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We celebrated Dick's birthday Labor Day weekend, Everyone got together in Napa and we ate our little hearts out, played Bacci ball (Guy was the undisputed champ with 2 4 ball wins) and just hung out. It was awesome! Plus, Paul and Arik made for Dick an album with 60 of their favorite pictures of him with titles that were both amusing and tugging at your heart strings. it was a perfect gift! I put some pictures on the website for you to share the festivities with us.

Also, thanks in advance for your comments and insights regarding 2009. My crystal ball is clouded by all the unprecedented developments we've seen in recent months. Thanks for helping me clear that vision up with your perspectives.

Article synopsis: 2009 will be a tough one, but there is a silver lining in every cloud.

2009 Outlook: The First Cut

I can't recall a time when I felt more tentative as I sat down to write my outlook for the coming six months. While my record has been quite good, I find myself questioning every economic factum, every projection, given the unprecedented pace and magnitude of the meltdown certain industry segments have experienced. We all continue to seek the bottom, and it continues to elude us.

Further, as I ask my friends for their crystal ball picture, unmitigated gloom rules the horizon. Almost to a person, the outlook for 2009 is bleak. I, the eternal optimist, have a difficult time seeing clouds everywhere. So, in addition to the sobering news yet to come, I'll offer some rays of hope that might warm our industry yet in 2009.

Real estate

The real estate market is at the root of our industry's turmoil. It is that market that built and then destroyed the CDOs, melted away up to $600 billion, some say, of capital, and accounts for between 30-50% of our economy directly or in related industries, some say. Hence, my outlook starts with real estate: residential, commercial, builders and homeowners.

The market, as I have said before, is supremely regionalized. While brand new, lovely homes in Merced, CA sell for 50% of their value a year ago, a 2000 sq. ft house in so-so condition in Burlingame, CA still sells at a premium to the asking price within 24 hours of coming on the market. Yet, we all know this is the exception to the rule, and such coveted markets are few and far in between.

Housing inventory looks like this:

• Housing under construction inventory has declined precipitously year over year in 2Q08, down 34.4%
• Finished vacant housing inventory is down slightly, 3.5%
• Vacant developed lots are UP 8.8%
• Future lot inventory is also up 8%

Conclusion: while builders wised up and reduced construction and inventories are being slowly absorbed as pricing rationalizes, finished and future lot inventories, a.k.a future houses, continue to grow.

The economy

The good news:

• Very strong government spending
• Service job formation
• Steady corporate profits
• Economic stimulus package
• Mortgage rates are holding at relatively low levels
• An election year

The bad news:

• High energy prices
• Job growth close to zero nationwide*
• Growing inflation concerns
• Consumer confidence has fallen to recessionary levels and their home-buying intentions are in the tank
• Eliminating subprime lending has caused effective housing demand to drop by 25%
• Subprime meltdown continues
• Housing prices are dropping; housing completions exceed closings
• Unemployment up to 5.5%
• An election year

*Job formation varies widely, from 65,000 jobs created in Dallas-Ft. Worth to 8,000 jobs lost in Detroit-Warren-Livonia in Michigan.

I anticipate bad news will continue. Unemployment will continue to rise, home inventory will also grow as consumers' intention to buy a new home is not keeping pace with the resale market, and the housing construction slowdown continues to drag the national economy into a recession that will blossom in 2009.

The regulators

The regulators and the FDIC, alarmed by the precipitous deterioration of real-estate intensive banks with no relief in sight, coupled with the huge IndyMac loss, are ready for battle. They are determined to ensure that such losses will not occur again, and are working nationwide to force loan and securities write-downs to realistic and below levels. No one is spared, and current appraisals are used to accurately reflect today's deeply depressed markets.

The regulators also redefined what adequate risk-based capital is, and in effect require 12%, not 10%, as their acceptable ratio. This puts further pressure on the already straining capital markets, increases the cost of raising capital, and pushes many banks to reduce their lending in order to manage their risk-based capital to these new expectations.

At June 30, 2008 the FDIC had 117 institutions with $78B on its problem list, a jump of more than $50B ($32B of which were IndyMac), and the number is expected to grow further. Non-current loans continue to rise and exceeded 2% 6/30/2008, the highest level since 1991. Mortgages were the largest category, but the fastest growing one was construction loans. Net charge-offs jumped to $26.4B system-wide in 2Q, the highest level since 2001, and bank earnings were very week at $5B, down from $19.3B in 1Q. This represents the weakest quarter of bank earnings since 1991 save 4Q97.

The industry

Two new phenomena are casting further gloom over the business. Recent bank failures and future anticipated ones include larger banks that take a serious bite from the insurance fund. This has made large accounts nervous across the system, and puts the growth of large deposits at risk. Since larger deposits have been the fastest growing deposit category, this is a serious issue in an industry that's already strapped for funding.

Secondly, deposits in the banking system declined during the second quarter for the first time in decades. This is another ominous sign, and its ramifications are clear. Over 5300 institutions borrowed from the FHLB $841+B

Overall, a $38.8B spike in loan loss provision wiped out a $8.2B system-wide gain in interest income. Only 42.6% of banks reported earnings gains, down from 56% two years ago.

Capital

It is at times like these that capital and liquidity become kings, and indeed they are. In excess of $200 billion of capital has been issued since January 2008, and some say another $400 billion are still needed.

Understanding the credit "hole" has been an issue, which resulted in longer lag times for capital raises, stricter due diligence by investors and heavy discounts to market.

To-date, over 90% of the capital raised has been to mega-banks with assets over $100 billion. However, many community banks are looking at capital raises, yet lack the resources to prepare for such a transaction since past experience is much less relevant to a successful raise.

Liquidity

The definition of liquidity and its secondary and tertiary sources has become a moving target, not just by the regulators but also by industry participants. Municipal deposits, for example, have become less popular given the intensive price competition and their classification as institutional funds and non-core. Instead, some banks have turned on their Internet Bank spigot, gathering deposits at similar or even higher prices; internet bank deposits "count" as core retail deposits.

The competition for deposits continues to be fierce, as fears of depositor panic and funding shortage press banks to lower deposits rates much more slowly than loan rates.

As the Fed lowers rates, earnings credit for checking accounts declines rapidly. In addition, their value appears to be marginal, since average deposit size is small relative to money market, internet and other deposit categories. Banks have been trapped in this quandary in the past, pursuing wholesale funding as the value of interest-free deposits declined with lower rates. I urge you all not to repeat past mistakes, and remember that checking accounts are ALWAYS beautiful, not just because of the huge margins they create, but also since they anchor the customer relationships and are a great source of fee income.

People

The human aspect of our industry crisis is rarely mentioned these days, when capital and liquidity rule our minds. Nonetheless, the question needs to be asked: how do you lead when there is little light at the end of the tunnel, and when the length of the tunnel is unknown? Stamina is critical in these tough times, which are expected to last at least 18 more months by the most optimistic outlooks. How do you retain, pay and motivate your staff? Management will be facing new and unique challenges in managing its human capital during 2009 and beyond.

Fee income

Capital scarcity makes fee income even more critical in 2009 than ever before. At the same time, traditional fee income sources that generated growing Capital-free income for ages, such as overdraft and ATM fees, are on the decline. New fee income tactics and sources are needed for all major bank lines of business: commercial, retail, wealth management etc.

Silver linings

The next 18 months will be very tough for almost all of us. Are there any bright spots on the horizon?

• Housing is a cyclical business. Within the next two years, in most markets, prices will decline enough to reach equilibrium, and we'll turn the corner toward recovery. This, too, shall pass (but not as quickly as we'd hoped...)
• The excesses are being wrung out of the system. We have consistently increase capacity for the past 40 years. Branch numbers are at an all time high. I believe 2008 will show that we're decelerating the rate of branch growth, which is good for all of us. This, coupled with some bank failures, will rationalize somewhat our delivery system.
• Scarce capital weeds out imprudent lenders. Reckless loan practices are on hold as banks continue to write down their portfolios. New loans are better priced, and, more importantly, enjoy better terms. We still aren't fully paid for the risk, but we're doing better.
• Non-core businesses are being shed. With capital scarcity comes discipline and better capital allocation practices, including more rigorous analyses of RAROC. Banks are looking at non-core businesses with a more critical eye and will employ their capital more wisely.
• Cost discipline is coming back. This could be a double edged sword, but, as a general practice, is a good thing.
• Acquisitions will reheat up, especially assisted deals. The second half of 2009 will bring us more bargains as the government will intervene to facilitate distressed sales by limiting the downside risk as it has done in the past.
• Margin landing is back in a big way. Lack of credit availability and banks' liquidity challenges have brought back better pricing and terms. Borrowers are learning to spell "Prime Rate" again and are not bulking at cross guarantees etc. in many markets.

Survival suggestions

• Strategic clarity. Know who you are, and, more importantly, who you are not. Stick to your successful business model, tweak and modernize, but don't veer too far afield away from your core strength.
• Core deposits. They might not look as pretty today in your transfer pricing system, but they are always beautiful in my book. Treat them today and tomorrow, no matter how low rates get, as indispensible elements and a core foundation to your business.
• Build customer relationships. Ultimately, predictability of growing, quality earnings is what we are all looking for. The way to get there is with reliable customer relationships where the value proposition offers win-win combinations for your shareholders and clients alike. Product design and effective pricing aside, solid execution is the real key here, one customer at a time.

In sum, my outlook for 2009 is: The strong will get stronger, and the weak will get weaker.