26/00

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12/26/00

1/26/01

2/26/01

3/26/01

4/26/01

5/26/01

6/26/01

7/26/01

8/26/01

9/26/01

10/26/01

11/26/01

12/26/01

1/26/02

2/26/02

3/26/02

4/26/02

5/26/02

6/26/02

7/26/02

8/26/02

9/26/02

10/26/02

11/26/02

12/26/02

1/26/03

2/26/03

Source: U.S. Bancorp Piper Jaffray Fundamental Market Strategy Group and AMG Data. As of March 5, 2003.

Equities Fund Flows - Weekly Change


($10)

($8)

($6)

($4)

($2)

$0

$2

$4

$6

$8

$10

1/26/00

2/26/00

3/26/00

4/26/00

5/26/00

6/26/00

7/26/00

8/26/00

9/26/00

10/26/00

11/26/00

12/26/00

1/26/01

2/26/01

3/26/01

4/26/01

5/26/01

6/26/01

7/26/01

8/26/01

9/26/01

10/26/01

11/26/01

12/26/01

1/26/02

2/26/02

3/26/02

4/26/02

5/26/02

6/26/02

7/26/02

8/26/02

9/26/02

10/26/02

11/26/02

12/26/02

1/26/03

2/26/03

Source: U.S. Bancorp Piper Jaffray Fundame ntal Market Strategy Group and AMG Data. As of March 5, 2003.


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2002 2003E % Chg 2002 2003E % Chg.

Investment Securities $130.0 $136.5 5.0% Deposits $170.0 $179.4 5.5%

Loans 150.0 159.0 6.0% Borrowings 110.0 115.5 5.0%

Other Assets 20.0 20.4 2.0% Equity Capital 20.0 21.1 5.2%

Total Asset $300.0 $315.9 5.3% Total Liab. & Eq. $300.0 $315.9 5.3%

Dials And Needles

What Is Really Important

When Modeling

We usually begin a commercial banking model with assumptions regarding loan and assetgrowth. Our loan growth assumptions rely somewhat on historical economic growthlevels within a given marketplace, plus an additional 1-2 percentage points of growth (i.e.,5%-7% loan growth) (see Exhibit 7). This general loan growth rule can also be brokendown into economic and interest rate cycle assumptions. Loans can generally be slotted

into four broad categories including mortgages, consumer loans, business loans, andcommercial real estate.

Money flows include the levels of deposits, equities, and money markets on an aggregatebasis, and willingness of investors to invest in each of these categories (see Exhibits 3-6).Many bank stock investors anticipate that with any improvement in the equities markets

we may witness a material outflow of bank deposits. In response, we would anticipatedeposit growth slowing to around 3.0%-4.0% when retail equity dollars flow back intothe stock market; however, several other events such as increased loan growth and higherrates may precede that trend. Bank deposits grew by 5.5% on average throughout the lastten years versus a current growth rate of 5.9% year over year.

E X A M P L E 1 : B A L A N C E S H E E T

Exhibit 7


Note: Some figures may not add up due to rounding.

Over the last 18 months business loans (or commercial and industrial) have been decliningdue to limited demand and tighter underwriting standards. In contrast, mortgage loans including first and second liens have been expanding rapidly, reflecting much lower U.S.interest rates. We would anticipate these trends to reverse themselves at some point overthe next 12 to 18 months.

Investment securities comprise the bulk of a banks remaining average earning assets andare primarily composed of government and mortgaged-backed bonds. Average earningasset levels are somewhat a function of loan growth, and the opportunity to leveragedeposit growth and any underutilized capital.


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Investment securities and loans provide an asset yield, which combined with balancesresults in interest income, and eventually to the income statement item, net interestincome, at commercial banks. Banks typically charge an upfront fee as well as ongoing

interest rate to the borrower, which can range anywhere from 2%-3% on large, highlyrated commercial credits to 12% on credit card loans, and can either be a fixed or floatinginterest rate priced off of a standardized rate. Over the last ten years, banks havesecuritized or packaged a large percentage of credit card and mortgage balances, thusremoving them from the reported balance sheet. However, in recent months banks havetemporarily reversed this trend, maintaining loans on the balance sheet, given anopportunity to fund these loans with abnormally cheap deposits.

E X A M P L E 2 : A V E R A G E B A L A N C E S H E E T

Exhibit 8



Bank deposits and wholesale funding typically provide the bulk of financing for averageearning asset growth at commercial banks and are considered costs, which when combinedwith balances results in interest expense and eventually the income statement item, netinterest income. The difference between interest income and interest expense is typicallycalled spread income (see Exhibit 8).

Over the last two years, interest yields and costs have been declining rapidly, given asignificant reduction in interest rates within the U.S. market. In fact, over this period theFed funds rate has declined by 525 basis points to 125 basis points currently, while thelong bond has declined by 115 basis points as of March 26. The short end of the yieldcurve (see Exhibit 9), namely, 3-month, one- and two-year money, has reached 40-yearhistorical lows. As a result, deposit rates have hit near historical lows, while short-termwholesale funding has declined as well.

Average Yields/ Interest Average Yields/ InterestBalance Rates Income Balance Rates ExpenseSecurities $50 5.00% $2.5 Deposits $150 3.00% $4.5Loans 180 7.00% 12.6 Borrowings 75 4.00% 3.0

Earning Assets $230 6.57% $15.1 Bearing Liabilities $225 3.33% $7.5

Other Assets 10 Equity 15Total Assets $240 Total Liab. & Eq. $240

Net Interest Income (NII) $7.6Net Interest Margin (NIM) 3.30%Interest Rate Spread 3.23%

Calculations: $15.1 - $7.5 = $7.6

$7.6 / $230 = 3.30%6.57% - 3.33% = 3.23%


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3 - M O N T H T - B I L L V E R S U S 1 0 - Y E A R U . S . T R E A S U R Y H I S T O R I C A L S P R E A D

Exhibit 9

Source: Federal Reserve and ILX


(100)

(50)

0

50

100

150

200

250

300

350

400

Jan-90

Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Basis Points

50-year average of

131 basis points

Dec-00 Low

Negative 70 basis points

Aug-00 Recent Low

153 basis points

Mar-03 Latest

251 basis points

An income statement item, net interest income is a function of the level of average earningassets multiplied by the net interest margin (see Exhibit 10 for calculation). The netinterest margin is a function of balance sheet balances, yields, and costs. Historically, netinterest margins have demonstrated a significant correlation to the steepness of the yieldcurve, as well as to absolute levels of interest rates. Banks have traditionally lent outfunds on a longer-term basis and borrowed funds at short-term rates, allowing them tobenefit from the spread or a steep yield curve. And although the yield curve is stillrelatively steep (i.e., favorable) by historical standards, rates have fallen so significantlythat banks are unlikely to benefit from further rate reductions. A banks ability to managethrough fluctuations in interest rates is called asset-liability or interest rate riskmanagement. Larger banks often use off- balance sheet instruments such as swaps to moreeffectively manage rate risks.


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Average Earning Assets $250

x Net Interest Margin (NIM) 3.60%

= Net Interest Income (NII) $9.0

+ Net Interest Income $9.0- Loan Loss Provision 1.0

+ Noninterest Income 5.0- Noninterest Expense 7.0= Income before Taxes 6.0- Taxes (35%) 2.1

= Net Income $3.9

Key Income Statement Stats:

Total Revenue = NII + Nonint. Inc. = $14.0

Nonint. Inc. / Total Revenue = 35.7%Efficiency = Nonint. Exp. / Ttl. Rev. = 50.0%

E X A M P L E 3 : I N C O M E S T A T E M E N T

Exhibit 10



Loans And Credit Quality Historically, credit quality (or asset quality) has been the biggest area of potential risks atU.S. commercial banks. And unfortunately, investors have few ways in which to analyzethe quality of an individual loan portfolio other than to rely on bank examiners and ratingagencies. The regulatory statements, including the FRY-9C, Call Report, and SECquarterly filings, are often the best source of credit-related information. Banks seldomwillingly discuss specific credits within their portfolio, given requirements of clientconfidentiality.

The Loan Review Process What Is Behind The Scenes. A commercial loan is usuallyreviewed by an internal review committee to determine a borrowers ability to repay loan

balances and make interest payments on an ongoing basis. Under a scenario in which aborrowers ability to meet future obligations is questioned, a loan might be placed on aninternal credit watch list. These loans might then fall delinquent on payment of interestand at some point be placed on nonaccrual status, which is to stop accruing interestpayments and is usually 90 days or more past due. Management must make a judgmentat some point regarding how collateral for the loan might cover claims in a situation inwhich the borrowing company ceases to be an ongoing entity. For instance, if collateral ina building is worth $125,000 and the loan is for $150,000, there is a chance the bankmay provision $25,000 of the loan. When the borrower ceases to make payments on theloan, this could result in net charge-offs or a write-down on the $25,000 difference.

Net interest income often contributes between 20% and 60% of a banks total revenueswith smaller banks usually experiencing the higher percentages of net interest income.During the 1990s many larger banking organizations sought to diversify away fromspread-based revenues by acquiring investment banks, asset managers, and processing,given concern over the competitive nature of traditional spread-based banking.


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Nonperforming Assets, Delinquencies And Charge-Offs When analyzing publiclyavailable financial statements, we often focus on levels and growth in nonperformingassets, or those assets which are no longer accruing interest and/or more than 90 days

delinquent. We also review delinquency trends within the portfolio, or when a borrowerbecomes past-due on the loan payments. And finally, we analyze net charge-offtrendswithin the portfolio, or those loans that are written down and off the balance sheet.Another indicator of problem loans that banks will sometimes discuss with investors is thewatch list, which is a broader definition of troubled loans than nonperforming assets andis an early indicator of potential credit problems.

Beginning Reserves $25

Charge-offs 5

Recoveries 1- Net Charge-offs $4

+ Loan Loss Provision 4Ending Reserves $25

Nonperforming Loans (NPLs) $195+ OREO (other real estate owned) 1= Nonperforming Assets (NPAs) $196

Key Credit Quality Ratios:

Net Charge-Off Ratio = Net Charge-Offs / Avg. LoansReserves Ratio = Reserves / End of Period Loans

E X A M P L E 4 : C R E D I T Q U A L I T Y

Exhibit 11



The accounting methodology for loan loss reserves is somewhat complicated (see Exhibit11). The allowance for loan loss reserves is a contra-asset account, similar to an allowancefor bad debt account. Provisions for loan losses are run through the income statement toestablish this account. Banks usually begin to reserve for losses when there is somepotential for loss, and then begin to charge them off (remove them from the balance sheet)when there is a reasonable doubt of collection in full. Banks often match provisions andnet charge-offs to maintain a constant level of loan loss reserves.

To analyze reserve adequacy, we focus on reserves as a percentage of total loans thereserve ratio for consumer banks, and reserves-to-nonperforming loans when reviewing

commercial loan losses. The reserve ratio is more crucial for consumer-oriented portfoliosbecause these loans are generally underwritten with some anticipation of loss and can befully charged off (i.e., credit cards) without being placed on nonperforming status. Incontrast, commercial loans usually have some collateral support and are much lumpier innature.


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Commercial loans, or business loans, have been the source of the biggest credit problemswithin the banking space over the last three years. Commercial loans and unused creditlines can be used for a variety of purposes but are often used to support working capital

and capital investment needs. Over the past two years, levels of commercial loans havedeclined significantly on a national basis, given both lack of supply and demand byborrowers.

In our assessment, supply has been constricted as many larger banks pulled back afterexperiencing significantly higher-than-normal net charge-offs on large credits. Sharednational credits (SNC), or those large loans originated by a lead lender and thensyndicated to a group of participants usually to either other domestic and foreign banksor insurance companies have experienced the most deterioration. Currently, the SNCmarket is very weak with few participants willing to accept risk without a significantlyhigher-than-normal reward, i.e., interest rate or collateral support. Over the next year,most large banks plan on further reducing their exposure to the large corporate loanmarket.

We view the SNC market as increasingly synonymous with the fixed income, or bondmarket, in both maturity and interest rates charged. Many of the larger banks are activein providing both services to their customers. Although certainly the syndicate market isdamaged near term, we do not believe the impact is permanent; and when lending doesreaccelerate there will be opportunities for growth at more reasonable returns. Manylarger banks including FleetBoston, J.P. Morgan Chase, Citigroup, Bank One, and Bank ofAmerica are experiencing commercial net charge-off ratios as a percentage of loans in the1.00% to 2.00% range versus a more normal 40 to 60 basis points.

In our judgment, most of the commercial loan weakness at large banks over the last twoyears has been associated with the large new economy exposures, such as telecom,technology, cable, and merchant energy loans. Going forward, we would also be

somewhat cautious on large automobile, trucking, and airline industry exposures reflectinga slight slowing in the broader economy. In contrast, the small and middle market loanenvironments have not experienced the same levels of credit quality deterioration andappear to be recovering somewhat from weak demand levels.

Consumer loans include a broad variety of credits including home mortgages, home equity,credit cards, and personal loans (i.e., purchase of boats, cars, etc.). Most banks have beensignificantly increasing exposure to the consumer (see Exhibits 12 & 13), given what havehistorically been more benign loss characteristics and a more annuity-like loss pattern,which is dissimilar to generally lumpy commercial loan losses. Further, there is a well-developed securitization market for mortgages and credit cards. In addition, the regulatorsrequire less capital be placed against mortgages remaining on the books.


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April 2003


Exhibits 12,13

Consumer loan growth has continued somewhat unabated throughout the last decade.Mortgage lending in particular has expanded dramatically in the last two years, given asignificant decline in mortgage rates. Although levels of personal debt as a percentage ofincome have increased dramatically, debt-servicing costs have remained steady given lowerinterest rates and increased income (see report published in April 2003, Bank Stocks andthe Housing Bubble).

Revolving Consumer Credit Outstanding

Monthly Data, 1990 To Date

$-

$200

$400

$600

$800

Jan-90

Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Source: Federal Reserve.

0%

5%

10%

15%

20%

25%Revolv ing Consumer Credit Outstanding ($ Bn)

Year-Over-Year Growth Rate

Jan-03 $729 Bn

YoY %chg. 2.3%

Total Home Equity Outstanding And Committed With

Growth Rates, 1991 - 2003E

19%18%

20%

25% 25%23%

38%

20%20%

25% 25%

16%

-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

500,000

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 09/02 2003E

TotalHELines(Mil.)

0%

5%

10%

15%

20%

25%

30%

35%

40%

GrowthRate(%)

Total Home Equity

Y/Y Growth Rate

Note: Estimated historic data for Charter One pre-97 and TCF Financial pre-96.Source: Regulatory data from SNL DataSource and U.S. Bancorp Piper Jaffray estimates.


16/54

April 2003


5.9%

3.6%

6.3%

5.3%

3.7%

2.8%

3.4%

4.5% 4.4%

6.1%

4.4%

7.5%

6.1%

4.9%

3.4%

4.2%

5.2% 5.2%

San

Francisco

San Mateo Santa

Clara

Alameda Contra

Costa

Marin Sonoma Napa Solano

December-01 December-02

Nevertheless, consumer loans are not without risk. We generally watch personal income,unemployment trends, and housing values within specific markets to judge potential fordeterioration in loan quality. Additionally, we believe regulators may be somewhat

uncomfortable with recent growth in sub-prime loan exposures. In response, the FFIECreleased guidelines (dated January 8, 2003) in which all loans with a FICO score of under660 are considered sub-prime. Although we view this as a somewhat arbitrarilydetermined high hurdle, it effectively dampens growth of exposures to this sector of themarket.

We are closely monitoring developments in the San Francisco Bay Area housing market, asperhaps a barometer for how higher unemployment (see Exhibit 14), reductions inpersonal income, and interest rates may negatively impact housing values. So far, housingvalues have held up reasonably well since 2001, despite a 400 basis point increase inunemployment on average, and pressure in personal income within that market.

S A N F R A N C I S C O B A Y A R E A U N E M P L O Y M E N T R A T E

Exhibit 14

Source: Grubb & Ellis Research & Advisory Services.

Revenue Components Total revenue, which is the sum of net interest income and noninterest income, typicallygrows anywhere from 4%-9%. We expect net interest revenues to expand by 2%-4% in

most cases on a normal basis, while fee-based revenues expand by 8%-12%. Overall, feesas a percentage of total revenues expanded to a peak of 56% of revenues in 1999 for thetop 10 banks, up from only 41% of total revenues in 1990, partially reflecting asignificant drive to exit low-return, high-risk traditional banking and expand in fee-basedbusinesses.

Usually the biggest component of fee-based revenue at commercial banks is service chargeson deposits, which include checking account fees, overdraft fees, monthly service fees,usage fees, etc. In general, service charge fee growth has kept up with accelerated depositgrowth over the last three to five years. In fact, improving customer service has recentlyresulted in service-charge growth outstripping deposit growth.


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April 2003


Noninterest Expenses Expense management usually takes on two different dimensions at commercial banksincluding synergies related to merger savings, or improvement of processes/six sigmaefforts. The typical banks nonintrust expense base expands by 3%-6% with mostvariation tied to incentive compensation structures in the capital markets and investmentmanagement business, as well as any acceleration in branch office openings or technologyexpenditures. Typically, salaries and compensation expands by 4%-5% per year,occupancy by 2%-3%, and technology by 7%-10%.

Investment banking fees, or noninterest income, is highly reliant upon the type ofinvestment banking done at an individual organization. Loan syndications are a big partof a commercial banks revenue stream as well as fixed income issuance and M&A

activity. Citigroup remains the only large bank with meaningful exposure to the equitiesissuance business.

Trading fees at commercial banks have been highly geared toward foreign exchange,derivatives, and fixed income. These products can often be cross-sold easily to largercorporate banking clients.

Asset management fees are usually somewhat related to aggregate investment levels,including equity prices. These fees can either be coincident in revaluation against themarket or lag the market impact, depending upon the asset management pricing structuresat these organizations. Over the last two years, we have witnessed a steady outflow fromthe higher-margin equity products and into lower-yielding fixed income portfolios at manyof the commercial banks we follow.

Commercial banks have also aggressively entered the insurance agency business over thelast few years, recognizing a consolidation opportunity as well as cross-selling primarilyfor the corporate client base. The biggest insurance agencies within the banking spaceinclude Wells Fargo and BB&T.

Securities gains and loan sales have been contributing a larger percentage of total revenuesover the last few years, which could be construed as poor quality; however, mostorganizations still have ample capital and securities gains to address any shortfalls. In fact,we estimate that the top 10 banks could boost EPS by between 1% and 52% by takingsecurities gains as of December 31, 2002. Most of these gains are attributable to theextended rally in the 10-year Treasury, when many banks have significant governmentbond portfolios.


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April 2003


2002 2003E % Chg

Net Interest Income $50.0 $54.0 8.0%

Noninterest Income 50.0 55.0 10.0%Total Revenues $100.0 $109.0 9.0%

Noninterest Expenses $50.0 $52.5 5.0%

Key I/S Ratios:Efficiency Ratio 50.0% 48.2%

Operating Leverage NA 400bps

Calculations 2003E:

Efficiency = Nonint. Exp. / Ttl. Rev. = 48.2%

Operating Leverage =

Rev.-Exp. Growth Spread = 9.0% - 5.0% = 400bps

E X A M P L E 5 : N O N - I N T E R E S T E X P E N S E S

Exhibit 15



The efficiency ratio, or overhead ratio, is one of the analyst communitys standard expensemanagement measurements and is defined as expenses as a percentage of total revenues.We tend to focus on any declining trend in this ratio as a positive contributor to earningsleverage (see Exhibit 15). Among those businesses with the highest or worst efficiencyratios are asset managers (70%-90%), followed in descending order by investmentbanking (70%-75%), retail (60%-65%), commercial (45%-50%), thrifts/mortgagebanking (40%-50%), and credit cards (30%-40%). The discrepancy in these ratios hasvery little to do with pretax profit margins or returns on equity, given differences in

compensation as well as required regulatory capital to conduct various businesses.

As an example of banks relatively conservative accounting, a majority of the banks wefollow have decided to begin expensing stock options and conservatively adjusting pensionplan return assumptions for 2003 and beyond. In fact, S&P estimates only a 7% negativeimpact to EPS for financial services companies from adjustments, while the adjustmentsfor Corporate America are an average of 31%.

Historically, many banks have posted significant restructuring and merger-related chargesthroughout the last 10 years, which have been steadily increasing as a percentage ofearnings among the top 50 banks.


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April 2003


Capital Risk-based capital guidelines were created during the early 90s, primarily as a result ofconcerns over safety and soundness within the U.S. banking system. Many savings andloans defaulted and were taken over by the government, due to excessive exposure to real

estate. Congress and regulators considered this deteration to be the result of a somewhatpoor calculation of the riskiness of selected assets on the balance sheet combined withinsufficient capital.

R E G U L A T O R Y C A P I T A L R E Q U I R E M E N T S

Exhibit 16

In our judgment, the two most important capital ratios to focus on at U.S. Commercialbanks are the tangible common equity and tier 1 capital ratio. Failure to meet certainminimum capital requirements (see Exhibit 16) can trigger corrective regulatory action.Rating agencies usually pay close attention to tier 1 capital for the larger banks andtangible common equity for the smaller banks (see Exhibit 17).

There is significant excess capital within the banking system estimated at almost $60billion, using a tangible common equity cutoff of 5.5%. Consequently, we have notwitnessed a significant round of capital raising for commercial banks since the 1990-1992time frame when many banks were emerging from severe commercial real estate-relatedcredit problems.

Ttl. Capital Tier 1 Leverage

Well Capitalized >=10% >=6% >=5%

Adequately Capitalized >=8% >=4% >=4%

Undercapitalized Neither Well nor Adequately Capitalized

Source: FDIC.


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April 2003


E X A M P L E 6 : C O M P O N E N T S O F C A P I T A L

Exhibit 17



Total Assets (TA) $1,100

Risk-Weight 64%

Risk-W eighted Assets (RWA) $700

Common Equity (CE) $85- Goodwill & Other Adj. (GW) 25

Tier 1 Capital $60+ Tier 2 Capital 20Total Capital $80

Key Capital Ratios:Common Equity 7.73% Tangible Common Equity 5.58% Tier 1 Ratio 8.57% Total Capital 11.43% Leverage Ratio 5.58%

Calculations:Common Equity = CE / TATangible CE = (CE - GW) / (TA - GW)Tier 1 Ratio = Tier 1 Capital / RWA

Total Capital = Tier 1 and Tier 2 / RWAEst. Leverage Ratio = Tier 1 Capital / (TA - GW)

Tier 1 capital which is a regulatory definition includes common stockholders equity,

qualifying preferred stock and trust preferred securities, less goodwill and certain otherdeductions. Tier 2 capital includes preferred stock not qualifying as Tier 1 capital,subordinated debt, the allowance for loan losses, and net unrealized gains on marketablesecurities. Total capital includes Tier 1 and Tier 2 capital.

Risk-weighted assets used when calculating Tier 1 and total capital ratios measures therisk included in the balance sheet, as one of four risk weights (0%, 20%, 50%, 100%) isapplied to the different balance sheet and off-balance sheet assets based on the credit riskof the counterparty. For instance, claims guaranteed by the U.S. government are risk-weighted at 0% while commercial real estate loans are weighted at 100%.

The leverage ratio somewhat considered similar to the tangible common equity ratio consists of Tier 1 capital divided by quarterly average total assets, excluding goodwill and

certain other items.


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April 2003


T O P 5 0 B A N K S B E N C H M A R K A V E R A G E S F O U R T H Q U A R T E R 2 0 0 2

Exhibit 18

Source: SNL DataSource

Avg. Avg.

Growth Seq. Y/Y

Loan Growth 2% 5%Deposit Growth 4% 9%

Revenue Growth 4% 10%Non-Int Exp. Growth 4% 7%

EPS Growth 4% 1%

Avg. Avg. Avg. BP Chg. BP Chg. 4Q02 Results

Avg. Stats. (%) 12/01 Q 09/02 Q 12/02 Q Seq. Y/Y High Low

NIM 4.07 4.04 3.93 -0.11 -0.13 5.43 1.22Efficiency Ratio 55.45 55.94 56.86 0.92 1.42 79.82 31.82

ROAA 1.37 1.50 1.49 -0.01 0.11 3.20 -0.20ROAE 15.51 16.40 16.83 0.43 1.32 42.75 -3.60

NPAs/Assets 0.56 0.61 0.57 -0.04 0.01 1.82 0.01

NCOs/Avg. Loans 0.90 0.78 0.69 -0.09 -0.21 2.88 -0.09

T. Equity/T. Assets 7.08 7.26 7.13 -0.13 0.05 12.31 3.57

Leverage Ratio 7.72 7.97 7.70 -0.27 -0.01 11.96 5.10


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April 2003


Price-To-Earnings In our assessment, the price-to-earnings (P/E) ratio continues to be the primary method bywhich to value traditional bank stocks. We can use the price-to-earnings ratio fairly freely,adjusting for some level of uncertainty in future earnings. Banks that have experienced themost significant reductions to consensus earnings throughout the last two years and mayexperience further reductions should sell at a discount, while those that have experiencedlimited impact should sell at a premium (see Exhibit 18).

The methods for valuing stocks within the broader sell-side analytical community havegone through a major change throughout the last 10 years with little impact on how wevalue bank stocks. More specifically, we have consistently utilized price-to-earnings, price-to-book, P/E to secular growth, and dividend yield measurements as a way to determinerelative value against the market and against peer commercial banks. Counting eyeballsand forecasting web hits or even measuring price to revenues for that matter haveseldom proven to be useful exercises within the bank stock investing space.

During the mid-1990s, traditional commercial banks sold at higher P/Es and P/Bs thanbrokers and asset managers; however, that changed dramatically throughout the late1990s as the market rewarded significant growth and higher returns on equity with bigger

P/Es and P/Bs. The bubble in the equity markets throughout the late 1970s fed thisgrowth.

Source: FactSet and Baseline

V A L U A T I O N M E T H O D S

2 0 0 3 H I S T O R I C A L C O N S E N S U S E S T I M A T E S , M A R C H 2 0 0 1 - M A R C H 2 0 0 3

Exhibit 19

Ticker Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03

1-Yr.

% Chg.

2-Yr.

% Chg.Large-Cap Banks

WFC (#=) $3.90 $3.75 $3.58 $3.55 $3.64 $3.67 $3.69 $3.64 $3.64 0% -7%BAC (#=) 5.50 5.65 5.84 6.13 6.27 6.30 6.27 6.21 6.19 -1% 13%

ONE (#>=) NA 3.53 3.12 3.13 3.13 3.14 3.14 3.07 3.06 -2% NA

WB (#@=) 3.08 3.05 3.33 3.18 3.13 3.14 3.10 3.03 3.00 -4% -3%C (#@>) NA NA 3.70 3.76 3.75 3.73 3.42 3.30 3.25 -13% NA

STT (#=) 2.80 2.76 2.72 2.53 2.56 2.52 2.47 2.36 2.00 -22% -29%

NTRS (#) NA NA 2.92 2.77 2.72 2.61 2.43 2.16 1.93 -29% NABK (#=) 2.81 2.80 2.57 2.64 2.47 2.35 2.26 1.86 1.75 -29% -38%

FBF (#) NA NA 3.77 3.56 3.54 3.33 2.69 2.50 2.43 -31% NAJPM (#>) NA NA 3.44 3.62 3.41 3.41 2.64 2.44 2.16 -37% NA

Small-Cap BanksCBH (#>) NA NA NA $2.02 $2.13 $2.24 $2.35 $2.37 $2.43 14% NAWTFC (#@>) NA NA NA 1.61 1.72 1.75 1.81 1.81 1.82 6% NA

TCB (#>=) NA NA NA NA 3.50 3.49 3.54 3.49 3.48 -1% NACFBX (#@>) 2.05 2.05 2.05 2.05 2.15 2.16 2.16 2.14 2.12 -1% 3%

SWBT (#>) 2.02 2.00 1.95 2.05 2.00 2.00 2.08 1.94 1.93 -3% -4%

GBBK (#>=) NA NA NA 2.31 2.48 2.58 2.58 2.34 1.95 -21% NABPFH (#>) NA NA NA NA 1.29 1.29 1.27 1.18 0.99 -23% NA

Brokers

MWD (#=) NA NA NA $4.08 $4.06 $3.85 $3.29 $3.06 $3.13 -23% NAMER (#+=) NA NA NA NA 3.80 3.56 3.26 2.99 2.68 -29% NA

S&P 500 IndexSPX NA NA 62.50 59.59 56.04 57.32 54.39 52.80 51.82 -8% NA


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April 2003


PEG Ratio Generally speaking, we can also use a P/E to secular growth ratio for banks, particularlyfor those that have been consistent earnings growth performers over several years. Thisratio is particularly important for smaller banks because using a simple P/E ratio may notmake much sense. In select cases, some banks should be selling higher than the market(see Exhibit 19).

Price-To-Book In our assessment, price-to-book (P/B) is usually the last backstop valuation measurementfor bank stocks when all other methods fail. Under such a scenario, investors mustdevelop a comfort level in which the assets on the books are worth stated levels accordingto GAAP. This is typically a very difficult process, given that public values for loan andventure capital portfolios are usually difficult to determine.

Historically, price-to-book values for the banking industry have ranged from lows of closeto book value during the 1991-1992 time frame, to highs of 2 to 3 times for the regionalbanks and 4 to 5 times for the processing banks during the 1999-2000 time frame.

Historically, investors have begun to trade on a banks forward-year earnings sometimeduring June or July of the current year. However, in recent years trading on forward-yearearnings has come earlier and earlier. In our judgment, this trend has been somewhat a

function of the broader market having little confidence in current year earnings. Last year,the banks began trading on 2003 sometime in February/March.

F A S T E S T A N D M O S T C O N S I S T E N T E A R N I N G S G R O W E R S

Based on Core EPS Growth, 1990-2002

Exhibit 20

Rank Company Ticker

Avg. Annual

Growth (%)

Avg. Chg. in

Growth Rate

(bps)

2004E

PEG

1 TCF Financial Corporation (#>=) TCB 17.5 (24.7) 0.54x

2 Synovus Financial Corp. SNV 16.4 (57.2) 0.75x3 State Street Corporation (#=) STT 15.1 (69.1) 0.86x4 Compass Bancshares, Inc. CBSS 12.7 (73.8) 0.81x5 City National Corporation CYN 14.5 (96.1) 0.71x

6 Zions Bancorporation ZION 14.4 (104.3) 0.65x7 M&T Bank Corporation MTB 16.8 140.5 0.74x8 Fifth Third Bancorp FITB 16.4 177.7 0.84x

9 SouthTrust Corporation SOTR 12.5 191.3 0.88x

10 Banknorth Group, Inc. BNK 15.8 (202.8) 0.54x11 Union Planters Corporation UPC 12.8 (204.2) 0.71x12 Citigroup, Inc. (#@>) C 12.7 (210.6) 0.69x

13 BB&T Corporation (#) BBT 11.8 229.2 0.84x14 Wells Fargo & Company (#=) WFC 12.0 231.6 0.91x15 National Commerce Financial Corp. NCF 15.3 238.4 0.74x16 Commerce Bancorp, Inc. (#>) CBH 11.6 279.4 1.12x17 North Fork Bancorporation, Inc. NFB 20.0 314.7 0.48x18 Investors Financial Services Corp. IFIN 35.7 486.3 0.40x19 Charter One Financial, Inc. (#) CF 13.2 (518.9) 0.70x20 Bank of New York Company, Inc. (#=) BK 13.9 (598.3) 0.73x

Average Top 50 Banks by Mkt. Cap. 11.4 3.4 1.18x

Source: U.S. Bancorp Piper Jaffray, ILX, Baseline, and SNL DataSource


24/54

April 2003


Some Attractive Yield

Opportunities

The spread between bank stock dividend yields and the 10-year U.S. Treasury arecurrently as narrow as they have been at any time over the last 13 years, reaching a recenthistorical low of 50 basis points versus 102 basis points in October of 2002 and 167 basispoints in October of 1990 (see Exhibit 21).

Currently price-to-book values range from 1.0-2.0 times for most banks, while processorprice-to-books are rather high at 2.3-2.5 times. We must also weigh these ratios within thecontext of the broader market. Although price-to-books are still rather high for many

banks, so are returns on equity (see Exhibit 20).

0%

20%

40%

60%80%

100%

120%

140%

160%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Rel. ROE

0%

20%

40%

60%80%

100%

120%

140%

160%Rel. Bank P/B

Oct-02: 88%

T O P - 5 0 B A N K S P R I C E T O B O O K A N D R O E

Exhibit 21

Source: U.S. Bancorp Piper Jaffray and Baseline


25/54

April 2003


Over the last three years, credit spreads on large bank bonds with 10-year maturities havenarrowed somewhat against the 10-year Treasury to between 60 and 122 basis points,currently from 100 and 170 basis points in December of 1999. Clearly, the impliedriskiness to bank stock capital has declined significantly.

We think these high yields represent a good opportunity to purchase bank stocks,particularly those for which we feel relatively comfortable with the intermediate-termearnings growth outlook. For instance, Bank of America is currently yielding 3.80% as ofMarch 14, 2003 versus the 10-year Treasury at 3.70%, TCF Financial is yielding 3.40%,and Wachovia is yielding 3.10% (as of March 14, 2003) (see Exhibit 22).

Source: U.S. Bancorp Piper Jaffray, Federal Reserve, and FactSet


B A N K S T O C K D I V I D E N D Y I E L D V E R S U S 1 0 - Y E A R U . S . T R E A S U R Y

Exhibit 22

-

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

Dec-89

Jun-90

Dec-90

Jun-91

Dec-91

Jun-92

Dec-92

Jun-93

Dec-93

Jun-94

Dec-94

Jun-95

Dec-95

Jun-96

Dec-96

Jun-97

Dec-97

Jun-98

Dec-98

Jun-99

Dec-99

Jun-00

Dec-00

Jun-01

Dec-01

Jun-02

Dec-02

Yieldsin%

10-yr. UST

Avg. Dividend Yield Top 50 Banks

Current Spread 50 bpsHistorical Average Spread 327 bps


26/54

April 2003


T O P - 5 0 B A N K S ( B Y M A R K E T V A L U E )

D I V I D E N D Y I E L D A N D 2 0 0 2 D I V I D E N D P A Y O U T R A T I O S

Exhibits 23 & 24

Source: FactSet, Baseline, and SNL DataSource


Under a scenario in which the Presidents tax bill is passed and elimination of the doubletaxation of dividends is supported, we would expect several banks to raise their dividendpayout ratio meaningfully. We think passage of this bill partially depends on length of war

with Iraq and the resultant deficit associated with financing it. Dividend payout ratios arecurrently averaging 39% for the bank group, down from 44% in 2001 (see Exhibit 24). Ascenario of a 10% increase in the dividend payout ratio could imply immediate 15% to20% appreciation in bank stock values when utilizing a dividend discount model.

Dividend Core Dividend

Company Name Ticker Declared EPS Payout

J.P. Morgan Chase & Co. JPM $1.36 $1.14 119%FleetBoston Financial Corporation FBF 1.40 1.50 93%

Comerica Incorporated (#) CMA 1.92 3.25 59%Huntington Bancshares Incorporated HBAN 0.64 1.09 59%Valley National Bancorp VLY 0.89 1.60 55%Bank of New York Company, Inc. BK 0.76 1.39 55%AmSouth Bancorporation ASO 0.89 1.66 54%Union Planters Corporation UPC 1.33 2.53 53%Wilmington Trust Corporation WL 1.01 1.99 51%Synovus Financial Corp. SNV 0.59 1.19 50%PNC Financial Services Group, Inc. PNC 1.92 3.94 49%Charter One Financial, Inc. CF 0.83 1.73 48%Fulton Financial Corporation FULT 0.59 1.23 48%National City Corporation (#) NCC 1.20 2.55 47%Regions Financial Corporation RF 1.16 2.57 45%BB&T Corporation BBT 1.13 2.52 45%U.S. Bancorp USB 0.78 1.74 45%Mercantile Bankshares Corporation MRBK 1.18 2.71 44%Associated Banc-Corp ASBC 1.21 2.79 43%First Virginia Banks, Inc. FVB 1.09 2.55 43%

Bank of America Corporation BAC 2.44 5.70 43%Nati onal Commerce Financial Corporation NCF 0.64 1.53 42%Compass Bancshares, Inc. CBSS 1.00 2.41 41%SunTrust Banks, Inc. STI 1.72 4.23 41%KeyCorp (#) KEY 0.90 2.26 40%Bank of Hawaii Corporation BOH 0.73 1.84 40%North Fork Bancorporation, Inc. NFB 1.01 2.55 40%Fifth Third Bancorp FITB 0.98 2.56 38%TCF Financial Corporation TCB 1.15 3.03 38%Wachovia Corporation WB 1.00 2.70 37%SouthTrust Corporation SOTR 0.68 1.85 37%First Tennessee National Corporation FTN 1.05 2.95 36%Hibernia Corporation HIB 0.57 1.61 35%Mellon Financial Corporation MEL 0.49 1.43 34%Northern Trust Corporation NTRS 0.68 2.04 33%Wells Fargo & Company WFC 1.10 3.37 33%UnionBanCal Corporation (#) UB 1.09 3.46 32%Bank One Corporation ONE 0.84 2.67 31%

Popular, Inc. BPOP 0.80 2.61 31%Commerce Bancorp, Inc. CBH 0.62 2.04 30%Marshall & Ilsley Corporation MI 0.63 2.20 28%Banknorth Group, Inc. BNK 0.58 2.05 28%Citigroup, Inc. C 0.70 2.58 27%State Street Corporation STT 0.48 1.97 24%Zions Bancorporation ZION 0.80 3.53 23%City National Corporation CYN 0.78 3.57 22%Commerce Bancshares, Inc. CBSH 0.62 2.85 22%M&T Bank Corporation MTB 1.05 5.07 21%Doral Financial Corporation DRL 0.42 2.63 16%Total: $47.42 $120.96 39%

Average: $0.97 $2.47 42%

Dividend

Ticker Yield (%)

JPM 6.30FBF 6.00

CMA 5.20KEY 5.20UPC 5.00ASO 4.50NCC 4.40PNC 4.40USB 4.00BAC 3.80RF 3.80WL 3.80ASBC 3.70MRBK 3.70VLY 3.70BK 3.60BBT 3.60CBSS 3.60NFB 3.60HIB 3.50

HBAN 3.50SNV 3.40TCB 3.40FULT 3.30SOTR 3.30STI 3.30FTN 3.20CF 3.10WB 3.10BNK 3.00NCF 2.90FVB 2.80UB 2.80WFC 2.60BOH 2.50MI 2.50ONE 2.40C 2.40

MEL 2.40BPOP 2.40NTRS 2.30FITB 2.10ZION 2.00CYN 1.90CBSH 1.80CBH 1.70DRL 1.70MTB 1.50STT 1.50IFIN 0.30Average: 3.21


27/54

April 2003


54%

51%

38%

35% 35%37% 37% 37%

39%38%

42%44%

39%

0%

10%

20%

30%

40%

50%

1990 Y 1991 Y 1992 Y 1993 Y 1994 Y 1995 Y 1996 Y 1997 Y 1998 Y 1999 Y 2000 Y 2001 Y 2002 Y

Source: SNL Datasource

D I V I D E N D P A Y O U T T O P - 5 0 B A N K S

Exhibit 25


28/54

April 2003


M E G A T R E N D S

C O N S O L I D A T I O N , C R E D I T Q U A L I T Y , A N D N O N B A N K I N G

Consolidation Large mergers within the banking industry have been commonplace throughout the last75 years, with the most recent waves of activity occurring in the 1994-1997 and 1998

time frames. The rationale for the first waves of merger activity in the 1990s was to createeconomies of scale and reduce overcapacity within the banking system.

Combinations in the first wave of mergers often included an initial year of dilution withan anticipated cost savings (20%-50% of acquired organizations expenses taken out) inthe second year due to combining technology systems and reducing branch office overlaps.The mega-mergers of 1998 generally involved fewer expected cost savings and were oftenbilled as mergers of equals (or MOEs) in which the senior managers of both firms playednearly an equal role in the new organization. The MOE concept often proved moredifficult to execute than expected, given cultural differences.

We have now witnessed four years of declining M&A within the financial services space(see Exhibit 25) primarily due to lack of willing sellers at reasonable prices. The takeout

multiples, namely, price-to-book and price-to-earnings, have been declining meaningfully.

In our assessment, three major trends impact investing in bank stocks includeconsolidation, credit quality, and exposure to nonbanking businesses. In our assessment,the expansions into nonbanking businesses and consolidation throughout the 1990s haverecently slowed but could reaccelerate with any meaningful improvement in the economy.Credit quality is also likely to improve with an accelerating economy.

B A N K A N D T H R I F T M & A A C T I V I T Y

Exhibit 26

Source: SNL DataSource

216

305

398

480

565

463 457 462

504

357

281260

189

41.2%

20.6%17.7%

-18.1%

-1.3%1.1%

9.1%

-29.2%

-21.3%

-7.5%

-27.3%

30.5%

0

100

200

300

400

500

600

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

YTD

NumberOfDealsPerYear

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

Year-Over-

YearGrowthRate

M&A Deals

M&A Growth


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Credit Quality Credit quality has been one of the biggest determinants of bank stock earnings or lackthereof throughout the last 20 years, often causing earnings shortfalls for the industry. Incontrast, prior to the 1970s, credit quality was virtually a non-event In fact, the termnonperforming assets did not surface until shortly there after. We view the surfacing ofcredit problems as a function of increased competition to bank lending, and thus thecompromise of otherwise healthy credit standards and spreads.

Perhaps one of the largest credit-related challenges for the U.S. banking industry cameduring the early 1990s, when many banks were overexposed to weakening commercialreal estate (see Exhibit 26). Real estate concentrations were cited for bank failures in thesouthwestern and the northeastern United States. Nonperforming assets to total assets

increased to more than 2.2% in 1991 versus current weak levels of 0.75%.

At the same time, the basic business of banking has experienced relative strength over thelast two years, posting double-digit earnings growth per year for the industry. In ourjudgment, we would have to experience a significant catalyst to encourage managements

to sell out, before takeout activity accelerates. This could include a rapid rise in interestrates or deteriorating credit quality.

Additionally, banks must now utilize purchase method of accounting for consolidationversus a historical performance for pooling-of-interest method. First Unions 2001combination with Wachovia was the first major deal in the new environment.

Branching Versus Consolidation - For several years branch closings were viewed aspotential cost-saving opportunities for larger banks acquiring smaller banks withoverlapping infrastructures. This worked exceptionally well throughout the 1990s as theacquisition environment heated up to a frenzied state in 1998. And then as the Internetcame of age, many analysts increasingly believed that the branch was dead and that theInternet would supplant the branch infrastructure as the preferred method of banking. We

have now come full circle with many banks building out their branch networks byopening up new offices or on a de novo basis. In Chicago alone, Bank One plans for atleast 30 new branch openings over the next two years.

As deposits have become an increasingly valuable source of funding, many banks haveincreased their focus on customer retention. Historically, banks have experiencedcustomer turnover of anywhere between 10% and 20% of the deposit base annually,primarily reflecting poor customer service as well as perhaps some rate shopping by thedepositors. In recent years, many of the larger banks have attempted to stop this normaloutflow by offering more competitive rates, reduced error rates, and extended branchhours.


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I N D U S T R Y N E T C H A R G E - O F F R A T I O S

Exhibit 27

in basis points FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 9M02 Avg.

1-4 Family 23 18 29 13 8 7 7 7 10 12 17 16 14

Commercial RE 193 121 79 47 18 2 3 1 1 7 18 11 42Commercial 152 144 83 32 13 20 29 35 44 56 114 119 70

Consumer 180 159 114 70 115 160 193 183 154 129 141 142 145Credit Cards 444 297 252 178 247 363 477 450 406 521 603 521 396

Other Consumer 150 128 76 36 56 84 93 104 108 97 110 110 96

Other 57 2 42 53 28 31 19 21 27 19 65 74 37

Total Loans and Leases 124 98 61 34 32 38 43 43 39 41 62 65 57

Note: Top 50 banks by market cap.

Source: U.S. Bancorp Piper Jaffray and SNL DataSource (Common Regulatory Fins.)

Several of the nations largest banks, including Citicorp, were on the verge of failure in

1991, given excessive real estate concentrations. Collateral values were often well belowloan amounts, as office vacancy rates soared. Several banks were taken over by the federalgovernment, restructured, and sold at open bid. NationsBank and Fleet were two of theearly beneficiaries of these government-assisted transactions.

During the late 1980s, large U.S. multinational banks also suffered through an LDC (lessdeveloped country) debt problem. Many of these weaknesses arose from a Latin Americansovereign debt binge, in which countries took on massive levels of debt to finance fiscalprograms, and then revenues failed to materialize. These issues were primarily withgovernments and country restructurings as opposed to corporate or consumer borrowers,unlike the recent shortfalls in Argentina during 2001-02 when the government effectivelydefaulted, many companies went out of business, and unemployment soared.

The most pronounced weakening in recent times has been due to overexposure to telecom,technology, and merchant energy business. In our assessment, recent credit losses havebeen due primarily to loans made with inadequate collateral support, excessive exposureconcentrations, and a weakening in the equities markets. Many banks that sought to lendto the new economy companies during the late 1990s have experienced serious loanlosses since 2000. We are currently focused on airlines and merchant-energy-relatedexposure as potential areas of weakness in 2003.

Unlike commercial lending, which has gone through two or three distinct cycles during thelast 20 years, we have yet to go through an applicable consumer-based credit cycle. In fact,it is difficult to get applicable historical consumer loss trends when we are operating in asignificantly different environment. The U.S. consumer debt has expanded to 104% ofincome from 85% in 1990. We would expect consumer loan losses to peak at a higherrate if unemployment increases significantly.


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Nonbanking Trends Among the top 10 major U.S. banks, fee-related businesses generate 41% of total earningsat U.S. commercial banks, including processing at 13%, credit cards at 11%, investmentbanking at 10%, and asset management at 7% (see Exhibit 27). The traditional

commercial and consumer banking businesses contribute 59% of total earnings.

L A R G E - C A P B A N K S 2 0 0 3 E E A R N I N G S M I X

Exhibit 28


Retail44%

Corporate

15%

InvestmentBanking

10%

Processing

13%

Asset Mgmt

7%

Cards

11%

Traditional

Banking59%

Non-Traditional

Banking41%

Investment Banking During the 1990s, commercial banks increasingly became involved in investment banking

through a loophole in the bank holding company act known as Section 20, which allowedup to 10% of total revenues from a subsidiary to be derived from securities activity (thislimit was later raised to 25%). Upwards of 25 domestic banking organizations had someauthority to underwrite and deal in ineligible securities activities by 1995. Thoseorganizations at the forefront of transformation were J.P. Morgan and Bankers Trust,which had pushed into investment banking products in the early 1990s. Several regionalbanks also acquired small investment bank boutiques in 1997-98, includingNationsBanks acquisition of Montgomery, Bank of Americas purchase of RobertsonStephens, and U.S. Bancorps acquisition of Piper Jaffray. In addition, many foreign banksacquired U.S. investment banks including Credit Suisses purchase of DLJ Securities in thesummer of 2000, UBSs acquisition of Paine Webber, while Chase Manhattan acquired J.P.Morgan in the summer of 2000 as well.

Since the summer of 2000 when the global equities market began to deteriorate, severalforeign banks have abandoned their U.S. capital markets efforts, while others have startedmassive downsizing programs. We estimate J.P. Morgan Chase has cut roughly 45% of itsinvestment banking staff since the peak, while Merrill Lynch has reduced personnel by30%. Nevertheless, securities industry employment remains somewhat high, down only10% since reaching a peak in 2000. In our assessment, many investment banks chased atechnology issuance bubble, where tech and telecom issuance activity during 1996-2001was nearly four times what it was compared to the previous six years.


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Asset Management During the 1990s, banks became increasingly active in selling investment products orrevamping existing Trust organizations. Mellon acquired Dreyfus and PNC purchasedBlackrock. These two deals, along with an effort to cross-sell investment productsincluding mutual funds and annuities, were prompted by concerns that investors wouldincreasingly shun traditional bank savings and deposit accounts for faster growthopportunities in the public markets. Ironically, deposit growth never slowed materially,while investment outflows and weak equities market performance have impaired somebanking organizations ability to post up earnings quarters.

Asset management remains a potentially very attractive business for banks as they cross-sell their deposit clients a broad array of products and services. Banks were heavilyinvolved in providing trust-related services during the early 1990s, but have tried todevelop groups of mutual fund families to address the needs of the retail investor.

Processing Banks have increasingly sought out processing-related acquisitions to expand their fee-based businesses. Processing is primarily the function of handling transactions for assetmanagers, money managers, pension funds, and corporations. Securities clearance,custody, wire transfer, corporate trust, and ADRs are the most common types ofprocessing. And processing banks have typically attempted to cross-sell additional fee-based products to their customers, including foreign exchange and analytical supporttools.

During the 1990s, the U.S. processing business went through a significant consolidationphase in which several banks recognized they could not compete from an economies ofscale perspective and thus sold out to larger players. Today, Bank of New York, StateStreet, and Northern Trust are among the major players in this business, while Citigroupand J.P. Morgan Chase are also well represented. The major processing companies

continue to acquire new contracts from other financial services players, while alsocompeting heavily amongst each other for existing books. We view the processingenvironment as exceptionally competitive (see Exhibit 28) with State Street, NorthernTrust, and Bank of New York recently paying very high prices for acquisitions.

S T A T E S T R E E T I N V E S T O R S E R V I C E S C O M P E T I T I V E W I N S A N D L O S S E S

Exhibit 29

Assets Won From

($US billions)

Assets Lost To

($US billions)

Assets Won From

($US billions)

Assets Lost To

($US billions)

Bank of New York (#=) 67 56 8 28Citibank (#@>) 5 83 40 1

Deutsche 86 3 7 0

J.P. Morgan Chase (#>) 123 12 21 7

Northern Trust (#) 5 4 81 2

Mellon 20 9 3 25

PFPC 161 0 1 1

All Others 181 15 40 40

Totals 648 182 201 104

01/01/2001 03/31/2002 04/01/2002 09/30/2002

Source: Company report


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Credit Cards In our assessment, the credit card market is becoming increasingly competitive with fewerand fewer players each year. Over the last five years there has been significantconsolidation with 10 players now controlling 80% of the overall market, up from 55%in 1995 (see Exhibit 29). We think some of the monoline credit card companies couldpotentially be acquired, while many marginal players continue to exit the business. Intimes of economic stress, monolines have suffered as the markets become less willing tosupport increased funding costs given the potential for higher credit costs.

Processing revenues are highly dependent upon equity market values and volumes acrossseveral markets; thus with a generally deteriorating capital markets environment, wewould expect revenues to decline also. We have significantly below-consensus estimates on

all the processor banks in 2003 and expect revenue growth to be 12% in 2003.

Rank Company 1995 Company 4Q02

1 Citibank (#@>) 44.8$ Citibank 116.6$2 Discover 27.8 MBNA 79.53 MBNA (#) 25.2 Bank One 74.04 First Chicago 17.5 Chase 50.75 First USA 17.4 Discover * 49.4

6 AT&T 14.1 Capital One 43.2

7 Household (#>) 12.9 Bank of America 30.78 Chase (#>) 12.8 Providian 19.69 Chemical 10.8 Household 17.010 Capital One (#>) 10.4 Fleet 16.2

11 Advanta 10.0 Sears (#) 12.412 Banc One (#>=) 9.7 Metris (#>=) 11.313 Bank America (#=) 9.2 Wells Fargo 11.314 Bank of New York (#=) 8.6 U.S. Bancorp (~+) 9.7

15 NationsBank 7.4 USAA Federal 5.416 First Union 5.4 First National * 3.417 Wells Fargo (#=) 4.9 Target (#>=) 3.318 Wachovia (#@=) 4.5 Advanta 2.619 Providian (#>) 4.5 Cross Country 1.9

20 Chevy Chase 4.3 CompuCredit 1.9348.6$ 560.1$

55% 80%

Industry Total *

Top 10 Market Share

U . S . C R E D I T C A R D I N D U S T R Y O V E R V I E W

End Of Period Outstandings

($ In Billions)

Exhibit 30

*Note: Includes Visa, MasterCard and Discover

Source: Company reports and The Nielson Report (U.S. bankcard only)


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April 2003


Mortgage Banking Similar to credit cards, the mortgage banking business has increasingly becomeconcentrated among a few large players (see Exhibit 30 & 31). This involves both theorigination of loans and servicing of mortgage portfolios. And ideally, there is an offset

between these two functions. There is a natural hedge between mortgage origination andservicing. When the economy begins to accelerate and interest rates increase, thatgenerally translates into lower origination levels and higher servicing values.

T O P 1 0 - R E S I D E N T I A L S E R V I C E R S A N D O R I G I N A T O R S

(In $ Billions)

Exhibits 31, 32

Source: National Mortgage News

Technology And The

Evolution

Banks have traditionally spent anywhere from 10%-15% of total expenses on technology

each year with the bulk of the investment in maintaining existing IT systems. Theopportunity has always been to transition from spending on maintenance to spending onR&D and enhancing the customer experience. For instance, banks are currently investingincremental dollars in data warehousing and intelligence software. Some have recentlyoutsourced technology programs to such companies as IBM and EDS (#).

Turning back the clocks to 1999, there was a time when the Internet was the dominantinvestment theme within the equity markets that some banks were quick to adopt. Forinstance, Bank One developed a stand-alone Internet channel called Wingspan givenfears that the Internet might disintermediate existing pricing for bank customers. Incontrast, better run organizations such as Wells Fargo continually stressed the Internet asjust one more distribution channel used to enhance the customer experience. Today,roughly a third of Wells Fargos customers are using online banking services, of which

about 30% pay bills online. In our assessment, those customers with bill paymentcapabilities are less likely to leave the bank.

Rank Servicer 4Q02 Y/Y Chg. 4Q01

1 Washington Mutual (#>+) 723.15$ 45.6% 496.70$

2 Wells Fargo Home Mtg. 570.32 16.9% 487.82

3 Countrywide Credit Ind. 452.41 34.4% 336.63

4 Chase Manhattan Mtg. 429.02 -0.2% 429.845 Bank of America CFG RE 264.52 -11.6% 299.09

6 GMAC Mortgage 198.64 3.5% 191.99

7 ABN Amro Mtg. 184.46 25.9% 146.48

8 National City Mortgage 123.10 38.4% 88.92

9 Cendant Mortgage 115.85 17.3% 98.80

10 CitiMortgage, Inc. 115.40 11.5% 103.51

TOP 10 Total 3,176.87$ 6.8% 2,973.31$

Rank Originator 4Q02 Y/Y Chg. 4Q01

1 Wells Fargo Home Mtg. 112.58$ 56.4% 71.97$

2 Washington Mutual 108.60 97.7% 54.94

3 Countrywide Credit Ind. 102.10 106.5% 49.44

4 Chase Manhattan Mtg. 60.86 20.8% 50.405 ABN Amro Mtg. 40.58 42.8% 28.42

6 Bank of America Cons. RE 31.88 39.6% 22.84

7 National City Mtg. 29.49 43.4% 20.57

8 GMAC Mtg. 25.14 64.9% 15.25

9 Cendant Mortgage 19.20 38.6% 13.8510 Homecoming/GMAC-RFC 17.20 48.9% 11.55

TOP 10 Total 547.63$ 54.3% 354.96$


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April 2003


H I S T O R Y O F B A N K I N G

Regulatory And

Legislative History The

Pendulum Swings Back

In our assessment, banks are once again becoming subjected to increased levels of scrutinyby regulators and legislators after experiencing several years of positive regulatorydevelopments. More specifically, increased attention has come from state attorney generaloffices in New York and California, while the state of Massachusetts attempts toretroactively tax banks located in that state. On the national level, the regulators haverecently created tactical rules, such as curtailing marketing programs to sub-primecredit card clients.

Throughout the last 100 years legislators have sought to improve the safety and soundnessof the banking system by enhancing regulations. Occasionally, these regulatory efforts

have gone beyond reasonable, resulting in overly burdensome hindrances to free marketactivity.

In exchange for a commercial banks sole ability to collect deposits comes a socialresponsibility as well as immense regulatory infrastructure. The banking organization isusually examined by at least three regulatory entities including the Federal Reserve as theholding company inspector, the FDIC, and either the state or Office of Comptroller of theCurrency (OCC) examiners. The Federal Reserve will also usually examine state-memberbanks as well.

During the early years of modern banking, significant bank failures such as those at theturn of the twentieth century were somewhat commonplace and depositors typically losttheir entire savings. Legislators sought to add stability to both the U.S. banking system and

the domestic economy through increased regulation. The Federal Reserve System wasformed in 1913 to regulate banks, act as a lender of last resort, and create a more formalmonetary/liquidity system.

The next significant legislation was the Pepper-McFadden Act of 1927, which prohibitednational banks from establishing interstate branching networks. This act somewhatallowed both small and large banks to flourish within their local markets without fear oflarge-scale competition.

The stock market crash of 1929 was followed by numerous bank failures and the greatdepression. In 1930, security affiliates of banks were sponsoring 54.4% of all newsecurities issuances. There were several incidences of individual excess and fraud leadingup to the stock market crash, which resulted in creation of the somewhat misguided GlassSteagall Act of 1933. This legislation sought to separate and limit banks investingactivities in an attempt to stabilize the banking industry. Recurring and stable returnsbecame significantly more important.

After several years, regulatory barriers began to slowly fade away during the second halfof the twentieth century, punctuated by the Bank Holding Company Act of 1956, the oneBank Holding Company Act of 1970, and finally, perhaps the most importantdevelopment, the Depository Institutions Deregulation and Monetary Control Act of1980. The Control Act phased out Regulation Q interest rate ceilings and introducednegotiable-order-of-withdrawal (NOW) accounts so banks could compete with moneymarket funds for deposits.


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Throughout the 1970s and 1980s banks found it increasingly difficult to compete withnonbanks as regulatory barriers were lifted. Funding cost advantages narrowed and assetsecuritization became more typical. Banks became unsheltered from nonbank competition

during the 1980s, reducing profitability and spreads in traditional corporate and consumerbusinesses.

In the late 1980s, U.S. commercial banks were beset by a number of high-profiledifficulties, as loan concentrations in LDC debt and commercial real estate negativelyimpacted many of the largest players in the industry. Citicorp was on the verge of failureand was under constant regulatory watch in 1990-1991. In some ways these severeproblems may have been a function of increased competition from nonbanks and aresultant stretch for profitability. Risk-based capital gu

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