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BirdsEye View

2010 outlook

My last article on asset quality drew many comments.  Here are a few.  Scott McBrair wrote:  "I reflect back on Bank One and the fact that this organization was always ready to take over a large bank from the FDIC or be a white knight for another targeted acquisition.  Then the merger "machine" took over for cultural assimilation particularly during the uncommon partnership years, as they realized the acquisition would only prove successful if the business continued to grow and benefit from related synergies delivered by employees.  There were videos, executive visits, Q & As, rallies, and in general frequent communication at all levels to allay any fears.  By the end of the process you felt privileged to have been acquired!"

Dave Maramen from M&I wrote:  "If you really want to flush out the issues, remember the old First Indiana  program I put in place via the incentive program.  If any 3rd party finds 2 or more downgrades to "Criticized" or 2 or more grade change, rather than the RM they are NOT eligible for any incentive payouts... that's how we found the problems jumping out of the wood work.  They were lined up outside my door to tell me about the potential problems.  You have to reinforce the no surprise attitude and not over react when the problems are surfaced."

  And Alfred Rath, CRO of Hancock Bank, said:  "This latest article is very good and you do us all a service to publish your newsletter as I know it is widely read - not only by credit admin types but by others too.  As you know, Asset Quality is near and dear to my heart and I am sure that is so with all "credit folks."  In 40+ years, I have never experienced such a deep and lengthy (and painful) cycle.  It is disturbing to see the list of failed banks and those on the verge - a large percentage of which are collapsing under the weight of ill advised credit decisions and poorly structured and administered transactions.  I can't help but reflect on the personal toll that is surely a part of each failure - dashed hopes, dreams and plans - what a tragedy.  Adopting your suggestions below will surely help.  Whether by check list reminder, deep knowledge, bullet points on a flip chart or other means, all bases need to be touched regularly if we are to minimize (and that is relative) the wounds during this challenging cycle."  

Brian Scott,  EVP and CCO of Midfirst, said:  "Good call on the Special Assets Committee.  We have been using one for about 6 months and it is effective for the reasons you cited.  In addition, it provides a higher level of confidentiality, better use of resources and also avoids dragging down the traditional RM's emotionally.  Listening to problem deals can be helpful from a training perspective, but a constant barrage can be damaging to the psyche of the origination force..."  

The second quarter is shaping up as we speak, and it's ugly.  The good news is, analysts already expected it to be brutal.  Among the KBW universe, for example, 2Q09 EPS estimates have been lowered for 109 companies in their universe an average or 22%.  Given past estimate slashes this is significant.  They project median operating EPS decline of 52% 2Q09 vs. 2Q08, and forecast net losses for 46% of their banks this quarter.  And we thought 2008 was a bad year...   As the antelope goes through the anaconda, I do see some green shoots, though, and hence my outlook for 2010 is not totally bleak.  Read below.  

On the personal front, I'm in Bhutan climbing the Himalayas with Dick after depositing Liat in Thimpu for her research and surviving the harrowing and unique experience of landing in Paro (again).  John Reed, the manager of the Aman Resorts there and brother of Kevin Reed, EVP of Wealth Management for Whitney, is the reason why we're back.  He's a true gem!  Plus their fabulous chocolate cookie recipe has been posted on www.anatbird.com.  Upon our return Guy and I are going to Sedona for a long weekend.  It makes me very proud to have a 36 year old son who's still willing to do our 1:1 trips after 30 years...



Article synopsis: Another tough year ahead, but better than 2009, with more opportunities, more bank failures and a better second half.


We're almost at the midpoint of the year, and I'm dusting off the old crystal ball as usual. It seems just a bit less cloudy than in the past nine months, and I hope this isn't just the optimist in me speaking.

The bailout. The very name upsets me. The government did a great job stabilizing the financial system, but, in the process, inflicted much damage on our sector. While the regulators correctly recognized that the credit crisis was in the secondary markets, not banks, the political side of the government blamed the banks for the meltdown, not distinguishing between commercial banks (and thrifts), investment banks and unregulated entities such as hedge funds. The government also ignored the key role that banks played in the unprecedented 18 year period of rising consumer spending and the use of excess leverage.

Thanks to this vilification and wild volatility and uncertainty, after less than two months of government scrutiny and rumors about nationalization of the banking system, bank stocks plummeted 33%, bringing the market cap of the top 19 to half its value since TARP began. The rebounding markets of today only brought those stock prices back to the previous levels, but stress testing should be thanked for that improvement.

I expect continued zigzagging in government policy and intent regarding our sector as we've seen in the past five months, with the on-going morphing of TARP beyond recognition of its original form. As banks rush to pay the funds back and raise equity in the newly opened markets, I fear the government will simply regulate the actions it is looking for throughout the entire system to achieve the political agenda, and the gap between TARP takers and decliners will narrow in many areas, most notably executive compensation.

The economy. Economists world-wide are still debating whether the recovery will be V shaped or very gradual. I'm no economist, but expect the latter to occur.

Meantime, plenty of bleak news continues to flood the markets:

  • Unemployment up to 8.6% and expected to reach 10% by 4Q09
  • Inflation concerns lurk as oil prices recover from their lows
  • Consumer confidence and activity weakest since 2Q1980
  • Jobless claims reached multi-decade highs; mortgage losses are yet to follow
  • More corporate bankruptcies expected, given the strong correlation between chapter 11 filings and unemployment (which rose 80%+ since 2007)

Green chutes. There are faint signs of life in the economy that bear examination:

  • Construction spending is up in March (vs. expectations of decline)
  • MBA purchasing index up 5%
  • Employment figures, while weak, better than expected
  • Shipping index, industrial metals, oil, all up due to improved economic fundamentals
  • Industrial production decline decelerated (down only 0.5% in April); rebound expected by 4Q10
  • Swap spreads (a forecaster of economic activity) started rising in 2007, well before the storm hit in 2008, peaked early October 2008 (well before equities bottomed out in March '09) and now are back almost to normal levels
  • SOME houses are selling across the country
  • Housing starts are down from 870,000 in 3Q08 by about 50% and expected to bottom out this quarter
  • Residential investment is down $38B 1Q09 and expected to rebound 4Q09
  • Over $12B of equity has flowed into REITs since March 6; REITs are the second most shorted sector in the S&P 500 at 9%

While we are far from a recovery, these and other indicators imply that we are getting closer to the bottom, which is a key factor in re-establishing market and consumer confidence.

The regulators, meanwhile, are gearing up for a slew of bank closures. After the embarrassment of IndyMac, Wamu and others, regulators are being extremely cautious as they approach banks. I expect the trend to continue and intensify as the FDIC and others complete the training of 1000+ new hires they brought on board in the past year.

The on-going mingling of regulatory oversight with political necessities will continue to plague our industry and might result in further restrictions and demand on ALL banks, both TARP and non-TARP recipients alike.

Among the newest regulatory trends (which might be obsolete by the time you read this) are:

  • Expectations of current (3 months or less) appraisals
  • Mark-to-market expectations for both real estate and securities (the new FASB rules did not provide the relief we all hoped for, and we're still in mark-to-no-market purgatory)
  • Capital requirements have unofficially been raised as follows:
    • Risk based - 12%+
    • GAAP - 8%+
    • Tangible (a new requirement) - 4%
  • Regulatory attention to liquidity is intense and will intensify further; wholesale funding ratio a major focus, as are detailed liquidity plans including alternative scenarios
  • Loan classifications under great pressure; global cash flow has been accepted again as a possible source of repayment, but, with it, come the contingent liabilities that might cause a successful project that can stand on its own to sink under the weight of the borrower's total obligations
  • BSA and pandemic are still on the map; don't let up on both issues

I expect regulatory scrutiny to continue and not abate on all fronts, The risk of being too lax is, at this point, unacceptable to all bank regulators, and banks must come to grips with the true value of their balance sheets or the regulators will facilitate that reality check in short order.

I also anticipate more one-time deposit premium assessments by the FDIC as more banks are taken over and the fund depletes further. If true, then analysis accounts become more valuable than ever, since they allow banks to pass on to their customers those special assessments.

The number of troubled institutions has risen to 308 in 1Q09, up from 180 in the previous quarter and 113 the prior quarter. I expect the number to break 500 by 4Q09, and bank closures to pick up pace the next two quarters.

The industry. Earnings performance weakness continues as earnings misses in 1Q09 were considerable, following 71% of the banks missing earnings in 4Q08. I anticipate minimal relief throughout 2009, given continued asset deterioration and insufficient reserves across the system. The sooner banks come to grips with portfolio losses, the better 2010 will look. The recent flood of equity into the sector, with more available for investment (albeit with significant dilution), should facilitate this reality check.

Net Interest Margin continues to experience pressure, with a 19 bp. Compression Q-o-Q in 1Q09, one of the steepest declines ever. NIM declined from 3.70% 1Q07 to 3.27%1Q09. Margins should moderately expand during the year as both deposits and loans are repriced to more rational levels.

Deposit growth has been unusually strong at 3.8% Q-o-Q, one of the strongest quarters on record. Most of the growth occurred in core deposits, which is ever better news. Unfortunately, the too-big-to-fail banks have captured the majority of the deposit in-flow. Nonetheless, I anticipate continued core deposit growth throughout the year and into 2010, as flight to safety persists and rates remain low, making the opportunity cost of not investing the idle funds low.

Loan growth system-wide has ground to a halt (0.1% decline Q-o-Q), reflecting primarily the megabanks capital preservation and inward focus. Community banks are experiencing meaningful loan growth, but are far more selective and demanding in their lending practices. Prepayment penalties, floors (5%+), solid pricing and deposit requirements are all back in vogue, and are appropriate. We have seen what happens when we don't get paid for the risks& I believe this is a brief opportunity window to capture new relationships that will close mid-2010 as other players who are currently on the sidelines re-enter the market with vigor. Pricing discipline, covenants and terms will go out the window as they have done in the past.

One positive side benefit to the slowing loan growth and increased deposit inflows is a meaningful improvement in loan-to-deposit ratios, now under 100% again among our SuperCommunity Bank members. Up until 2009, many banks have been funding their loan growth through increased wholesale borrowings, given the costly deposits, resulting in lower margins. 4Q08 FHLB borrowings were $1.3 TRILLION, up from $870B+ 3Q08. 5300+ banks have been borrowing from the FHLB, so the funding issue is quite wide-spread.

Analysts observe that banks that are less reliant on wholesale funding could see more stable earnings and less pressure on NIM, all things equal.

Asset quality continues to be ugly. Average provision continues to climb, but NCOs are climbing even faster and are at 1.06%, up from the trough of 0.06% in '07, and even up from the previous peak of 0.81% in '92. Reserve to NCO ratios have been declining since 2Q05, when they peaked at 11.8X, and are now at a multi-decade low of 1.5X (and reserves to NPLs are a meager 0.8x). Actual reserve levels remained relatively stable, but NCOs have risen sharply.

Non performing loans are at 2.3%, up from their prior peak of 1.33% in 3Q91, and from a trough of 0.26% in 1Q06.

Analysts believe that the industry as a whole needs to significantly raise its reserves in the coming quarters to offset inevitable losses in residential construction and commercial portfolios.

Capital has risen again as king, except in a new permutation. While Tier1 capital has been boosted by TARP funding, Tangible Common Equity continues to slide, down to 8.2% from 9.7% 1Q03. The TCE ratio will improve in 2Q09 and forward, as banks replace TARP funds with common equity, thanks to the recently opened equity markets. Following the stress test results, over $60B of bank equity were raised in the first month alone. The KBW bank index is up over 90% since it bottomed out 3/10/09, and volatility is down 46% since the early March peak.

In recent years banks have levered up their balance sheets to grow earnings, but deleveraging is now the word of the day and will continue to be for a while, especially as the Trust Preferred market remains in a coma.

Liquidity is queen, if capital is king. As credit deterioration persists, liquidity becomes even more important to the regulators. Core deposit growth has been impressive, as mentioned above, but it's too early to declare victory. Only strong cross-selling will ensure that these deposited don't merely use our balance sheets as parking lots, and will flit away as soon as consumer confidence in the markets improves.

Toward that end, adjusting transfer pricing to reflect the true franchise value of deposits will help inspire your troops to continue pursuing deposits and relationships in earnest.

More ways to lose money than ever before? In the olden days, banks could only lose money one of two ways: by making bad loans or taking imprudent interest rate risk. Today, we have witnessed a proliferation of these money losing opportunities:

  • Originating bad loans
  • Buying bad loans from someone else (participations)
  • Interest rate risk
  • Securities write-downs, including government securities
  • Acquisition premiums write-downs
  • FHLB stock?

Fee income - sweeter than ever. With capital more scarce and dear than ever, capital-free businesses are more valuable than ever before. Wealth Management, treasury Management, Payments, are all great opportunities that should be pursued with vigor. This is particularly true as traditional fee income sources, such as ATM and NSF fees, are declining system-wide and are unlikely to ever recover to previous levels.

The key to successful expansion in these lines of business is focus, management oversight, investment of resources and, most importantly, managing to the bottom line, not to the revenue line alone.

Human capital. It's easy to forget about the people these days, as layoffs and draconian cost reduction efforts rule the landscape. I'd like to remind all of us of what we already know: our brand and our bank is our people. Human capital is still the most precious capital we have, and it's tougher than ever to motivate and incent the workforce, especially for TARP recipient banks. Employee engagement during difficult times is far harder than achieve, and yet so central to our success.

These are also great times for hiring and "lift-outs" of talented bankers from both good and bad banks (there are good people in bad banks). It's a strategic investment in the future, and it represents a unique (and brief) window in time.

While the financials are front and center, people are at least as important during these times for holding on to franchise value and building it further.

To sum up:

The landscape:

  • Tangible common equity is king
  • Core deposits are valuable today, tomorrow and forever
  • Credit deterioration will not stop in most markets
  • Regulatory scrutiny and demands will intensify, especially around capital, credit and liquidity
  • Credit availability is extremely tight, which puts those who have money and willingness to lend in the catbird seat

Actions to consider:

  • Liquidity is queen and must be managed carefully, NOT only through deleveraging
  • Manage the credit deterioration as fast as you can (and your capital will allow) through reserves, workouts and liquidations, even though it's unclear where the bottom really is
  • Strategize now for 2010-11; invest the few investment dollars available wisely and in a very focused manner
  • Integrate expense management into the company's culture as a way of life vs. a "project"; cuts should not compromise revenue growth and relationship building
  • Identify one or two (no more) fee income generating businesses that fit your strategy and build on core strengths, identity and market position and build them intensely
  • Make more with what you've got; use sales management to expect and get more out of your various sales forces
  • Re-introduce and reinforce discipline in everything that you do