Why this 125-year-old thrift is getting into commercial lending

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After 125 years, Capitol Federal Financial in Topeka, Kan., is stepping outside its comfort zone.

The $9 billion-asset company had been an industry stalwart, living up to its status as a thrift by focusing heavily on mortgages. In recent years, however, it has built a small commercial real estate book by buying loan participations.

Capitol Federal is set to distance itself even more from its past with the pending purchase of the $434 million-asset Capital City Bancshares, which is known more for its commercial focus. The $38 million deal will add business banking to Capitol Federal’s offerings for the first time.

The shift makes sense given challenges in the mortgage business and the benefits that can come with having cheaper commercial deposits, industry experts said.

It also highlights the overall challenges that mortgage-centric thrifts face maintaining their business models. The number of savings institutions has decreased by about 40% over the past decade, to about 750 institutions, according to data from the Federal Deposit Insurance Corp.

Other banks, including Flagstar Bancorp, have de-emphasized mortgages to pour more resources into commercial lending.

“Everyone is wanting to get more into commercial lending,” said Lynn David, CEO of Community Bank Consulting Services. "A lot of your commercial accounts are noninterest bearing. That’s still a reason why [banks] go after commercial loans — because they want the commercial deposits.”

Capitol Federal, for its part, has no plans to completely scrap its old model. It will still originate and hold residential mortgages.

“We won’t abandon our retail operations,” said Kent Townsend, the company’s chief financial officer and treasurer. “This is really just being adaptive. [Capital City] matches up with our conservative assets.”

Capitol Federal originates a variety of fixed- and adjustable-rate mortgages that it keeps on its book. It also buys residential mortgages from other lenders. Roughly two-thirds of its loans are 30-year fixed-rate mortgages, Townsend said.

The model has historically succeeded because of the company's scale and its use of technology to address compliance issues, Townsend said. Capitol Federal’s efficiency ratio was around 43% on March 31. In contrast, the average efficiency ratio for banks with $1 billion to $10 billion of assets was almost 60%, according to FDIC data.

Still, Capitol Federal decided to expand into commercial lending to help offset some of its risk tied to long-term residential lending, Townsend said.

Due to historically low interest rates, it’s likely that the mortgages on Capitol Federal’s balance sheet will stick around longer than normal, said Damon DelMonte, an analyst at Keefe, Bruyette & Woods. That will weigh against the company as interest rates rise and institutions start to pay more for deposits.

“I think they could have continued with their previous business model, but their overall profitability is starting to shrink," DelMonte said. "Their funding has become an issue.”

Capitol Federal has relied on mostly retail deposits and wholesale funds to support its loan growth. Its loan-to-deposit ratio is 133%, according to the FDIC.

Commercial loans tend to have shorter durations and reprice faster, while retail deposits typically cost more than commercial funding, industry experts said.

Capital City addresses those issues.

Capitol Federal has been experimenting with commercial lending, amassing about $460 million in commercial real estate loans over the past five years, tapping into its network of correspondent banks. Doing so allowed management to become familiar with commercial lending with little risk.

“Capitol Federal is entering [commercial lending] the right way,” said Bob Wray, a managing director of Capital Corp., which advised Capital City on the deal. “First, they dipped their toe in by buying participations so they could see how they work.”

The deal also helps with Capitol Federal’s funding issues by bringing in lower-cost commercial deposits. Core deposits make up more than 93% of Capital City’s funding, the companies said.

Commercial deposit accounts are generally larger than retail accounts, especially for a bank of Capitol Federal’s size and potential legal lending limits, said Andrew Christians, a managing director at Donnelly Penman & Partners. And banks often give commercial clients better loan rates if they bring their deposits over.

While the deal draws attentions to challenges with the thrift model, it should not be viewed as a death knell, industry experts said.

“I would never say the industry is dead but just challenged," Christians said. "It has been for some time. “If interest rates start increasing and the economy stays strong, it is a viable business model.”

Capitol Federal plans to stay below $10 billion of assets, a threshold that triggers more regulation, Townsend said. Management doesn’t have set targets for commercial lending, though it may buy fewer participations as originations increase.

Additional acquisitions are possible if this first foray into commercial lending goes well, said Andrew Liesch, an analyst at Sandler O’Neill. But he also noted that the acquisition of Capital City was a unique situation that includes keeping President and CEO Bob Kobbeman on to help run the commercial lending platform.

“I think they will start with this one and see how it goes,” Liesch added.

Townsend said the deal didn’t signal a bigger plan to become an active acquirer. Capitol Federal has only acquired one bank, Southwest Federal Savings and Loan Association in the 1980s, according to its profile on the FDIC.

“We feel this is a very strategic move,” Townsend said. “We can implement this over a number of years and see where that takes us.”

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