Continental's Theobald Banks on Middle Market

CHICAGO -- When the Federal Deposit Insurance Corp. sold its stake in Continental Bank Corp. last month, Thomas C. Theobald threw a street party complete with banners, wine, and live music.

Thrilled that the government was finally out of Continental's hair, Mr. Theobald donned an apron and helped grill franks for a mob of employees.

But the festivities were little more than a diversion for Mr. Theobald. In an interview the day before, Continental's chairman and chief executive conceded that the FDIC stock sale was just "one more step in a long stairway that has to be climbed."

Indeed, Mr. Theobald's larger concern is his much-ballyhooed turnaround strategy, which his critics say is beginning to show signs of unraveling.

Focus on Middle Market

Since coming aboard in 1987, Mr. Theobald has set about transforming Continental from a sprawling money-center bank to a tightly-focused business bank catering to middle-market companies, mostly in the Midwest.

In a controversial element of this plan, Mr. Theobald pulled Continental entirely out of the retail business, concentrating instead on offering commercial loans, letters of credit, and other banking services.

So far, it looks like Mr. Theobald's strategy has steered Continental smack into trouble. As the recession battered Continental's chosen customer base, the banking company managed only $74.6 million earnings last year, representing a paltry 4% return on equity. What's more, the company finished the first quarter of 1991 with a disturbing 5% of its loans in default. This year, Continental is expected to earn $120 million, which would still give it half the ROE expected of a healthy bank.

Warning on Dividend

Having paid out common dividends equaling 143% of common earnings in 1990, Continental recently warned that a dividend cut may be in the offing. And because of fallen credit ratings, the bank is having trouble borrowing money at rates lower than what its own customers are expected to pay for loans.

"Continental has a fairly high risk profile," said Felice Gelman, a banking analyst with Dillon Read & Co., New York.

Wall Street has taken notice. The bank's stock has been trading at a 47% discount from its book value of $23.90 per share. As of midday Monday, Continental's stock was trading at $12.75.

Yet Mr. Theobald, 54, staunchly defends his middle-market strategy. "This is a bet there will continue to be companies growing to a size and complexity that their needs cannot be met by a consumer-oriented bank, and on the other hand are not so large as to be one of the 10 best customers of Salomon Brothers," he said.

What is especially remarkable about Continental's current travails is that many are of recent vintage. After all, when Mr. Theobald took the helm at Continental in 1987, he inherited a bank whose portfolio had been sterilized by the FDIC only three years earlier. He then turned Continental into a prime conduit of financing for highly leveraged transactions, and that is the root of many of the bank's problem loans.

Continental finished 1990 with the highest percentage concentration of HLT credits of any big bank in the nation, according to Thomson Bankwatch Inc., an American Banker affiliate. At the end of the first quarter, 15% of the bank's $2.1 billion HLT portfolio was delinquent.

On top of that, Continental's decision to abandon the consumer business means that the company is now dependent on the volatile wholesale funds market for about two-thirds of its total funding needs. This can drive up Continental's cost of funds, putting added pressure on lending margins.

A Viable Strategy

"The whole idea of focusing exclusively on business customers was Mr. Theobald's," said Richard Mueller, a banking analyst with Duff & Phelps, Chicago. "The question now is whether the strategy is viable."

Mr. Theobald rejects analysts' concerns as ill-founded and peripheral to his mission, saying "It is the estimation of the customer that counts."

Acting on the conviction that customers and the capital markets over the long term reward companies that develop competitive specialties, Mr. Theobald said, he embraced business banking because that was Continental's best and most unique asset when he came aboard.

Turnaround Takes Time

And he still feels good about the decision. So long as Continental keeps its customer base of 2,000 companies intact, asserted Mr. Theobald, the company can receive sustenance from revenues derived from the sale of various loan, financing, and risk-management products.

What's more, said Mr. Theobald, whipping Continental into fighting shape has required considerable time, effort and expense. "It takes an incredibly long time to make substantial change in a large organization, even if you go at it with what you perceive to be superhuman energy and initiative," he said.

Since 1987, spinoffs, layoffs, and departures claimed 8,000 of the bank's 10,000 employees. The company has since hired 3,000 new employees, giving it a work force of 5,000.

LDC Repair Costly

Continental last year took a $46 million restructuring charge, most of it related to work force reduction. A $62 million special provision in 1989 stemmed from the sale of First Options of Chicago Inc., an unprofitable trading subsidiary.

Shrinking Continental's LDC portfolio to $389 million from $2.3 billion absorbed an additional $850 million of capital over the past 42 months. And further retooling is needed at Continental's overseas offices, which together lost $66.4 million in 1990.

These house-cleaning costs, combined with the costs of rising loan defaults, have masked the strength of Continental's strategy, said Mr. Theobald.

Excluding special gains or losses, for example, Continental's 1990 revenues of $904.2 million are down only 3.76% from the level in 1988 - the best year in the company's history.

The relative stability of Continental's revenues in the face of a recession is only one of Continental's unappreciated strengths, said Mr. Theobald.

Realty Portfolio Is Solid

For one thing, he said, Continental's $2.8 billion realty portfolio is hanging together: At March 31, deliquent realty loans and foreclosed properties of $105 million comprised a manageable 3.72% of total realty credits.

At year end, Continental had operating loss carryforwards sufficient to shield $735 million of income from taxation - a potential $250 million benefit that will augment the company's earnings over the next few years.

And according to a survey of industrial and service company officers compiled by Goldman, Sachs & Co., "a significant recovery in bank borrowing demand" is expected during the second half of 1991.

No Worry over Revenues

"I don't have the slightest worry about our ability to find a billion dollars of [annual] revenues," said Mr. Theobald.

Mr. Theobald, a former vice chairman at Citicorp, knew he was taking a risk when he joined Continental. And he is only half-joking when he says his initial goal at the bank was "to survive." Still struggling to stabilize customer relations after its 1984 failure and rescue, the bank was overgrown and searching for direction.

What appealed to Mr. Theobald was the chance to establish himself as a turnaround artist. In Continental's distracted bureaucracy, Mr. Theobald saw an environment where changes could quickly be made.

And the job represented a refreshing escape from what he viewed as an elitist bureaucracy of Citicorp, where he was responsible for investment banking "worldwide."

Discovering Excellence

He wanted "to prove there is excellence in unexpected places," said Mr. Theobald, whose 1990 compensation was $890,000.

Whether the executive prevails in his all-business strategy largely hinges on how well Continental navigates the tremors and aftershocks of the U.S. economic recession, say analysts who follow the company.

With bankers increasingly characterizing the U.S. realty market as being in a depression, analysts say they can't help but wonder if Continental's realty portfolio will deteriorate.

And Salomon Brothers Inc. worries that further HLT defaults will help push Continental's nonperforming assets up to $900 million from $778 million.

Loss Reserves Thin

That would only widen a perceived deficiency in Continental's loss reserves. The banking company's 43% ratio of loss reserves to problem loans at March 31 pales in comparison with a 75.6% aggregate ratio recorded by 153 publicly-owned banking companies surveyed by Keefe, Bruyette & Woods Inc.

Matching the standard set by the Keefe group at March 31 would have required Continental to take an additional $233 million loss provision that in turn would have reduced the company's common equity ratio from 5% to 4.11%.

Mr. Theobald declined to comment on the outlook for Continental's loan quality. He said problem loans on the average are marked down by 25% when placed on nonperforming status, which he believes makes the bank's reserve position sound.

Credit Ratings a Problem

Where Continental is getting hurt the worst, said Dillon Read's Ms. Gelman, is in its credit ratings. In a recent subordinated debt offering of $100 million, for example, Continental paid a whopping 302 basis points more than the yield on a Treasury security of equal maturity.

"If you are not a better credit than the companies to which you are lending, your cost of funds is not much cheaper than theirs, and it is hard to make money," said Ms. Gelman.

Mr. Theobald acknowledges it is far to soon to declare his game plan a success.

"Considering where we were, and the events of recent years, and what's happened to our competitors, we feel pretty good about our strategy," he said. "But is there a long way to go? Yes sir." [Graphs Omitted]

PHOTO : THE FDIC IS GONE, but Thomas Theobald still faces problems.

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