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PNC: Why is the LGD of Mercantile Bancshares So Low?
October 11, 2006

Market Risk: PNC Financial -- Why Is Mercantile Bancshares LGD So Low?

Back in February, when we heard that PNC Financial (NYSE:PNC) was going to merge its 70% stake in Black Rock (NYSE:BLK) into the asset management unit of Merrill Lynch (NYSE:MER), we applauded. Cashing in part of the Black Rock stake certainly made sense for long-suffering PNC shareholders, especially selling to the struggling MER. The $1.6 billion gain recorded by PNC after halving its stake in BLK made the bank a top performer among large regional�names.

But when we heard that PNC was spending a large part of that cash pile to buy more exposure in the crowded Baltimore-Washington banking market, this just as the US real estate valuations are showing signs of distress, we had to wince.

PNC will pay dearly to acquire the $17 billion asset Mercantile Bancshares (NASDAQ:MRBK), a multi-bank holding company that features some well-known DC area franchises. The $6 billion in cash and stock consideration�works out to more than 2.6x book value and some 3.7x MRBK's tangible book value of $1.6 billion.�

If you are a MRBK holder, look to hit the bid on that PNC paper.� This is not the most expensive large bank M&A transaction in the US market this year nor is MRBK a bad performer. With an ROA of 1.6% and an ROE of 13.7% as of Q2 2006, MRBK actually boasts better LTM performance benchmarks than its new parent, especially in areas like lending returns and Loss Given Default.

But maybe the LGD of MRBK is too good. The 11 MRBK bank units are a varied collection of�familar Washington-area brands�whose aggregate assets are 50% deployed in real estate lending. At just 8%, MRBK boasts one of the lowest LGD rates for any bank holding company of this size, although in years past the subsidiary banks of MRBK�did benchmark more closely with�the 50%�average peer LGD and the group hit 90% LGD�in 2002.��PNC, by comparison, averages an LGD of about 60-65%, dead on the large regional peer group, according to the IRA Bank Monitor.

Question that occurs, then, is whether the current low LGD experience of MRBK�is an indication of bad things ahead. As we have noted in previous comments, low LGD rates in community lenders like MRBK are usually caused by strong recoveries and equally strong collateral values. Assuming that the US real estate market bottoms big time in 2007, the valuation of MRBK may be seen in retrospect to be even more rich that it appears today.

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