Bank of Montreal's surprise deal for Marshall & Ilsley Corp. indicates consolidation is fast coming to the regional bracket, with those banks still plagued by problem business real estate loans the most vulnerable.
The $4.1 billion agreement also shows that those types of loans, which became an obsession for midsize lenders before the crisis, may be in worse shape than M&I and other industry laggards will admit. The Canadian company's inspection of M&I's loan portfolio found that it is barely halfway through its losses on loans to home builders, apartment owners and other commercial borrowers.
That means an unexpected development like Friday's news — the takeover of one of the 50 biggest banks in the U.S. — may become increasingly common in 2011, experts say, as more institutions seek a partner in the face of heavy commercial losses.
"I don't come in on a Friday morning expecting to see a big deal," said Scott Siefers, a managing director of research with Sandler O'Neill & Partners LP. "Most people had hoped that they were a little further along; it suggests that M&I had some work to do … hopefully [M&A] is coming back."
That optimism sent shares surging on Friday at other regional institutions that, like M&I, have been slow to recover from the downturn and are in danger of falling far behind rivals that have managed to turn things around.
M&I's deal intensifies pressure on three other money losers: Zions Bancorp., Regions Financial Corp. and Synovus Financial Corp.
It also raises the stakes for banks that in 2010 managed to make money again after a long period of losses. Experts say the resurgence of three of them in particular, KeyCorp, Huntington Bancshares Inc. and Fifth Third Bancorp, is key to understanding why M&I agreed to sell itself even though it had made promising gains stanching its loan losses this year.
Key, Huntington and Fifth Third are making money again and investing heavily in ways to poach business and consumer clients in the intensely competitive Midwest, which isn't growing organically. Fifth Third is extending branch hours from Cleveland to Chicago; Key has flashy new branches in Indianapolis. Huntington has been on a hiring spree for business bankers and call center workers in Michigan.
M&I, meanwhile, is still a ways off from investing for growth due to a disastrous expansion into the Florida and Arizona home-building markets. The $52 billion-asset company, Wisconsin's largest bank, with 374 branches, decided to make property loans in those regions in the early 2000s because of the dismal growth prospects in the Midwest. The Milwaukee company has lost $4.8 billion in bad loans since 2007 as property values plunged in Florida and Arizona and as home and business real estate developers went bust.
The way M&I has been dealing with that problem, shrinking its balance sheet by selling and charging off loans in those regions, makes it harder to earn money even after it has stopped losing it. Revenue growth — the industry's next big challenge — becomes harder as borrowing and deposit relationships that could pay off in the future are terminated. M&I's loan recovery been bumpy, with real estate losses rising last quarter even though they were lower than they were a year earlier.
The transaction with Bank of Montreal, which plans to merge M&I with its U.S. subsidiary, the 312-branch Harris Bank in Chicago, indicates that M&I still had ways to go to work through its issues. Mark Furlong, M&I's chairman and chief executive, said in a press release that the deal is "good news" for M&I because it "positions us with the capital strength and scale" to grow the business.
Bank of Montreal says it expects to lose money on about 20%, or $2.6 billion, of all of M&I's outstanding construction, apartment and office property loans. It says it expects M&I to lose a total $4.7 billion on those types of loans as well as home equity, consumer and commercial and industrial loans.
According to Bank of Montreal's analysis of M&I's loan book, the company is barely halfway through its expected loan losses.
That is an unexpectedly high loss estimate, analysts said, even if Bank of Montreal is being conservative with an eye toward recouping money on loans it is aggressively writing off that may become current when the economy rebounds. "BMO is taking a huge mark on these loans," said Anthony Davis, managing director with Stifel, Nicolaus & Co.
Davis said the sale to Bank of Montreal would solve M&I's two biggest problems: containing all of those bad construction loans and repaying the $1.7 billion it received from the Troubled Asset Relief Program. The burden of returning its bailout money increased every day it lagged its Midwest rivals, he said.
M&I was probably going to have to raise capital to get out of Tarp, so it faced the prospect of issuing shares even though they are trading well below the company's book value, something that would have been highly dilutive to shareholders, he said.
He said M&I at its core has a solid franchise despite its problems in Arizona and Florida. It essentially owns Milwaukee when it comes to deposits, and it has a firm footing in the Midwest wealth management and commercial banking markets, which are attractive business lines. Harris is big into those areas as well.
"What this merger does is allow them to repay Tarp and put credit issues and cost control issues behind them to basically focus on customers and growing market share," Davis said. "This allows them to go on offense immediately."