Below is an edited transcript of Nov. 4 conversation between our roundtable participants and American Banker staff members. The participants were Robert Kafafian, the president of the Kafafian Group Inc., Theodore Kovaleff, an analyst at Horwitz & Associates, and Christopher McGratty, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc.
American Banker: What's your overall outlook for M&A in community banking next year?
THEODORE KOVALEFF: There's going to be a rise in M&A, and I think we also have to say that it's going to be with an ongoing amount of FDIC assistance. We've got in Florida and Illinois alone over 100 institutions with Texas ratios over 100. And anything up that high is guaranteed to lead to some strong actions and likely takeovers with FDIC assistance. And there's certainly no shortage of interested buyers in both of those two states.
Now, going to the community bank acquisitions of other community banks, absent FDIC assistance, I think you can look at some of the recent acquisitions as a prologue to more. And I'm looking at Rome in New York being taken over by Massachusetts-based Berkshire, a major expansion of footprint. And then you've got Brookline taking over [First] Ipswich, an unbelievable premium there. And I think what that shows is that a lot of institutions are selling way below the value that's there, and a key point — and this applies to both the Rome and the Ipswitch acquisitions — managements have lowered expectations, because the head of Rome had looked for at least $12 as a selling point the last time I had talked with him. And he settled for something over 10. So that's a major change in expectations, and I'm sure that we're going to see that throughout the country.
CHRIS McGRATTY: We wrote a pretty lengthy piece about bank M&A in July. We think it's an emerging trend. I think beginning with what Ted said on the FDIC front, I think what you're seeing is the deals are getting smaller. The average size of a bank on the problem list by the FDIC is roughly a half a billion. So what you're seeing is, these are too small for your larger-cap banks to look at, and given the change in economics of the deals, I think we're beginning to see the banks look at not only FDIC-assisted transactions, but also open-bank M&A. I think it's a trend that's going to continue to emerge this year and well into next — for the next several years.
I think it's important to distinguish premiums on deals versus valuation. Obviously, stocks are at pretty low valuations. So some of the takeout metrics in terms of the premium to the last sale might be skewed because of the valuation. But I think what's important to keep in mind is, at least early on in the cycle, the economics are going to favor the buyers, and that's a clear distinction. I think the valuation multiples are going to be a lot lower, at least early on in the cycle, than they were at the end of last cycle. So if you look at the early '90s, and we detailed this in our piece, the multiples, whether you look at it on price to earnings, price to book, core deposit premium, they're a lot lower in the early part of the cycle, frankly, because the buyers can afford to pay a low price. There's far more sellers today than there are buyers.
So over the length of the cycle, that's going to change. But clearly, early on we've seen some transactions actually being a take-under. We saw a take-under with Wilmington last week. So I think that's an important, I think, data point for the industry in that M&A's exciting in terms of a lot of people want to talk about M&A. But I think we've got to keep in mind that some of these banks are selling for a reason, and they're selling because they have problems. So that doesn't necessarily mean big M&A premiums that we saw at the height of last cycle.
What are the criteria of who's going to actually get bought? Is it quality of depositors, or is it some kind of fee business, or is it they have some loan problems, but not in the wrong area?
KOVALEFF: I think that you're going to have a lot of small institutions be purchased or acquired, simply because the cost of being a small institution has gone up and will continue to go up, what with all the regulatory requirements that are out there. Dodd-Frank is not going to save money for a lot of these institutions. And so in a number of cases, it's just not going to be economically feasible in the long run to be a small institution.
McGRATTY: I would say that first of all, banks are sold. I think that's what we're seeing. Deposits clearly are a key in any transaction, in the funding base. If we learned anything in this cycle, it's the importance of a strong funding base to be profitable. I would say geographic footprint makes a lot of sense for banks willing to either gain additional scale in their markets or perhaps reach into a new market. I think that's important.
And then, as you saw with the Wilmington transaction, banks are clearly attracted to fee-income platforms that are non-capital-intensive, but are high-return businesses. So clearly, I think a lot of the metrics that were looked at last cycle will be looked at again.
Are there a lot of, I guess, good fee business buried within some of these franchises out there that are being sold, or is it kind of relatively rare for the companies that you cover?
McGRATTY: Yeah. I would say it's rare to have a proportion of fees like a Wilmington. And it's not just mortgage banking. They don't have — it's not a mortgage bank. It's not — I mean, that's not what I'm seeing. It's not as valuable as a corporate trust business or an asset management business. So for community banks, it's more the minority, or the exception rather than the rule, to have such a distinguishing feature.
KOVALEFF: I second that thought. One of the situations is that the fee-based portion of income of the small community banks is a lot less rich than that of the larger ones. There's a great deal more exposure to, for instance, fees on checking, and that's going to turn out to be a problem, too, what with the new regulations on how much you can charge for a bounce and all the rest.
Sticking on Wilmington, one of the drivers of that was that those construction loans that they had that went bad made it just have to sell itself, because it was going to threaten the fee business. This is my understanding. How many of the banks that you cover are exposed to that kind of construction portfolio tied to the home business, and could this be a further impetus to M&A moving forward, pushing more sellers out there, or is this just a rare instance of that?
McGRATTY: I would say community banks are disproportionately weighted to real estate to begin with, whether it be commercial real estate or construction. So what we saw during the cycle was really, really strong growth in these asset classes while times are good, and now they're paying the price because property values are down significantly. So they're less diversified versus a larger cap, rather, and that's a reason why they got into their problems, lack of diversification.
Did they learn their lesson going forward? What else do you do, if it's not that?
McGRATTY: I would say the push has always been C&I. Everyone wants to be a C&I lender, but what we've really learned is it's very hard to be successful at it, so banks turn to real estate lending. Banks make the same mistakes every cycle. … It's a varying asset class, but they make — a lot of the same mistakes that we see in this cycle they made in the early '90s with commercial real estate. So that's just, I guess, an ongoing battle with the industry.
KOVALEFF: One of the other things, I think, that you have to look at is, there's always a new group of thrifts or small-town banks that decide they want to become community banks, and they all say they want to have less exposure to the one- to four-family owner-occupieds. And they don't all have the experience to do this. And so they are often led astray by the higher return on the construction and other real estate development type loans. So there are going to be folks that make the same mistakes that have been made before. So we're going to see in the future similar problems, but just by different companies.
I was talking to some folks from Warburg Pincus about many investments they've made, and they were saying what they're really looking at are companies that can do — that are still doing CRE, but that they're doing it the right way, they're doing it well, because they said it's like everyone else is trying to get away from that, just do a lot of C&I lending. What's your take on that? Do you think that the companies that are continuing to do CRE but may be just changing the way they're doing it are going to be more successful or kind of stand out? Are there any companies also that come to mind that are doing that already?
McGRATTY: I would say, what I would offer is that banks that are growing this asset class today are probably getting paid a lot better for it in terms of risk-adjusted returns. I think what you saw at the height of the credit cards, before everything peaked, is that credit spreads were really narrow, and banks really weren't getting paid to put on the level of risk that's embedded in those loans. I think for the companies that have the ability to grow those asset classes today, you're probably getting better returns. So it is — you can make money, and it's just, you've got to price it correctly.
[To Kafafian] Give us your take on what you're seeing with the clients that you're working with in terms of, you know, sellers, who might be buyers, just in general where you think it's going.
BOB KAFAFIAN: Well, at the moment, I think that the sellers that we're seeing are mostly distressed sellers. There are some financial institutions that are healthier that are considering a sale at this time, but what they're finding is a lack of buyers, and oftentimes the prices that are being offered are unacceptable to them. So I'm hearing people say that we're going to see an acceleration in deal volume over the next year or two. I see that starting more slowly than quickly, and once the economy starts to recover and once deal values start to increase or pricing starts to increase, we might see a lot more transactions.
So in general, what're the criteria of the seller? You're saying they're distressed. How are they distressed? Is it loan issues or is it just they don't have — they're not able to make money?
KAFAFIAN: The three major issues that we're seeing in the planning work that we do are — and I'll talk about them in terms of critical issues — the top three critical issues that we see are banks that are first addressing regulatory problems. So that's No.1 on our list. Secondly, they have credit issues, and those credit issues are both in the loan and the investment portfolios. And then thirdly, the result of those first two items has caused capital to become distressed. So what you've got is a lot of financial institutions that are kind of fighting for survival, and their focus is not necessarily on serving their core business, as they have in the past.
For those that are not dealing with those three issues, I think there's great opportunity to take market share and to grow business and to even be a consolidator. But right now, I would say roughly 40% of our client base is under some sort of regulatory action and dealing with a whole myriad of issues.
Then the other part of the question was, you're saying there's a lot more sellers than buyers. So what's the —
KAFAFIAN: I'm not so sure I'm saying there's a lot more sellers than buyers. I think that there are people that are sort of dancing on both sidelines. If I had to fall on one side, I probably would say there are more sellers than buyers, but not significantly more. And I think a lot of the buyers are not buying, because first of all, they're uncertain of what they're buying, and due diligence has become more important than ever. It's not a wink and a promise anymore. And also, a number of the buyers during the process are finding that they're running into their own troubles and their own problems, and so some of them have backed off. There are some deals — and obviously, we won't mention specifics — that I know that have been called off, some deals that are going to be called off, and some banks that maybe got into transactions they wish they didn't get into.
The question was going to be, so, in your best guess or assumptions, what are the criteria of the sellers that are going to actually be worth buying, the ones that might be like taken out?
KAFAFIAN: We still think that core deposits are the biggest driver of franchise value, and for the moment, and for the foreseeable future, branch footprint still has some importance, as well. But we're seeing trends that we may have hit the peak in the number of physical facilities. And so over a number of years — let's say three to five to seven to 10 years — we're going to see more technology, and probably less independence on the branch. But right now people still want to bank with a bank that has a branch close to them, even if they don't use it.
So I think core deposits and footprint are critical factors. Credit quality, obviously, is on the list because nobody wants to buy a portfolio that they think is going to fall apart on them. There are some institutions that are looking for other institutions that might have capital. It's very difficult to raise capital these days, and for those financial institutions that have capital, there may be opportunity to sell that capital through some sort of a transaction.
You talked about core deposits, obviously, with M&A, so I was kind of curious, with everything going on on the lending side, what are you guys seeing from the community banks in terms of how they handle their funding?
KAFAFIAN: My opinion on that is that if you look at the statistics, for example look at a five-year compounded annual growth rate compared to a one-year growth rate, the deposit growth between 2009 and 2010 was lower than the five-year compounded annual growth rates in many markets. The result of that, is that loan volume has declined, so banks that, let's say, had loan-to-deposit ratios over 100% a few years ago that were chasing CDs and brokered deposits are now saying, "You know what? We can start to reposition our deposit mix, focus more on core, lessen our dependence on CDs, because we don't have the loan volume." And so I see a lot of banks pushing down rates and remixing their deposit base — changing their deposit mix to be more favorable towards core.
KOVALEFF: And I think that if you look at the pricing of CDs, it's amazing how the offerings at the short end have fallen. And you could find CDs being offered at 50 basis points now for a year to 18 months. So in some ways, I think you have to look at core plus cheap CDs, because anybody who has stuck with a CD that's giving you 50 basis points is likely to be a pretty sticky depositor.
KAFAFIAN: I agree with that.
McGRATTY: But that's not going to last forever. I mean banks that I follow — I mean, the deposit repricing game is largely done, so margins are going to get squeezed to the extent there's any — you know, there's no longer a — you've got deposit costs flat, at record bottoms, so the deposit flows are mainly positive. Banks are putting it into their securities book, which we know are yielding a lot less than a loan. So introducing the topic of the margin, margins are going down. I mean, I think there's pressure on net interest margins from the industry. Once that trend reverses and we see loan growth, we're going to see banks deploy some of that from their securities portfolio into loans. But right now it's very rare to see a bank make a loan or increase loans this quarter.
KAFAFIAN: Well, Chris, there's an added point to that: margins over the first half of this year actually increased. They may have moderated a little bit in the third quarter. A lot of the increase had to do with the floors that were put in on many loans. So as the cost of funds was continuing to decline and floors were put in on loans, this essentially widened margins. If and when rates do start to rise, even if there's a lag effect on the liability side of the balance sheet, you're going to see that rates have to move to a certain level before we hit the floors again and before asset pricing can start to move up.
I think that's just a really fascinating topic. So what do you do, right? So if interest rates go down further, you're kind of screwed, right? Because with the —
KAFAFIAN: They can't go much lower.
Yeah, but even if they go up, it doesn't make a difference, either, because we're already at these floors.
KAFAFIAN: Chris made a really good point, which is — that all of this is about managing for the time you're in, and then obviously preparing for the future. The challenge is, while there are customers that are accepting 50-basis-point CDs today or don't pay attention to the interest rate on their checking, when rates do ultimately start to rise, then they will start to get more rate sensitive again. And so that money that you think may have moved into a non-interest-bearing checking account or a low-cost savings account or money market account could start to flow back into CDs. And only time is going to tell how much of that will occur.
Let's talk about, I guess, the securities issue, like you were mentioning before. Just walking through issues or concerns, feedback you're getting from the companies that you talk to. Just —
McGRATTY: Obviously, securities portfolio growth's been pretty strong this year, in no loan demand, positive deposit flows. You've got to put the money somewhere. I think the key is managing your interest rate risk. We've seen banks last cycle get into trouble with mismanaging their interest rate risk, and when the yield curve moves against you, it doesn't work. It doesn't work very well. So I think banks are very cognizant of staying very short in terms of duration. They're willing to give up margin today to ensure they do not jeopardize their balance sheet strength in the future.
I think in terms of what they're buying, I think what we've learned in the last few years is that they're sticking with agencies and Treasuries. Again, they're forgoing yield, but they're not getting into the hairier stuff that may have blown them up in the last couple years.
KOVALEFF: And also is highly liquid, so that should an opportunity come along — for instance, in M&A — they can cash in their chips and not have to necessarily take out loans because they're stuck.
Yeah, that's interesting. I was going to ask you about that. But just securities and M&A. Does it factor in? You know, I'm sure somebody that's either going to be doing deals, whether they should be putting the money into securities, or if at a target that has securities, that's something that — does it even factor in?
KAFAFIAN: I suppose I've heard both sides of that. I've heard the side that if you're liquid — you're giving up some yield and you're maybe giving up some profitability now. The other side is if you're liquid, you're giving the buyer the opportunity to invest those funds in the way they would like to invest them. I think the bigger challenge — and again, to Chris's point — the bigger challenge is this whole idea of interest rate risk that banks have historically taken. And as the years of this low interest rate environment continue, there are banks that are tempted to go out on the curve. I just spent two days in a strategic planning meeting with a bank that was discussing how much longer can we wait before we go get yield? And the other half of the room is saying, "But what happens if two or three years from now interest rates start to move up? You know, we may not like those decisions that we made today to get return today."
So I really think this comes back to just prudent balance sheet management. Obviously, you're going to have all sorts of varying durations on your balance sheet, and it's about being mindful of all those points and the price swings that you expect as rates start to move. I do know one bank that's about a $500 million in assets that has $110 million in liquid funds, fed funds, basically overnight funds, and they've got 110-basis-point net interest margin. You wonder how long can you hold out like that.
Where are banks going to be actually making money after things get normal? In talking to large banks, they talk a lot about cross-selling, right? Right now they're taking a lot of market share, so hopefully they can get some relationships built and make commercial and industrial loans. I guess for the community banks, what do you hear people talking about? Where are the earnings actually going to come from? Is it going to be typical loans-to-deposits things? Are they going to be pushing hard on the business stuff?
KAFAFIAN: First of all, let me give you some background. We do a lot of performance measurement work for banks, and in that capacity we do product, organizational branch, and customer profitability and we work largely with community banks. For the last 10 years, the majority of those community banks have lost money in their fee-based lines of businesses.
Now, I'm not talking about the transaction-type charges, like checking charges and so forth. Obviously, overdraft fees have significantly contributed. But the standalone insurance, wealth management, trust type product lines, many of them have lost money. And the reasons for that is there's not enough critical mass in their business to be profitable, and candidly there's not enough breadth of expertise in a lot of these smaller community banks. So the ones that are being successful in those areas are really using those as complementary products to their traditional spread products and most often doing them through third parties. And I candidly don't see a lot of performance coming out of these fee-based lines of businesses for these smaller community banks in the near and medium term.
Now, some of them have carved a niche and done pretty well with it. So what does that really mean? It comes back to the traditional spread-based products. And what I see a lot of the community banks being focused on is the small businesses throughout their markets that not only can provide them higher-balance checking accounts than retail accounts, but then, potentially, lending opportunities. Secondarily, the personal business of business owners, because they often live and work in the same area that they bank. So I'm seeing a lot of small-business focus and trying to get the full relationship of that small-business customer.
McGRATTY: I would add, obviously it's a lot of the businesses, the asset management businesses, the trust businesses are very scale-oriented, so it's very hard to make any amount of money for, really, community banks. But I would just back up and just say — your question was, how do banks make money? How are they going to make money? They're going to make a lot less. I mean, ROEs are going lower because capital requirements are going higher. Leverage is going lower, and you talked about regulatory costs. We know fin-reg is affecting a lot of these banks. So you kind of add it all up, and it's — banks that were earning close to 20% returns on equity, small caps, in the last cycle, I think you can think of as low teens at best. So it's more of a sobering outlook.
KAFAFIAN: I think you're right.
KOVALEFF: Well, I would point out that not all of the community banks have missed the train, if you will, with the fee-based. First Niagara, for instance, has become one of the largest banks with insurance sectors.
KAFAFIAN: Would you call them a community bank, anymore? They're 30-plus billion.
KOVALEFF: Well, yeah. I know. What with the NAL acquisition, they are big. Yes.
KAFAFIAN: But they have grown to some significance.
KOVALEFF: Yeah, absolutely.
KAFAFIAN: Where I thought you were going, Ted — and actually, this is an interesting point — a lot of people think that community banks under 250 million in assets are dead. Some people are even saying 500 million or less are dead. And you know what? That may be true for a lot of them because of the regulatory burden, and because of the competitive nature of the markets they're in. I can probably point to dozens of banks that we see around the country, that are still getting an ROA of over 1 and an ROE of 12. And so obviously they're doing something right or in great and/or isolated markets. This would include rural market areas where they control a market, and their credit quality hasn't deteriorated and so forth. But there are still places where you can make money, and if you're managed properly you can be successful. But I think that they're may be becoming more the exceptions rather than the rule.
First Niagara — let's talk about them a little bit. I'm just interested in them because they seem to be like graduating from junior high to going to the next class, you know?
KAFAFIAN: They went straight to graduate school, right.
Yeah, right, pretty much. So I guess the first question specifically for them is, I've talked to that CEO before, and he's like, "We're just going to be a super regional community bank, you know? We're going to still do the community thing. We have the selling point of getting relationships, and we're you're local bank, but we're going to be superbig." Is that feasible, that kind of idea that —
KOVALEFF: Well, you know, there are a number of institutions that have kept the local names of the companies that they have swallowed up. For instance, New York Community Bank has Roslyn and Roosevelt and a whole panoply of different names, all of which funnel into their back office. And if you have an account at Roslyn, you can definitely make a deposit or withdrawal at Garden State, no problems.
And following that through, I think that the acquisition of New Alliance by First Niagara is going to turn out to be a similar situation, partially driven by the fact that they are planning on having a separate headquarters in New Haven. Now, that's going to certainly ensure a much more friendly attitude and relationship compared to if it were all headquartered in Buffalo. So the true community aspect is, I think, going to work for them. Now, a couple of disclaimers here. I own stock in both First Niagara, New Alliance and New York Community.
Do you guys want to talk about scale versus losing that common touch?
KAFAFIAN: Let me start this way. Wells Fargo, obviously, a large bank, has been one of the most successful large banks and still maintains a community feel. A lot of that's about the people that you hire locally and the way you empower them and how they get involved in the community, because big-bank people can build relationships in local markets just like small-bank people. And I actually do think that sometimes community banks overstate their customer experience and the service they provide. They think it's wonderful just because they're the local community bank, and it's not necessarily the case.
With First Niagara — the biggest fear that I always have is that when a company grows that quickly — and I dealt with another bank 10 years ago that didn't grow quite as quickly, but fairly quickly — you always wonder whether they have the infrastructure and the organization to operate a bank of that size. And that includes management team, that includes systems, that includes a whole bunch of things that small companies don't need to worry about. It becomes more of a managing or management business as opposed to doing business. A CEO of a $100 million-asset bank does everything. The CEO of a $30 billion bank better have a good management team around him.
So I think the biggest challenge that I see for First Niagara is assimilating into their size with their staff expertise and their infrastructure. And if they stay focused on wanting to be community-focused, and accomplish that, I think they can be successful.
Where's the sweet spot, asset size?
KAFAFIAN: I think that we all try to figure out what that is. I'm not so sure there's a right answer to that. With all due respect to my investment banking friends — and I'm a pseudo-investment banker, too — you talk to any investment banker, and they say, "What's the size your bank should be?" and they all say, "Twice as big as you are now." Well, I think that there's a challenge on the low end because of operating expenses. So obviously there's got to be certain critical mass. On the higher end, as long as you're building your infrastructure and building your management team, you can maintain continuity and success.
But there is the whole theory around the bigger you are, the more you have to standardize, and the more you have to standardize, the less you can empower — Fulton's another example, Financial, of one that has run multiple banks. Susquehanna did it. But oftentimes what you see is there comes a point in time where those companies find a need to consolidate into a single charter or fewer charters than they have.
KOVALEFF: A classic example there is Synovus.
Sticking with just the consolidating, growing question, I used to cover private equity, and when I would talk to these guys, they'd always be like, "Oh, we always make the deals with the biggest returns during down markets. They turned out to be the most lucrative and profitable transactions." Taking that point, banks always consolidate, right? That's how — that's what the industry.
KAFAFIAN: Well, we've been a consolidating industry for a period of time.
But they consolidate in normal times, and now they're going to be consolidating in the times ahead.
KOVALEFF: Can I just throw out, one reason for that is pure greed on the part of the CEO, the president and the rest of management. Because a bigger bank pays a bigger salary, and there are more options, etc. I mean, I look at, in some cases, like Peoples of Connecticut, where the bank directors are hell-bent for acquisitions, and I look at the stock down about 35% from its second step saying, "You know, the best acquisition you might make is your own stock. But that's a downsizing." And it takes a special management team to see that side of the coin.
McGRATTY: I would say, consolidate — your point was consolidation's been happening. I can show you the numbers. Yeah, we have 8,000 banks today. We had double that going back a few years. Part of the reason why some banks aren't with us today are because they made poorly timed acquisitions, so
That's what I'm getting
McGRATTY: So I would agree. I would get to your point, and maybe flesh it out on private equity, but —
KAFAFIAN: And that's to Ted's point, too, that a lot of times those deals were just done with egos involved.
McGRATTY: Yeah.
KOVALEFF: Yeah.
I guess what I'm getting to is, in thinking about — OK, so there's a lot of consolidation coming. In bank mergers, when you have a tricky economy, does that exacerbate the dangers of consolidation in terms of executing it? Like, you know, which we talked about, is he going to look in five years …
KAFAFIAN: Can I go back to your private-equity question? Because that's what your original question was, I think. What was the word you used? Did you say they made a killing?
You would always hear — I can't remember the exact word I used, but they always —
KAFAFIAN: The biggest return.
They always got the best returns doing it.
KAFAFIAN: Think about some of the deals that have been and are being done in the last year, and in some cases they've been done at discounts to book value or slightly over book value, and they're tremendously dilutive to existing shareholders. So obviously, if those companies turn around, and if you brought in a company at 90% of book, and if bank stocks go back to trading — at normal multiples — let's say we just go back to 1.5 times book — there's a huge return in that. So the challenge that I see banks wrestling with, those that can attract private equity is, first of all, are they willing to give up control, and secondly, are they willing to significantly dilute their existing shareholders?
For the smaller banks, a lot of the PEs won't even consider them. There aren't that many firms out there that would look at them. So the capital-raising options for a lot of those smaller firms are pretty limited.
I actually think where this is probably going is there is a bifurcation between the larger banks and the smaller banks, and what's going to probably have to happen amongst these smaller banks is they're going to have to do mergers of equals, which is really a fallacy unto itself. But they're going to have to do mergers of equals or consolidate amongst themselves to be able to absorb the regulatory burdens and the operating environments, and then maybe they grow to some critical mass by the consolidation of a number of community banks that a larger bank becomes interested in them.
When the cycle started, right, Wilbur Ross said a thousand banks were going to go down. And we're really not in that pace right now. Is there going to be a long enough duration of banks going under to hit that?
KAFAFIAN: I think that the pace will be slower to start than some people predict, but I think a thousand banks out of the system of a little less than 8,000 is not unrealistic in a five-year period, certainly. Some people are predicting 3 or 4,000 in a five-year period.
McGRATTY: We've seen — I mean, FDIC — through the FDIC, we've seen 300 so far. And you point to the banks with the high Texas ratio. There's nearly 450 have Texas ratios above 100. So I'm not going to call any specific company, but the law of averages suggests these banks are going to have a tough time making it.
How many more companies do you think are out there like First Niagara, doing what they're doing, kind of graduating to the upper classes? Are they just a rarity, or is that kind of a model you think some of the stronger community regionals are going to be following? Are they just unique, or are they a blueprint for more to come?
KAFAFIAN: I'm a little hard-pressed to think who else.
McGRATTY: No.
KAFAFIAN: And I can't think of anybody else that has taken that first step like them, but that I think would be like them. At least when I think about the banks that we've worked with. That's not to say somebody wouldn't come out of the pack. But they're a bit unique.
KOVALEFF: You know, I'd like to throw one out to you, and that's Iberia Bank Corp. out of Louisiana. And you say, "Out of Louisiana?" Well, now it's all the way over to Florida and Texas. And they have definitely taken advantage of both the regular acquisition and the FDIC assistance. And, caveat, I own stock in it.
Just to kind of marry the thoughts that we're talking about here, about the consolidation and the FDIC deals, we've seen a lot of banks grow through FDIC transactions. Are there any unique consolidation risks there that you see in 2011? I realize that pricewise they got those deals, those banks at a song. But I would imagine there have to be some growing pains that might be in the works as they try to take advantage of their loss-sharing agreements and bolt on a bank that was battered for a few years.
KOVALEFF: I have to agree with you, and one of the things that is out there sort of under the rug is the regulatory requirements that have to be fulfilled to be able to take advantage of the loss sharing, because if you haven't dotted the i's and crossed the t's of all the reporting that has to be done, you lose. And I know of one bank that has, which shall remain nameless.
KAFAFIAN: I think the trend has been that we're seeing the tightening up of loss-sharing agreements. So the idea that banks are going to get the deals in the coming year that they got in the past year, I think the trend is moving away for that. The specific thing that I see is that the banks that have not historically been used to doing deals have integration risk, and the integration risk is exacerbated when it's a troubled bank. So if there's something that I think that needs to be focused on, it's probably that.
McGRATTY: The change in loss sharing is purely a function of the supply and demand, right? I mean, there's more banks that are healthier today than there were 18 months ago. So what you saw from the original 80/20 loss share, and then tiered 95/5, they've done away with it, and now it's changed significantly. So the gains that banks are recognizing up front are modest at best, and frankly a couple of my companies have reported goodwill, and there's no gain associated with it up front. That's a clear trend, which also suggests why banks are also considering traditional M&A, because the economics aren't as good, and there's less incentive to bail out the government.
Right. I understand that there's a lot of these — that the loss sharing has changed over the last year. But the ones that did deals over the last 18 months, I mean, they're going to be working out those loan portfolios for a while, right?
KAFAFIAN: Right. The risk is that the longer it takes for the economy to recover, there may be further deterioration in those portfolios. In my experience this has not been a uniform decline. I'm seeing banks today that are just now experiencing credit-quality declines, and those that did a year or two ago. First Niagara is the beneficiary of this. We have other clients in upstate New York. A lot of the banks in that northwest part of New York State, in the Buffalo, east of Buffalo region, had some real quality issues a few years ago. Many have come through those problems, and performance has really bounced back remarkably. So there's an area where we see a turn in the economy, and there are other parts of the country that I see that are just hitting issues now.
KOVALEFF: One of the things you have to take into account with western New York is that that was a pretty dead economy for quite a period of time. So if you don't have a high, you're just pretty much skating on the level. And so there was no bubble.
Speaking of credit quality, guys, there were several banks that as of third quarter moved to sell large pools of nonperforming assets. Do you see this as an encouraging sign, or is this an indication of desperation that we're not going to be able to work these out, we haven't had a robust recovery? Do you think this quick disposition of such assets, usually at a discount, is a good idea? Are we going to see more of it?
McGRATTY: That's a good — I think it's part of the healing process, is to get these problem assets, to the extent you can absorb the loss, off your balance sheet. Banks aren't in the business of managing — it's expensive on the residential side to keep up with the maintenance of the house, pay the taxes, cut the lawn. I mean, there's certain costs associated with maintaining property. To the extent there's a bid — and I think the bids in the market have firmed up over the past year — banks have already marked it down, to put at nonperforming to begin with, and they have a reserve against it already. So the incremental hit, yes, there is one, but it's a lot less than it was a year and a half ago. Now you've largely, if you're doing a bulk sale, moved a lot of the problem assets away so you can kind of resume your traditional banking business. So, yeah, it's healthy, I think. But not every bank can do it. I mean, not every bank can take the mark, because their capital position's not strong enough.
KAFAFIAN: I think it is healthy, and I think it is natural. But I think it's a bank-by-bank decision, as opposed to a singular trend. Every bank has to make their own decisions based on their own set of circumstances. The ironic twist of accounting in some instances — and I can't give you a specific example — is that you sell some of the assets off your books, and your risk ratings actually improve because of the high risk ratings that were assigned to certain product that you sold. So there's a lot of decisions that come into play that need to be analyzed in order for people to make informed decisions. I think the natural reaction is, if we can get the bad stuff off our books so we can begin to turn the company around and focus on the good stuff, and we have the capital to do that, it's not a bad thing to do.
We kind of obsessed over consolidation … Anything on here [list of questions] jump out that you think is really important, or just other things that you think you want to tackle, or we just keep firing.
McGRATTY: Tarp [Troubled Asset Relief Program] recaps.
KAFAFIAN: Tarp. There may be some banks that are going to be stuck with it for a while. I think that's the gist of it. And part of it is that the government won't let them pay it back. Part of it is, they just don't have access to the capital markets. Again, I think this discussion is really a focus on community banks, correct? Think about the conundrum that community banks are in, they can't go back to their current retail shareholders. Retail shareholders aren't interested in putting up any significant amount of money. A lot of the broker-dealers are hesitant to do common offerings and project any success. Some of them have gone down the path of preferred-type offerings, sometimes usually with directors or people close to the organization. I've seen community banks try the subordinated-note route unsuccessfully. A few have been successful, but largely they've been unsuccessful. The PEs aren't interested in them.
So what you find is that their options, for most part are extremely limited. So if they're a Tarp bank, they're going to have to hold on to that until they either earn their way out of it, or the markets loosen up, and there's an opportunity for them to go raise capital within, hopefully, the five-year window, but maybe even beyond.
KOVALEFF: You know, there's been a major increase in the number of mutual holding companies taking the second step, and I think that that's in another perspective something that follows from this, because it is a capital raise. Interestingly, the last two attempts at mutual holding companies taking the second step have failed. That is to say, Capital and Northfield. But prior to that, a number of the second steps — well, all of them, actually, this year had to go to syndication, meaning that the depositors weren't interested in buying more shares, the community wasn't interested, and so it became the investment bankers' responsibility to get the requisite number of shares sold. And so in several cases, I believe that the regulators had forced them to sell at a higher level than maybe was justified. Maybe at minimum, rather than midpoint it would have led to better results. And when I say better results, a good number of the mutual holding companies that converted this year are selling below the conversion rate. Usually that's 10, but in the case of Oneida it was 8, and they're selling at discounts now. So I think that that is another aspect of the difficulties of raising money, and too, then, afterwards, how the market perceives the new entity.
Ted, could you just talk a little bit about the impact that that has had on other mutuals, the fact that a lot of the companies trying to take the second step have been — either had a tough time or, in the case of the two that you mentioned, have been unable to complete them?
KOVALEFF: Well, if you take a look at the S&L index for mutual holding companies, year to date it is the worst performer when compared to thrifts, bank and thrifts or banks that have taken Tarp. So I think that the statistics there suggest that it has taken a toll.
However, there are a number of mutual holding companies that have performed decently to quite well. And they're ones that have taken advantage of the structure of the mutual holding company. And I am not talking about the dividend waiver when I'm talking about this. I'm talking about the opportunity to acquire a mutual, which is something that a fully public bank cannot do. So that is something that is an important point. So, you know, you cannot use a broad brush stroke and say, "Well, all mutual holding companies, dot dot dot."
KAFAFIAN: They certainly have taken notice, though. When they see that these deals have been pulled, they're going to take notice, because there's a cost that they can't recover.
KOVALEFF: Right.
Does it ever get better? Is it going to go back to the way it was?
KAFAFIAN: If I had a crystal ball, I'd tell you the answer. Well, let me say this. I think for good management teams, and for community banks that remain relevant to their marketplace, because the minute they become irrelevant to their marketplace, they're just another player in town, and the big banks have a lot more that they can offer to customers, and I think for those that are focused on that, yes, there is opportunity. But I think that the industry's just going to continue to consolidate, and there will be smaller levels of successes. It's only natural that that will occur.
KOVALEFF: You said what I was going to say.
McGRATTY: If banks are going to make money, we're going to — credit cycles have a beginning and an end. But I think it needs to be put in the context that, I think the most — what people will remember is that we came from probably peak profitability and peak leverage, and it's not going back there. It's somewhere in between. It's not — credit costs are going to abate, but they're not going to — and leverage is going to come down, but returns have to be — you have to kind of frame that in the context of returns are going to be more reasonable.
KAFAFIAN: Can I put it in another context for us? I agree with everything Chris just said, because when you talk about, can it ever return, we're talking about a three- to five- to seven-year window, because all bets are off beyond that. I heard Jamie Dimon speak at the New York Bankers convention last year, and he started to list all of the crises that he worked through as an adult, and it started with the oil embargo in the '70s, the interest rates hitting 21% in the '80s, the savings and loan crisis in the late '80s, the commercial real estate crisis in the early '90s, the dot-com crash, and now the subprime mess. And think about that. Think about the time frame of all of these events. Every five to seven years there was another significant event, and virtually every one of them was different from the other. Would you all agree with that?
McGRATTY: Latin America. You left out Latin America.
KAFAFIAN: You could add a couple other things, I'm sure. I mean, obviously, I didn't even mention 9/11 in that. But he was talking about mostly business events there — and for Chase, certainly, the world economy has an impact on them more than community banks. But here was his point, that if we think this is the last event or crisis, we're mistaken. We just don't know what the next one is.
Now, when people pressed about what would be the next crisis, some of his thought was around terrorism as it relates to data security and identity theft and the movement of money worldwide using technology versus traditional terrorism. It could very well be. But the point I think that he made that I took away from hearing him — and I thought he did a great job — was that management is charged with operating through good times and bad times and understanding the risks. And we're in the business of taking risk, and so we need to manage that risk. And I always believe that good management teams — I don't care what size you are — can be successful. And I can point to community banks that are successful, and I can point to large banks that are successful. I think that unfortunately this industry probably has been fraught in many respects with a lot of mediocre management teams, and to the extent that maybe stronger people assimilate into management positions we may see some opportunity there.
KOVALEFF: I'd like to just add that I have worked under the assumption that big banks are much more likely to have major screw-ups than are community banks as a whole.
KAFAFIAN: But they affect community banks.
KOVALEFF: Yes, exactly.
KAFAFIAN: They can't recover from it if they have a major screw-up, like some of the big banks.
KOVALEFF: That's absolutely right, yeah. But then again, you look at the screw-ups in the past, and how many of them would have been able to recover had it not been for the governmental aid?
KOVALEFF: And not only Tarp, but the other aids that went through.
McGRATTY: I kind of — I would just say, these community banks have made a lot of mistakes. They can't just blame it all on the big banks. A lot of — everyone's made mistakes, but if you look at the portfolios of these community banks, it's so disproportional to real estate lending — particularly construction, of course, real estate. Macro events didn't drive that. It was
Location, location, location.
McGRATTY: Yeah, it was leverage, returns — it was leverage and returns and growth. So I would just say you can't exempt the community banks, and you can't exempt the consumer. Because I think that's something we haven't talked about, either. Everyone — the media loves to report upon the banks, the banks, the banks. Banks have their faults, but so did consumers who lived way beyond their means. I think that's an important concept, that they were — banks were levered, but consumers were levered, if not more, with speculative purchases and living off credit card and pulling money out of your home. I think there's a sense of accountability that needs to be placed with the American public, as well.
The next thing, if you can answer this, just in various community banks, just your thoughts in general, as like bank analysts, I guess, what do you guys worry about, the next thing? The thing that I worry about is just like a really long period of stagnation. Like Japan. And the fact that everybody does dump it on the banks and everything else, but the fact of the matter is because consumers — because everybody's used to living beyond their means, and it's not going to be there.
KAFAFIAN: The idea, are we going to be like Japan? And I don't know that we know the answer to that yet. I mean, with the political infighting that goes on in Washington, forget about what side of the aisle you're on, the question is, can they get anything done? But I think that's a real risk. I think you're hearing bearishness, maybe, out of all of us, because I think what we're probably collectively saying is that over the next three to five years — and I won't speak further than that — I see people just trying to get a hold of themselves and spend more time surviving rather than succeeding. There's a target in my mind on both ends of this industry. There's the too big to fail, so you have these living wills that are saying, "OK, big banks, you've got to figure out a way how to break yourself up and dispose of yourself if you've become a problem to us." Whether that really works or not, we'll have to see when the first event occurs.
And then you've got the too small to survive or too small to succeed. And I think that there's a target firmly on both ends. We talked about this a little bit earlier. I think it was maybe one of the first questions that you asked me. What I'm really seeing with many smaller banks is that they are fatigued, and the directors are fatigued. And when they get fatigued, it's when they often say, "OK, we'll get out at any price." That's No. 1.
And No. 2, think about this. This is a scary proposition. In two cases, I can point to banks that will not be named, different states, different regulators, where they're both under 250 million, and in both cases they were kind of quietly being nudged by their regulator who have said, "You know what? We don't want to have to worry about examining you anymore. Maybe you ought to find a partner."
KAFAFIAN: This is from two different states, two different regulators, so I can't even say that it was a trend from one agency. But that's a scary proposition. By the way, these are two banks that I would consider troubled. They have nonperformers, like everybody else, but they're not astronomical. There are banks that are probably fatigued that are now maybe going to throw up their hands and say, "You know what? This isn't worth doing this anymore." So I think for the smallest banks, that's, and even the medium-size, $500 million community banks, the pressures of those regulators and the fatigue that they're feeling could set them off to do things that may not actually even be the right thing to do.
KOVALEFF: In terms of worries, I look at QE2 as a major source of worry. That is to say, the ramifications of it. Now, granted that even were the Fed, to purchase everything that they have said they were going to do yesterday, the whole money supply today would be lower than it was prior to the meltdown. But the ramifications of this are going to be much higher commodity prices, much higher oil, which actually, I guess, has to be viewed as a commodity. But what does that do to the cost of living here in the United States? It's going to raise the cost of living. And you're going to see, for instance, the price of gasoline rise because this morning oil was 86 as opposed to, a couple of months ago, 75. That has to go through the system. And heaven help us if we have a real cold winter. You're going to see oil up significantly.
Now, that plays out into inflation, even if it isn't demand-pull inflation, it's cost-push inflation. And you're going to then see certainly a widening of — or a rise in interest rates. And that will be something that can slow any recovery even more.
Chris, Armageddon, is it coming?
McGRATTY: No, I think I've kind of laid out practically what I think are my risks. I think it's clearly growth, and I think it's important to recognize, this is a cycle that took many years to build, and it's going to take many years to de-lever. So I think we're in the midst of it. No one talks about the credit cycle of 3Q10. They talk about the '90-to-'94 period. They talk about — so I think we're in the midst of recovery, but it's a drawn-out process. I just think expectations need to be realistic that, yes, things will get better, but it'll be slow.
