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First big domestic bank merger post-crisis

| February 8, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The surprise merger announcement between BB&T and SunTrust provoked a sharp rally in SunTrust bonds. Reduce or exit positions in two of the SunTrust callable preferreds, as they lack change of control language and extension risk is material.

SunTrust bonds rally on merger announcement

In a big surprise in the domestic bank space, BB&T Corp. (BBT: A2/A-/A+) agreed to acquire SunTrust Banks (STI: Baa1/ BBB+ Pos/ A- CWP) in the largest deal since the financial crisis. Mergers have been all-but forbidden not only for the larger banks given the antitrust and market concentration limitations, but also for the larger regional banks. The near-failed effort for M&T Bank (MTB: A3/A-/A) to acquire Hudson City Bancorp took over three years to close after the announcement in Aug 2012, due to extra scrutiny on M&T’s anti-money laundering protocols. That acquisition by MTB was relatively small, or only 1/6th the equity market valuation of the BBT / STI merger.

The markets have already moved materially on some of the securities, which investors should act upon. Namely, the STI 5.05% NC22 and the STI 5.125% NC27 notes traded up considerably on the day of the announcement. The 5.05% notes are callable in June 2022 and have a floating reset of 3mL + 310.2 bp, and the 5.125% callable in Dec 2027 have an even lower reset of 3mL+ 278.6 bp. Both of these notes do not have change of control. Some investors are of the opinion that the potential move to investment grade justifies the move to $97.50 after the merger announcement. Reduce or exit this position anywhere close to this price as the extension risk is material. JPM 4.625% NC22 are investment grade, have a reset of +258 bp and are trading with a yield to call of 7.15%, which is a better measure for pricing perpetual risk.

The all-stock deal will combine BBT, the 10th largest and STI, the 11th largest domestic banks to be the 6th largest bank as measured by total assets with an expected balance sheet of $443 billion. This will put the yet-to-be-named pro forma company just behind US Bancorp (USB: A1/A+/AA-) with $465 billion and ahead of PNC Financial (PNC: A3/A-/A+) with $380 billion in total assets. What this means for the broader industry will be left for debate for months to come, but what seems clear is that since the shift in political winds in the US, the lower regulatory friction is likely to be positive for banks looking to grow through mergers.

Before we look to evaluate other merger candidates, it is important to evaluate the pros and cons of the BBT / STI deal:

Pros

  • Cost savings net of investments are expected to be $1.6 billion annually, which will help keep the pro forma company overhead ratio in the low 50s area.
  • Combination of complimentary business lines in lending and fee revenues, which are expected to be in the area of 40% of total revs.
  • Strong cultural over-lap will help make integration easy.
  • Commanding market share in a number of markets in the Southeast.

Cons

  • Company estimates deposit divestitures will be $1.35 billion, but with such tight market share overlap in 20 cities, this could be a low estimate and change the funding profile of the company.
  • Given the move for each BBT and STI from Category IV banks (as measured by assets) to a Category III bank, this will elevate the funding burden. Category III banks must maintain LCR and NSFR requirements at an expected range of 70-85% of what the SIFI banks are required to maintain.

Evaluating other merger candidates

As soon as the deal was announced, investors immediately began looking at what other regional banks could be potential merger candidates. This list is not long as there are few meaningful transactions that could happen, and none of which would be as large as the BBT / STI deal:

  • US Bancorp is the fifth-largest domestic bank at $465 billion in assets, though far behind Wells Fargo at $1.87 trillion in assets. USB tends to be very conservative in its management style, which has garnered it the respect of investors. This is evident in the tight spreads of the bonds, which tend to trade inside of peers. However, the geographic footprint of USB lacks presence in the Northeast or Southeast, which could leave the door open to anything from COF, CFG, RF or MTB. Each of those transactions has limited appeal either because of the riskier business at COF, the lower ROA at each of those banks versus USB, or the challenges in “selling” it to the markets.
  • Capital One Financial (COF: Baa1/BBB/A-) is already a roll-up story of its own with a multitude of small M&A transactions, as well as some big deals. With $363 billion in assets as of year-end 2018 this is the amalgamation of COF, NorthFork, Hibernia, GECC assets, and HSBC branches. Despite this acquisitive nature, COF only has a meaningful branch network in NY, VA, TX and LA, which leaves the door open on such acquisitions as FITB, RF, or MTB to name a few.
  • Citizens Financial Group (CFG: nr/BBB+/ BBB+) is the spin-off from RBS in 2014. With a good branch network in the Northeast, this bank is more likely to be an acquisition target given the low price/book of 0.8x, which leaves it with very poor acquisition currency and what would be dilutive measures in pretty much any purchase.
  • The “other run” banks that are likely reviewing a multitude of pitch books from investment bankers include: KEY ($139 billionn assets), MTB ($117 billion), HBAN ($106 billion), and CMA ($71 billion) from which point the drop-off in assets is rather steep for any other likely acquirers.

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