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BBV Buys Compass Banchshares: What's Normal When You Dance On a Volcano?
February 27, 2007

BBV Buys Compass Banchshares: What's Normal When You Dance On a Volcano?

"[The] real problem... is not that global investors are unaware of the risks. Rather, they are too used to living on the edge of the volcano. Until the eruption proper, another few rumbles are neither here nor there."

Tony Jackson
Financial Times

Last week, when we suggested that a certain oil-producing nation might eventually run into financial trouble, this due to the manic tendencies of its titular leader, it was pointed out that the credit default spreads for Venezuela were trading at just 150bp -- hardly a confirmation of our bearish views. Indeed, spreads on the entire emerging markets complex are as tight as ever, making some wizened observers wonder if plentiful liquidity is really a good thing for asset prices and investor behavior both.

Low risk spreads and equally toppy equity market valuations have not stopped a spate of "innovative" private equity deals and M&A transactions in the past couple of weeks. To the contrary, the hunt for new transactions, whether to create the appearance of growth or to generate near-term fees for advisers, is driving the deal machine relentlessly, notwithstanding the growing concerns from the risk community that the narrow risk spreads cannot possibly compensate investors willing to offset such risks.

The recent mega buyout deals in the real estate and power generation sectors have two common threads: astronomical valuations and, we hear, meagre pre-deal diligence. One observer of the Equity Office process describes laptop wielding child bankers hunched over valuation models in conference rooms as the sum total diligence in that transaction. Such is the press of urgency and competitive heat behind these deals that nobody, it seems, has time to sweat the details. Perhaps this is why some of the victorious sponsors seek to offload big chucks of the target assets before the ink on the deal docs has dried.

As we noted several months ago (The IRA: Will the CDO Machine Destroy Public Equity? ), the plentiful supply of liquidity available to the buyout community is making virtually any public or private company a viable target, regardless of whether the economic fundamentals actually make sense. Remember, it's all about yield to commission. And the valuation madness still extends to the banking industry -- even as the aggregate performance and loan loss data suggests that the industry is headed for a loud belly flop in terms of credit experience and asset quality.

News that Banco Bilbao Vizcaya Argentaria SA (NYSE:BBV), Spain's second-biggest bank, agreed to buy Alabama-based Compass Bancshares Inc (NASDAQ:CBSS ) for $9.6 billion or some 3.3x book value seemingly confirms that the animal spirits are not ready to retreat. CPPS is a strong, above-peer performer, with an ROA of 1.39% and ROE over 15%, but paying 3x book for any bank, to us at least, is a sign that valuations still don't make sense.

Among the reasons why we like CBSS is the above-peer lending returns, the short Weighted Average Maturity of its loan portfolios (3 years) and the low Exposure at Default of just 43%, well-below peer. Loss Given Default at 72% is above-peer for CBSS and has been so for many years, as has the net charge-offs which were 0.31% of total loans and leases vs. just 0.21% for the peer group established by the Federal Reserve Board.

CBSS appears to be a high-quality, but expensive target for BBV, especially if that loan loss rate starts to climb. In the 2001 period, the aggregate default rate for the bank subsidiaries of CBSS was just 69bp vs. 80bp for the peer group, according to the IRA Bank Monitor using data from the FDIC, however since that time CBSS has trended above peer in terms of charge-off experience even as the aggregate loss experience for the peer group fell generally.

After almost five years of declining defaults at CBSS, albeit above peer, did BBV pull the trigger at the start of a secular upswing in loan default experience? As the FDIC notes in its latest Quarterly Banking Profile, insured institutions reported total net income of $35.7 billion in the fourth quarter of 2006, the lowest quarterly earnings total in 2006, but still more than the industry earned in any quarter prior to 2006. The liquidity tide may be going out, but it has not gone yet.

Has the availability of easy credit from the Fed set up acquirers such as BBV for a nasty surprise in 2008 and beyond? If the deal team at BBV normalized the loss expectations in their credit models base on the past five years, when defaults never broke 1%, then the answer could be yes.

In order to escape the distorting effects of Fed monetary policy and get a realistic view of loan loss rates for modeling purposes, analysts seeking to benchmark default simulations need go back to the early 1990s, when the peers of CBSS reported almost 200bp of defaults. For those of you who were still in nappies back then, that's more than the bank earned on assets in that year.

Similar questions may have been asked by the analysts who crunched the numbers for some of the largest ever buyout deals announced in recent weeks. Buy maybe not. Doing the deal, let us never forget, is an end in and of itself. Monetizing the asset acquired in the process of generating today's fee is tomorrow's problem. And after all, the volcano is not going to erupt today, right?

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