SAN FRANCISCO - California's sick economy has turned community bankers' world upside down.

Their outlook on the business, traditionally as bright as the state's fabled sunshine regardless of short-term economic changes, has turned despondent, even nostalgic.

Good Old Days

"You could depend on things getting better, and you were willing to take a risk," recalls Carroll R. Pruett, chief executive of Mid-State Bank, a $795 million-asset bank in Arroyo Grande, a coastal city midway between San Francisco and Los Angeles.

Amid the state's worst downturn since the Depression and the near collapse of commercial real estate, some bankers even doubt that an economic recovery would restore vibrancy.

"I don't think the future looks as good as the past," says Allan E. Dalshaug, chairman and chief executive of Sterling West Bancorp, Los Angeles.

Though California's economic woes are hitting the state's major banks, too, it is the smaller independent banks that seem most demoralized. Closely tied to a confined geographical area, a local bank suffers symbiotically with its community.

The banks are, essentially, small businesses that lack the-management depth, diversified product lines, and access to capital of larger institutions.

Strategically, many community bankers are focusing simply on survival. They are paying close attention to working out existing loan problems and have slowed the flow of new credits to a trickle. Most banks report fewer outstanding loans and lower loan-to-deposit ratios.

Just about every institution has tightened underwriting. Many have tried to make permanent changes in their credit culture.

Although cost cutting has been on the agenda for some time, bankers say tough times have forced them to act more quickly and dramatically to trim expenses.

Facing the Issues

Long-term planning is something of a luxury now. But California's healthier banks are going through a self-evaluation process and trying to face up to difficult strategic issues.

With the hefty profits of commercial real estate lending no longer readily available, bankers are asking where revenue will come from in the years ahead. Many bankers are taking steps to diversify their business, raise prices on loans, and find new sources of noninterest income.

"We've all become very conservative," says Mr. Pruett.

What follows is a sampling of views of community bankers from across California. Some of their banks have been deeply wounded by the recession. Others have largely shaken off the effects.

But all six chief executives are finding that banking conditions have changed, perhaps permanently, and that old ways of doing business may not work in the years ahead.

After recording stellar earnings in 1989 and 1990, Pacific Bank has gotten hammered. San Francisco's largest independent bank lost some $29.3 million between September 1991 and June 1992, mainly because of hefty provisions for loan losses.

The bank recently announced that additional provisions would probably result in a loss in the third quarter, too.

Pacific Bank's main business lines are commercial lending and private banking. The bank, founded in 1983, has a small construction portfolio.

Real Estate Problematic

But at yearend, it had more than $227 million in commercial mortgages outstanding, credits that have been hit hard by declines in appraised values on commercial real estate in the Bay Area.

Such conditions, combined with pressure from the Office of the Comptroller of the Currency, have forced a far-reaching overhaul of credit procedures and a pruning of the lending staff.

"The lending side has had to change entirely," says chairman and chief executive Norman C. Eckersley. That has forced the bank to fire some staff members. Says Mr. Eckersley: "Some lending officers don't have the ability to conform."

After budgeting 10% to 15% annual increases in loans in recent years, Mr. Eckersley now expects a 15% shrinkage of the loan portfolio. The cutbacks are affecting commercial credits as well as real estate. But the bank continues to build its trade finance portfolio, mainly for small Bay Area manufacturers. "International is thriving," says Mr. Eckersley.

Pacific has pushed its loan-to-deposit ratio down to 75% from 86.4% at the end of 1990, while adding to its holdings of short-term government securities. "In this climate, one has to have a better liquidity position," says Mr. Eckersley. "Cash is king."

Although Pacific exceeds all regulatory capital requirements, it recently announced that is considering plans to raise equity. And it promoted chief credit officer Michael Tun Zan to president and chief operating officer.

"We set out as an entrepreneurial bank, but now you cannot be an entrepreneurial bank," says Mr. Eckersley.

SC Bancorp was one of those lenders that feasted on the Southern California real estate boom in the 1980s and is paying the price today. In the second quarter, SC lost $3 million. due partly to big chargeoffs and a $4.9 million provision for loan losses.

Those actions, painful as they were, significantly improved SC's credit position. At the end of June, nonperforming assets represented a tolerable 2.47% of SC's total assets, while reserves totaled more than 62% of non-performers.

President and chief executive Larry D. Hartwig is pushing to shrink and diversify the loan portfolio.

Changing the Mix of Loans

Construction loans peaked at roughly 22% of loans, but are down to about 6% of the portfolio. At the same time, accounts-receivable lending has grown about 50% in the last few years and now equals about 17% of loans. Total loans are down more than 3% from those a year ago.

A smaller loan portfolio hasn't kept Mr. Hartwig from aggressively building deposits gathered through a network of 16 branches in the Los Angeles-Orange County area. Deposits have risen nearly 6%, to $421.5 million.

"We will take incremental deposits as long as we can reinvest them" at a spread of 2.25%, he says. Much of the inflow goes into a diversified investment portfolio that includes municipal bonds, short- and medium-term Treasury issues, and mortgage-backed securities.

Time for Reexamination

While the banking market is weak, Mr. Hartwig has been taking stock. "We've used this year to examine our strategy," he says. That self examination has prompted the bank to reduce costs through steps such as installing a computerized telephone banking system while trimming branch staff.

Mr. Hartwig has also moved commercial lending out of the branches and centralized it into special business banking centers.

More than a third of Sterling West Bancorp's assets consist of construction loans or commercial mortgages, but the company has stayed profitable despite its location in the economically weakest parts of California.

That's because Sterling West has a commercial finance unit and a mortgage company to counterbalance problems in its flagship bank.

"Thank goodness for diversification," says chairman and chief executive Allan E. Dalshaug. "Our earnings would have suffered dramatically if we had not had those businesses."

In the first half of 1992, Sterling West earned about $1 million, thanks largely to the mortgage unit's sale of servicing rights. But the company may be overdue for some hits.

Nonperforming assets reached $11.9 million at the end of June, and loan-loss reserves stood at just 15.3% of that total. Although Mr. Dalshaug says the company has maintained prudent reserves, analysts believe additional provisions will be needed.

As the economic slump has deepened, Sterling West has worked to build its capital cushion. Total risk-adjusted capital stood at a reasonably comfortable 11.32% of assets at the end of June.

"When you build capital, you lose your leverage," says Mr. Dalshaug. "But there are times when you have to accept that and this is one of those times whey you have to make sure you ride out the storm."

Carroll R. Pruett may not be clairvoyant, but Mid-State Bank's president and chief executive started battening down the hatches more than four years ago.

"Like other California banks, we had been riding the real estate feeding frenzy," he recalls. "But we felt this thing coming on early in 1988."

Around that period, Mid-State, which operates in the coastal region midway between San Francisco and Los Angeles, launched what it called a "recession-proofing" program.

The bank shortened loan maturities, diversified its asset mix and tightened credit quality. At the same time, with high-margin construction loans cut back, it began looking for new sources of revenue.

Focus on Mortgages

About three years ago, Mid-State set up a mortgage department to originate, sell and service home loans. "We figured the mortgage business was going to be around for a long time to come'" says Mr. Pruett.

To improve noninterest income, the bank began charging processing fees on loans and commitment fees for lines of credit.

Acting early helped Mid-state avoid severe loan problems. But profitability has fallen substantially. After earning returns on assets near 1.5% through most of the 1980s, Mid-State fell to around 0.8% in 1991 and a similar ratio in the first half of this year.

The bank continues to grow. At the end of June, deposits were up 6.9% from the level a year before. Though loans have fallen slightly, total assets rose 6.2% because of a growing portfolio of securities.

Mr. Pruett says the bank has picked up depositors from failed thrifts and customers unhappy with the BankAmerica-Security Pacific merger.

It's not just real estate loans that are hurting California banks. Home Interstate Bancorp is a case in point.

Home, with 13 branches in the Los Angeles-orange County area, raises deposits mainly from consumers while lending to small businesses. Construction loans represent a significant part of Home's loan portfolio, but the biggest bombshells have exploded elsewhere.

Last year, Home took a big writeoff on an $8.6 million portfolio of securities guaranteed by failed Executive Life Insurance Co., and that was the main reason why earnings for the year plunged 81.1%, to $1 million.

Red Ink for the Year

This year, things are worse. Through the first half, nonperforming assets represented just a little over 2% of total assets. But recently the bank found a multi-million-dollar loss in its accounts-receivable lending unit. As a result, Home will probably record red ink for the full year.

With business conditions at a low ebb, "our business strategy is back to basics," says president and chief executive James P. Staes.

That means tougher underwriting, fewer loans and a smaller asset base. The bank has shrunk its loan portfolio more than 10% from its peak two years ago.

Home continues to make small-scale credits for residential construction, mainly "onesy-twosy things, mostly with existing clientele, on the low-price side of the spectrum," says Mr. Staes.

Meanwhile, the bank has cut full-time staff more than 18% since the end of 1991 through a hiring freeze and outsourcing of some back-office functions.

Home has also reduced its profit targets. In good times, the bank aimed for a 1.25% return on assets, but the current business plan sets a 0.75% return as the goal.

The lower profit target means Home is willing to take smaller margins to attract good customers. The bank uses a relationship scoring system to measure profits from commercial customers.

It recently dropped the score it will accept by 10% for some customers, meaning lower pricing on some credits. "We have made concessions to get new relationships," says Mr. Staes.

Don't talk to Carl J. Schmitt about the recession. His bank is doing just fine, thank you.

University National Bank and Trust continues to report excellent profits: return on assets for the first half of the year equaled 1.12%, up from 1.07% in the period last year.

"I don't think we've made any changes to think of," Mr. Schmitt says. "We've always run a very conservative shop."

In contrast to many peers, University is trying to build its loan portfolio and increase the proportion of loans to total assets.

"This is a very rich deposit area," Mr. Schmitt says about the affluent communities University serves south of San Francisco. "Finding loans to consume those deposits can be difficult."

About a year ago, Mr. Schmitt decided University was turning down too many creditworthy borrowers. "We were saying no to deals that we should have made work," he recalls.

The bank started aggressively seeking new loan, customers, provided they met stiff underwriting standards. With many Northern California banks turning away customers, finding borrowers hasn't been a problem. "The business has come to us," Mr. Schmitt says.

Increase in Investments

The portfolio, a mix of adjustable-rate residential mortgages, small-business credits, and commercial mortgages on owner-occupied properties, soared 24.5% in the year ended June 30.

In a credit crunch, University is able to charge steep prices on its loans and it expects borrowers to give it virtually all their banking business.

"We extract a pound of flesh," says Mr. Schmitt. "We expect to be their banker."

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