Chief Investment Officer
Commercial Loan Automation
to tarp or not to tarp
Yesterday's BirdsEye View got lots of reaction, and many requests for TARP information. The boards I serve on have been asking the same question. In response to these requests, below is my own offering as to the TARP question: To TARP or not to TARP, this is the question... This is the first time I've offered two articles back-to-back, but time is of the essence.
My apologies to those of you who find the topic of less interest. Just click "delete" :)
Again, those of you who are interested in the Morgan, Stanley detailed outline, just email me back and I'll send it to you.
A reaction to yesterday's article from Robert Boyd, SVP and CRO for Zions Bank, Utah, can be helpful to all of us:
"In addition to the points your raise, I have a couple other thoughts (in no particular order and somewhat disjointed thoughts):
Loans should be transferred to or involve the work out area as early in the deterioration cycle as possible. The options for rehabilitating a borrower or working out of a problem are dramatically better the earlier they are recognized and addressed. Loan officers that bring problems to the forefront should receive positive reinforcement not negative criticism (of course if every loan in the officers portfolio is a problem, maybe the officer is the root cause!).
Use your resources to the full advantage. Loan review should be a consultant to your loan groups not a nemesis. Discussions with this group on what they are seeing globally as well as specifically can help identify trends early. With proper intervention or adjustments, problems can be isolated and remediated much more easily. This will only work if the review/exam group has the attitude of a consultant and not a "gotcha" mentality.
A lot of effort goes into to post mortem analysis and policy and exception tracking but all to often the warnings these efforts provide are ignored. If it is worth the effort to track you should be willing to act upon the information. If not, quit wasting everyone's time and energies. (AB note: Too true!!)
You mentioned loan officer turnover as an early indicator of trouble. Another more subtle component may be the average number of years in lending for your loan officers and specific individual years of lending. As mentioned, many of the loan officers of today have not been through a down cycle. It is very easy to hide weak credit in an up moving economy. Many loan officers had "time bombs" in their portfolios that did not explode for the mere timing of when they moved to the next lender. The younger the lending group (in year of lending not actual age) the more you need experience oversight to keep an eye on trends and portfolio quality. This experience level will also help to identify trouble earlier and get to the proper people to work through.
Even your best customer will be negatively affected in a cycle as broad and harsh as the current environment. You cannot ignore your best customers in difficult times. You should be looking ahead with them now on what may impact their business and what they and you need to prepare for and be ready to address. You may need to set some internal limits on how much additional credit you will lend, or how low you will allow ratios to fall before you take action or require action by the borrower. Some of these issues should be openly discussed with your borrower so they can be prepared as well. You both need to understand the consequence of action and in-action. It is much easier to deal with problems when you have a plan in place before you get there.
Don't forget the human factor. Dealing with problems is not easy. Closing a business or foreclosing on property does not make people feel proud or good. In fact, many people can be emotionally upset knowing they are putting people out of jobs or out of homes. This weighs more heavily on minds during holiday seasons. Keep an eye on your employee moral and as times get difficult you need to show more encouragement, do more team building and employee motivation functions. Take time to laugh and have fun and forget about the problems for awhile.
At the end of the day, you still need to know "when to hold 'em and when to fold 'em." Some loans are just too far down to make a successful recovery and you end up liquidating. But why do we always wait until the bad times to manage our portfolios? It is easier for borrowers to refinance with another bank when they are not steps away from the grave or bankruptcy. Right now everyone is battening down the hatches and trying to hang on for dear life. When the storm is over, we will still need to look at the loan portfolio and determine which loans will be in the next wave or crisis. An active review of loan portfolios to weed out the weak should be conducted on a regular basis. Move the marginal borrowers before they become a problem.
Try not to be the last bank in the line who gets the marginal borrower that turns into a loss! Easier said than done. Why is that customer you've been calling on for years suddenly interested in talking to you? Why is price no longer an issue to the borrower? Why is the borrower calling you now when they would not even see you in the past? When banks turn from the "weather the storm" focus to ramping up production again, many of these questions will never even be asked! let alone given serious thought.
Article synopsis: TARP has pros and cons, but the pros outweigh the cons.
To TARP or not to TARP?
CEOs of large and small banks alike are wrestling with the question: should they avail themselves of a piece of the government's $125 billion of capital offered to them? Unlike the nation's largest 9 banks, they have a choice in the matter.
Answering this question isn't easy, particularly given the countless uncertainties associated with the plan. A recent conference call with 35+ SuperCommunity bank CEOs confirmed that the vast majority of executives are deeply concerned about the unknown elements of the program.
Below is an attempt to outline some of the pluses, minuses and unknowns we are all facing. I hope the laundry list will help you determine whether TARP is for you.
TARP will strengthen the banking system, which is a good thing for all of us. Customer jitters have exceeded expectations, as evidenced by the tapping out of Treasury issues (and their price) as well as customers' flight to quality (or interest-free DDAs, now temporarily fully insured).
The recession is upon us, but none of us knows how deep or long it will go. Excess capital will help everyone weather the storm better.
Banks can't get capital on better terms today, and some can't get it at all. The financial aspects of the plan are very attractive (5% for 5 years, then 9%, callable in 3 years etc.), notwithstanding the $64 billion dollar question: what will the government do next, once its nose is inside our collective tents?
TARP will provide stronger banks (it's only available to banks with CAMEL ratings of 1 and 2, and, on a case-by-case basis for 3 rated banks), with excess capital that will facilitate their buying weaker banks and thereby further rationalizing the system.
Capital availability overall is questionable. Even if one is willing to accept draconian terms, such as double digit dividend rates, generous board seats and huge ownership dilution, capital might still not be available.
The temporary capital glut can be EPS neutral through a securities purchase program in the short term, until better uses for the capital emerge.
Your first loss is your best loss. TARP money can help some banks truly come to grips with their asset quality and securities market valuations and further write down their assets to a more realistic level.
It is unclear whether not taking the capital will result in negative stigma to the bank.
The financial system is getting re-intermediated, with $2.5 trillion of loans that were in SIVs, CDOs etc. coming back on banks' balance sheet. You need the capital to absorb your fair share of the credits.
It'll take growing the securities portfolio 3-4 times to make the excess capital neutral/cover the cost. It's a significant medium-term commitment.
Availability to sub S banks is unclear. My expectation is that they will be able to access the capital.
It this a fair deal to those banks who have run a strong balance sheet thus far? Isn't this supporting weaker banks unfairly? What about free market and Darwinistic capitalism?
Are you delaying the failure of any bank whose deposits are worth buying 4-5 years hence?
Do you want to be the CEO who missed the opportunity?
You may become acquisition bait if you didn't take TARP funds and another bank with capital did.
The money is callable only after 3 years; who knows what will happen between now and then?
Rating agency treatment is uncertain, despite their demise, their opinion still counts
Known activity limits include:
- no share repurchase;
- no golden parachutes;
- no 280G treatment to senior executives' compensation during change of control;
- no dividend increase without approval of Treasury for three years;
- no tax deductibility of executive compensation above $500K;
Equity markets might be very inefficient in 3-5 years when it's time to replace the capital. There will be a flood of capital issued which will impact pricing and market capacity to absorb, pricing etc.
This might be only the beginning, a harbinger of more government intervention.
Timing of unwinding the leverage position might also create temporary but critical pricing aberrations.
The government retains the ability to transfer its warrants at any time, flexibility that might imply lack of control over your own destiny.
The government can always change the rules.
To summarize, the pluses are:
- Cheap capital
- Strengthen regulatory capital ratios
- Peer pressure
- Cushion in uncertain economic times
- Enhances strategic flexibility
The minuses are:
- Limitations on business
- Limitations on CEO compensation
- Some banks don't need it
- Uncertainty as to final terms and future changes
Obviously, every bank has its own unique issues and opportunities to consider. Only you know how deep is the hole within your assets, and whether you have enough capital to fully handle it. Some banks, most notably recent IPOs, have more capital than they can currently deploy, and have no use for additional cushion. Even if you could use extra capital, but can't deploy it immediately, TARP money will depress your earnings temporarily.
At the same time, we should recognize that we live in unprecedented times. What we are seeing these days are phenomena that have never occurred before, and therefore we can't predict how they will get resolved. This is true not only regarding the precipitous rise and fall of the residential real estate market, the melt-down of the secondary market for mortgage instruments within hours and the evaporation of robust, deep markets such as the Trust Preferred market literally overnight. This is also true for other key financial instruments that reflect the extraordinary unpredictability we've had to deal with in recent months, such as the swap curve, which so many banks use as a central indicator in their asset/liability management. The 5 year swap to Treasuries is at an all time high, while the 30 year is at an all time low, and has, for the first time, reflected a negative spread to Treasuries. We are seeing behavior in the financial and derivative markets that was professed to be impossible, both by market forces and by mathematical calculations.
This level of uncertainty requires extraordinary protective measures from all of us. It might be time to say, there is no such thing as too much capital&at least not in the short term!