Raising the Stakes

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As a kid growing up in Cleveland, James Rohr opened his first checking account at National City Bank.

He couldn't have known then that more than 40 years later, as chief executive of rival PNC Financial Services Group Inc. in Pittsburgh, he would step in to save his hometown bank from the brink of failure.

Capitalizing on the Darwinian dynamics of the financial crisis, PNC acquired a badly hobbled National City late last year for a mere $5.6 billion, or $2.23 per share. The deal, which more than doubled PNC's asset size, was sealed in National City's downtown Cleveland headquarters, across the street from where Rohr's family once owned a restaurant.

"No question about it, it was a homecoming for me," says Rohr, who joined PNC predecessor Pittsburgh National Bank in 1972, after getting his MBA from Ohio State University. "I love Cleveland. If you don't have warm feelings for the city you grew up in, something's wrong."

Rohr's return to his roots is a significant gamble for PNC. The company's saving grace through the early stages of the crisis was that it was less of a bank than most of its competitors — a big fee generator that, unlike National City, steered mostly clear of risky residential real estate. In 2008, 57 percent of PNC's revenues came from non-interest sources, including a 34 percent ownership stake in BlackRock Inc., the investment management operation, and a powerhouse technology unit — a fact Rohr frequently highlighted in investor presentations. Strong fees meant that PNC didn't need to chase yields to drive profits, leaving it in relatively good stead as the credit crisis blossomed.

The deal has changed all that, transforming PNC into a $286 billion-asset behemoth — the nation's fifth-largest banking company, with 6 million customers and 2,600 branches stretching from the nation's capital to its heartland, but concentrated in the distressed industrial Midwest. It also makes PNC decidedly more bank-like; it now gets more than half of its revenue from retail banking, and just 42 percent from non-interest sources.

In essence, the 60-year-old Rohr has abandoned the strategy that has made PNC one of the industry's success stories because, he says, old-fashioned banking is attractive again. "Earlier this decade, when everyone could borrow at LIBOR-plus-a-quarter, you weren't getting paid to take risks," he explains. "Now, the spreads are wider and deposits matter. For first time in a long time, you're getting paid to lend." To drive home the point, he notes that PNC's net interest margin rose by 44 basis points in the first quarter alone.

PNC's move reflects a change in both operating conditions and the industry's conventional wisdom. With securitization markets all but shut down and margins increasing, traditional lend-and-hold banking is staging a comeback.

Other large survivors that have acquired troubled or failed banks, including US Bancorp and even JPMorgan Chase & Co., also are holding more loans, a practice that almost by definition mandates smarter underwriting.

"We're seeing a return to basic blocking-and-tackling - making smart loans, funding them with deposits and holding them on the books at attractive prices," says Fred Cummings, a former bank stock analyst and president of Elizabeth Park Capital Management, a hedge fund based in suburban Cleveland. Fees are still important, he says, "but you can make money as a traditional bank again."

Even so, it's a bold move for Rohr - one that, for better or worse, will shape his legacy. "This is Rohr's defining moment. He's taking a gamble by shifting away from a business mix that differentiated him into one that's more about plain-vanilla banking," says John McDonald, an analyst with Bernstein Research. "Having the opportunity to double your footprint for a $2 stock price was too good to pass up, even if it is a bad footprint and dilutes the business mix. But there's no doubt about it; they've increased their risk profile."

PNC and National City had talked about a merger of equals earlier in the decade, but couldn't work things out. Then the real estate crisis hit, battering National City, and freeing PNC to buy it on the cheap, without having to worry about who would call the shots.

Jimmy Dunne, the senior managing principal for investment bank Sandler O'Neill & Partners, says Rohr has taken advantage of the industry's changing dynamics with a shrewd counter-cyclical checkmate. "Jim understands how to play the extremes. When everybody was building their loan books, thinking that credit would always stay perfect and housing prices would always rise, PNC did the opposite," says Dunne, who advised PNC on the deal. "Then the credit crisis happens, ... allowing [PNC] to strike a deal at very, very favorable terms."

While it has fared better than many big banks, PNC hasn't been immune to trouble. It lost $248 million in the fourth quarter - its first quarterly loss in seven years - thanks to $990 million in loan-loss provisions ($504 million related to the National City acquisition) and a 79 percent increase in net charge-offs from the previous quarter.

In the first quarter, non-performing assets jumped to 2.02 percent of total loans, from 1.23 percent a quarter earlier-a steep rise that officials attribute to "recessionary conditions in the economy." The company reported net income of $530 million, or $1.03 per-share, after paying a $47 million preferred stock dividend to the government for its $7.7 billion investment in PNC as part of the Troubled Asset Relief Program. Though the number smashed the consensus analyst estimate of 42 cents per-share, PNC is far from out of the woods.

After the deal closed, PNC's management reviewed the entire loan book, and took a $7.4 billion charge to mark down $19 billion of "impaired" National City real estate loans. That leaves seven percent of the portfolio "de-risked." Company officials say the loans have been performing better than expected, but some analysts think more markdowns will come, due to the worsening economy.

Potentially more troubling is a big book of commercial and industrial real estate loans, most of them from PNC's legacy portfolio, which represents 55 percent of the combined company's $177 billion of loans.

Such loans have not taken huge hits thus far, but Bernstein's McDonald predicts PNC could charge off as much as $6.4 billion over the next two years — split more or less equally between the non-impaired Nat City loans and those of legacy PNC — if the economy continues to weaken.

In recent months, Rohr has felt some heat from shareholders and regulators. Earlier this year, the company joined its industry counterparts and slashed its dividend, by 85 percent, sparking some testy confrontations at PNC's annual meeting in April. "I could accept the stock [price] going down," said one shareholder. "But you destroyed the dividend. That kind of bothered me."

Says Rohr: "Clearly, we'd like to bring the dividend back meaningfully. But we have to get from here to there first, and the only thing that might stop us is capital. In times like this, we have to preserve it."

(PNC's tier 1 capital ratio jumped 50 basis points in the first quarter, to a healthy 10.2 percent. Its tangible capital equity levels were less favorable, standing at just 3.3 percent of total assets at the end of the first quarter - up 40 basis points from the quarter before, but on the low end when compared with some other large banking companies. Government stress test results had not been released when this story went to press, but several analysts predicted that PNC would be required to raise additional capital, though it could likely do so on its own, without having to convert government-held preferred shares to common stock.)

The annual meeting also saw Rohr grilled by activist gadfly Evelyn Davis - a regular at many big-bank shareholder meetings - about the company's decision to accept TARP money when PNC "didn't really need it." She also asked point-blank if the government had forced PNC to buy Nat City. (Rohr said no.) The tone might have been critical, but Davis — who doesn't pass out compliments freely — closed out her comments with this endorsement: "You are one of the very best executives I've ever dealt with," she said, adding that PNC is "a role model for other corporations."

Such accolades are telling for a guy who has struggled at times to win respect on Wall Street. Rohr doesn't always know the operational details as well as some investors would like. To others, he comes across as too unpolished to run a large company. One analyst privately calls him "marble-mouthed;" another recounts a tale of Rohr, an avid golfer, affably dropping curse words during post-round drinks.

His lieutenants know there is a perception problem. "Jim comes across as a good-ol' boy," William Demchak, head of corporate and institutional banking, conceded in a 2008 interview. "The rap is, you wonder if there's anything to him."

Investors might grouse, and sometimes customers do, too. When the Pittsburgh Steelers played in the last Super Bowl, Rohr took some clients to Tampa in PNC's corporate jet, eliciting howls from the masses. "The airplane has become a focal point for people," he says.

Still, Rohr is respected in-house, and his demeanor seems to play well in the blue-collar Midwest. Go to a Pirates baseball game with him (at PNC Park), "and by the time you get from the parking lot to your seat, you'll have stopped and talked to 1,000 people," Dunne says. "People underestimate Jim Rohr all the time. But they do so at their own peril."

The National City deal — and his overall management of the company through crisis — has the potential to silence the naysayers. As recently as 2002, PNC was the one in trouble, operating under tight regulatory scrutiny after it had offloaded bad credits to three off-balance sheet entities.

Rohr, who became CEO in 2000, took the heat. Some shareholders demanded his resignation; others pressed for a sale. Instead of buckling, he overhauled the company and its management team, hiring Demchak from JPMorgan Chase & Co., and Richard Johnson, another JPM defector, as chief financial officer. The team boosted internal controls and turned risk-management into its own department — one that used complex models to identify the best risk-adjusted returns on capital, not merely the best returns.

The experience helped PNC turn lemons into lemonade. When Riggs National Corp. in Washington, D.C., was forced in 2005 to sell after pleading guilty to criminal money-laundering charges, PNC stepped in, buying the $6 billion bank and its 50 branches for a then-bargain price of $643 million. "I don't think we'd have bid on Riggs if we hadn't gone through what we experienced," says Joseph Guyaux, PNC's president and head of consumer banking. "We were confident" dealing with the government.

Two other troubled bank purchases followed. In 2007, it acquired the $2.7 billion-asset Yardville National Bancorp, a central New Jersey operation that had been suffering from credit quality issues. Last year, PNC bought the $3.3 billion-asset Sterling Financial, a Lancaster, Pa., company that had been reeling from an alleged fraud scheme involving its equipment-leasing unit.

At the same time, Rohr reorganized the guts of the company. Under the program, dubbed One PNC, it Web-enabled its branches, appointed sales coaches and began making better use of data to sell — all employee suggestions. It also began slashing costs, but only in ways that didn't affect the customer experience. One example: reducing the square footage per-employee from 280 earlier this decade to 180 today.

Still, even with all of its experience absorbing troubled companies, PNC has never taken on an institution as large or as hobbled as National City. Among that company's more spectacular blunders were jumping feet first into the mortgage market during the boom, holding onto subprime originator First Franklin too long, and then getting saddled with about $10 billion in bad loans that the buyer, Merrill Lynch, couldn't stomach. Then, to replace some of the revenue lost in that sale, it bulked up on $10 billion in brokered home-equity loans, which are now considered poison.

National City also paid $2 billion for two Florida banks, with heavy commercial real estate exposure, at the very peak of the market in 2007, and repurchased $3 billion of stock when share prices were topping out — capital that could have saved it a year later. As loan losses mounted, the company faltered. Things got so bad that not even a $7 billion private-equity investment led by Corsair Capital in April 2008 could preserve its independence.

PNC will begin converting National City's nearly 1,600 branches into PNC offices later this year and is expected to complete the job in early 2010.

Assuming Rohr's team can get National City's loan portfolio under control, a key to making the deal work long-term, analysts say, is overhauling the bank's organizational and incentive structures to encourage more cross-selling within the branches. It promises to be a labor-intensive task, made more difficult by the economy, but there are reasons for optimism.

Nat City's core banking operations are considered to be well run, and PNC has been good in the past at wringing the most out of stagnant markets by pricing for risk and cross-selling products. Rohr says that a team in Scranton, Pa., has exceeded sales plans in three of the last five years. "We're not afraid of going into Kalamazoo, Michigan," he says. "We know how to grow market share and make money in places like that."

There remains some lingering resentment toward the deal in Cleveland. "People were heartbroken" after Nat City's application for TARP money was rejected, says Cummings, who lives in the area. "They were angry with the government, and didn't think National City was given a fair chance to recover."

But National City's chief rivals, including KeyCorp and Fifth Third Bancorp, are preoccupied with their own balance sheet problems, meaning they're not positioned to poach clients. It hasn't hurt that Rohr is a native son, or that he pledged not to cut employment too drastically. (PNC aims to slash 5,800 jobs, or 10 percent of the combined workforce.) He also bumped up the company's charitable contributions in the city by $5 million.

Early indications suggest that PNC's strength is helping the old National City franchise win customers. Since the deal was announced in October, deposits at the National City branches have increased by about $2.5 billion. Often, "the acceptance from customers has been great," says Paul Clark, a former National City executive and now the Cleveland-based head of northern Ohio for PNC.

Employees seem energized, too. Prior to the deal, "it was tough around here ... National City was struggling and employment engagement was spotty," Clark says. Within days of the acquisition's closing, "it was as if all of the setbacks employees had experienced were reversed."

Rohr argues that the new PNC will be poised for fast-growth once the economy rebounds. He plans to lower the loan-to-deposit ratio to about 84 percent — PNC's level before the deal for National City — and hopes to see fees as a percentage of revenues rise with more cross-selling. He also aims to slash some $1.2 billion in annual costs from the operations through layoffs, branch divestitures and increased efficiency. Reducing the average square footage per-employee of National City staff from roughly 350 feet to the PNC average of 180 square feet per employee "will save us about $70 million per year," Rohr says.

"It's a hard time to be a banker. There are a lot of moving platelets to contend with — the housing crisis, the federal government's involvement, the economy. It takes a lot of work," Rohr says. "But frankly, we're in a position where if we can execute, I think we can do really well going forward."

If Rohr can make the old National City look and act more like PNC, he will have proved that you can go home again.

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