Unfairly Treated?

KIRK WYCOFF, CEO of Progress Financial Corp., thought that his $851 million-asset thrift was like the “Little Train That Could.” That it could play in the same league as the biggest banks in the country and rack up superior earnings. In the process, he got his thrift into trouble with the Office of Thrift Supervision, stirring up many issues facing community banks and thrifts.Among them: Can a thrift be successful in commercial banking? Should a community bank try to substantially increase fee income? Are thrift regulators capable of understanding commercial or investment banking? Should community banks be barred from engaging in highly sophisticated businesses?Progress is an unusual organization. It has been on the leading—and at times the bleeding—edge of banking. It produced a negative return on equity of 5.24% in 1994, largely the result of problems in its mortgage banking business. But the next year its ROE soared to 18.62%. Since then, its ROE has bounced around in the 13% to 15% range, except last year it dropped to 1%.The origin of Progress's recent flap with the OTS was around 1996, when Wycoff started making big changes to drive up fee income. Progress entered such businesses as lending to young technology companies, offering mezzanine debt and setting up a venture capital subsidiary. It was copying what some of the nation's biggest banks were doing. And they were making a lot of money at it, at least until the high-tech bubble burst. The same could be said for Progress. Its performance doesn't seem to have been much different. But it is regulated by the Office of Thrift Supervision, rather than by bank regulators, and the OTS might have been intimidated by some of the relatively sophisticated businesses in which Progress engaged. Progress, although technically a thrift, behaves more like a commercial bank, and its management has a strong commercial banking background.Despite the problems Progress has encountered, Wycoff says he is happy with a thrift charter, and that he believes OTS regulators are becoming more sophisticated. But the issue touches on the debate regarding whether the OTS should be absorbed by the Office of the Comptroller of the Currency, which regulates federally chartered banks, or whether the agencies should remain separate.Others have bolted from the thrift charter. Last year, the $37 billion-asset Charter One Bank, based in Cleveland, decided to switch from a thrift charter to become a national bank. It had been the biggest thrift supervised by the OTS. Charter One attributed the conversion to the fact that it does a commercial banking business and wants to be viewed that way by the investment community.Scott Albinson, managing director of supervision at the OTS, declined to comment on the specifics of the Progress situation, but says that the OTS is up to snuff on supervising commercial bank-like thrifts. “We've developed core areas of specialized expertise, especially in the commercial lending area,” he said in a recent interview.From the outside, it's hard to know exactly what went on at Progress. But it appears to have behaved similarly to commercial banks that have not been punished by their regulators.Initially, Progress Financial fared well. By 1999, fee income accounted for about 45% of the company's revenues, and return on equity reached 15% (the second year in a row), up from 12.9% in 1996. Indeed, Wycoff was so elated that he wrote in Progress's 2000 annual report, “Our corporate goal remains to achieve an 18% return on equity on a consistent basis.”How sad. The high-tech bubble burst, and so did Wycoff's dreams. Progress's ROE plunged to 1.04% in 2001, down from 15.16% in 2000. Worse, the Office of Thrift Supervision issued a directive in July 2001 requiring Progress to increase its capital above the standard levels for well-capitalized banks. Chief operating officer Michael B. High says that's because of “the perceived” higher-risk of “lending to technology and pre-profit companies.”It appears that Progress's sharply lower earnings and its need for more capital was largely the result of a tough approach taken by regulators about the quality of the thrift's loans. The question is whether similar standards were applied to the nation's largest banks, and whether they, too, if they were under OTS regulation, would have been forced to substantially increase their capital.Wycoff speaks well of OTS supervisors, although he did indicate that, initially at least, they had difficulty understanding the business of lending to high-growth companies. Such lending, Wycoff says, was only “a little over 5% of our loans at the peak,” and did not expose Progress to significant harm. He said such companies often don't make a lot of money in their early years, and usually are funded by venture capitalists.“The OTS came to understand that risk, although we had to spend a lot of time with them, showing them that a company that has a lot of cash but not a lot of profit can be a good loan risk,” says Wycoff.OTS officials might have “learned,” but it appears they still compelled Progress to place a much larger proportion of its loans in the criticized category than Progress thought was warranted.When asked whether the regulators had pushed Progress to increase the number of criticized loans in its portfolio, COO High replied, “The regulators review our internal classifications and sometimes they disagree on a particular credit. We usually have to change the classification to their grading.”Progress's provision for loan losses last year rose to $7.1 million, from $4.4 million in 2000. Of course, U.S. Banker doesn't know how other regulators might have judged the quality of those loans, or how many had been criticized by the OTS. But an indication that the loans may not have been as bad as the OTS thought is that the thrift supervisor required Progress to sell $25.6 million in loans that it had made to early-stage technology companies. The thrift subsequently sold those loans to Detroit-based Comerica, which is known as a savvy lender to such companies. If the loans were really poor, they probably would have been sold at a discount. But, according to High, the loans were sold around par to Comerica. “We actually ended up with a small net premium on the sale of the relationship,” which included the deposits as well as the loans, said High.In other ways as well, Progress's 2001 results were not as bad as they seemed, while its 2000 results were not as strong as they appeared. In 2001, the company reported a $1.9 million loss on warrants, but that was merely an unwinding of a $1.9 million gain in 2000. “In 2000,” explains High, “we had a warrant that was worth $1.9 million from US Interactive, which was recorded as income. In 2001, that warrant became worthless and therefore the company had to effectively reverse the income of the year before. The company didn't pay anything for the warrant and also never got anything. It is a timing issue between the two years.”On the other hand, Progress reported an $802,000 gain in 2001 on its sale of an investment in NewSpring Ventures, a small business investment corporation venture capital fund. “We owned a 20% interest in the Fund and we sold 13.33% to a third party and realized a gain of $802,000,” says High. “The gain resulted from write-downs we took on this investment in prior periods.”Progress also reported some non-cash losses. One was a $440,000 write-off of goodwill, which stemmed from the purchase in 1998 of Pam Financial, a leasing company. “We have decided to downsize the leasing operation significantly and therefore have written off this goodwill,” says High. It also recorded a $301,000 loss as the result of the early payoff of a high-interest borrowing. The $301,000 was a penalty for prepayment, which should be more than made up for from savings on less expensive borrowings.In all, Progress has gotten out of five businesses: venture capital fund management and private equity investing; lending to pre-profit companies; lending to technology and venture-backed companies; real estate development and construction management, and asset-based lending. And it is downsizing its exposure in the leasing business. Although it's made these moves, Progress is not yet out of the woods. It still has a way to go before it meets the OTS's stricter capital rules. In December, the OTS extended the dates by which Progress must meet certain ratios. On March 1, classified assets no longer could exceed 25% of capital. By June 30, classified assets can't exceed 30%, according to the thrift's fourth-quarter earnings report. At yearend, the ratio stood at about 36%.Despite the problems, the 43-year-old Wycoff believes the bank knew what it was doing. He attributes the problems largely to the decline in the Nasdaq and the recession. “A year ago we felt we were well capitalized and profitable, and that we understood our underwriting and loan portfolio and that we would be able to manage our way through any losses in those portfolios,” Wycoff says. “Nine months later, that's essentially proven to be true.” Wycoff argues that the recent losses from Progress's venture into the tech field were “modest” compared with what it had earned in previous years.There's no question that Progress doesn't fit the mold of a thrift. Technically it is a thrift, but as Wycoff says, it has “a very commercial bank-like balance sheet.” And that's unlikely to change. The first five years of Wycoff's career was with Girard Trust, an old-line commercial bank, which subsequently was acquired by Mellon. He then went to PSFS, a thrift that was trying to move into commercial banking. PSFS—originally the Philadelphia Savings Fund Society—effectively was bought by Mellon. Says Wycoff, “I've spent my whole career on the corporate and real estate lending side of the business.” He compares Progress with commercial banks of comparable size, and tries to attain the same kind of returns as those in the top 20 percentile. He says he's working for the shareholders, and that's what they expect. That's why he set the ROE goal in 2000 at 18%.“You don't pick out GE's return on equity and say, 'we've got to do that.' You've got to take a bunch of risks to do it. You say we have to earn our right to be independent everyday. Then we can strive to be in the top 20% of our peers.”Wycoff said that in 1996 Progress listened to many analysts who advised banks the size of Progress to generate a large amount of fee income. “We bought into that, and believed in that, and tried to do it in ways that were financial in nature.”He now sees it differently. “Having come full circle we've learned there's a vast difference between generating a high level of fees and generating a high level of profit. Typically businesses that are fee-based require a higher level of professionals, people who can generate revenues every day, every year, starting from scratch.” That's different than traditional banking, “where every year we start off with a portfolio of loans and deposits, which generate income.” Wycoff said he now realizes that “in the banking business, our gross margins are typically 30%.” Although he plans to keep Progress in wealth management, Wycoff says he found that most highly profitable fee-type businesses, such as securities processing, require huge scale, which a $1 billion company doesn't have. “The community bank that desires and drives for a high percentage of fee income is misplaced in today's environment,” says Wycoff.“Our shareholders are best rewarded by a more simplified earnings stream, one that's easy to compare and understand,” he continues. And while he is discouraged about bringing in a lot of fee income, Wycoff says bankers have far more control over interest risk than they had in the past.He says Progress uses two interest-rate models. “If you look at our net interest income over the last seven to 10 years, when rates rose, our net interest income went up slightly, when rates fell, our net interest income went down slightly—so you're able to smooth out curves. In the 70s we weren't able to.”Wycoff says he plans to keep Progress essentially in the commercial banking business. “My entire team is from commercial banking,” he says. The head of corporate lending had been with First Pennsylvania Bank and Trust, which was bought by Corestates, which subsequently was bought by First Union (now Wachovia); the head of real-estate lending had been with Hamilton Bank, a Lancaster, PA, bank, which was bought by Corestates; and High had been with Meridian Bank, also bought by Corestates. The head of retail banking had been with North Fork Bank on New York's Long Island. “How do you turn a thrift into a commercial bank,” Wycoff asks rhetorically. “You have to start with the right putty. We're in a very good market in the metropolitan Philadelphia area. We had a long history, over 100 years here, of service to the community. We had core deposit customers.”Might Progress switch its charter to that of a commercial bank? “The reason we're a thrift today is that the thrift charter is the best charter in terms of flexibility for accomplishing high-end performance,” says Wycoff. He says it provides flexibility in terms of your holding company capital structure, and argues that most community banks with “very high performance ratios” don't have more than 20% of their portfolio in business loans. And, “as a thrift, I'm allowed to have 20% of my portfolio in business loans.”Meeting that ratio is far easier today than it had been seven to 10 years ago, he says. The rule is that 65% of a thrifts loans had to be considered “qualified” as meeting the standard for thrifts. That has become much easier to meet because the category now includes mortgage-backed securities and other loan categories, such as consumer loans.“The OTS has done a good job of making the thrift charter an exciting one from which to operate. The final piece, obviously, is they're coming up the curve in learning how to regulate banks that have a lot more loans that are not residential than residential,” Wycoff says.