Last month the Office of Thrift Supervision closed NetBank Inc. and appointed the Federal Deposit Insurance Corp. as receiver.
The FDIC immediately announced a purchase and assumption of some of the online thrift's $2.5 billion of assets and $2.3 billion of deposits by ING Direct, a wholly owned subsidiary of the giant Dutch insurer ING Group NV.
After the FDIC was appointed receiver, the publicly listed parent of the federal savings bank immediately filed a bankruptcy petition. It is notable that the bank's deposits above the insured limit took a haircut at 50%, pending disposal of the $1.1 billion of assets retained by the FDIC.
The loss to the Deposit Insurance Fund is so far estimated at $110 million. In announcing the transactions, the FDIC noted that "the failed bank was an Internet bank and did not have any physical branches."
This fact, however, only partly explains the failure of NetBank and, with it, the independent online banking model.
In 1989 NetBank was known as Allatoona Federal Savings Bank, a $15 million-asset institution. At the end of 1997, what was by then known as Atlanta Internet Bank had grown to $83 million of assets but was not profitable. At the end of 1998 NetBank was born and had reached almost $400 million of assets, most of which were deployed in loans.
Within a year assets had tripled, to $1.2 billion, but the bank still was just barely profitable. It was spending 86 cents to generate every new dollar of revenue. About 63% of its assets were in loans, but the gross yield, at just 495 basis points, remained well below peers' performance.
By the end of 2001, NetBank reached $2.8 billion of assets, supported by over $1 billion in Federal Home Loan Bank advances.
NetBank's assets grew in the next four-plus years to peak at just more than $5 billion in mid-2005, when its return on assets was 0.07% and return on equity was 0.91%. By then the bank's efficiency ratio was 148%, meaning it was spending $1.48 to get every $1 in new revenue.
This bank was dying — but it wasn't dying from bad loans. An irrational growth strategy, supported by $1.2 billion in FHLB advances at the end of 2005, was actually killing NetBank.
By the end of last year, NetBank's efficiency ratio was 227%, and its assets had dropped to $3.6 billion. The bank reported losses equal to 4% of assets and 49% of equity. The losses mounted this year until the bank had just 2% equity to assets at June 30.
The remarkable thing about NetBank is that investors and bank managers continue to believe, even today, that the Internet banking model is viable for a stand-alone business. Examining the peers of NetBank in the Internet category, it is difficult to find an institution even close in terms of returns on assets or equity to the performance of its peers in asset size.
Branches and people remain an important part of the business model at U.S. banks. Remember that scale does not seem to be an issue at Internet banks. In fact, the largest player in this category, ING Direct, which assumed NetBank's insured deposits, continues to turn in truly awful results. With an ROA of 0.33% and an ROE of 4.13%, ING Bank FSB has consistently lagged its peers for the past five years.
Last year when my firm suggested to this newspaper that ING Bank was one of the worst-performing thrifts in the United States and that it could be under supervisory guidance were it not for its large, well-capitalized parent, a representative from ING replied that the bank's equity returns were not so bad because only half of its capital was funded with equity at the parent level (the rest apparently with debt).
That comment by ING reminds this writer of the television ad in which Yogi Berra expounds on the metaphysical aspects of finance: "And they give you cash, which is just as good as money."
The moral of the story is that no matter how fast a bank's assets grow, stable profits will be elusive if the business model is insufficiently broad and consistent.
The fact that many online banks seem to have a hard time achieving adequate profitability suggests that this business model may not be viable except as a loss-leader within a larger organization. Look at the proliferation of online banking arms at the major banks, and it seems reasonable to ask how a free-standing Internet bank can survive.
For investors, NetBank's failure illustrates a profound lesson: when the capital of a federally insured bank falls below a certain level, the primary regulator can appoint the FDIC as receiver, leaving the parent holding company no alternative to bankruptcy.
For the record, FDIC officials say that none of the brokered deposits immediately repaid in the NetBank resolution were above the insured limit! Why the FDIC immediately paid out brokered deposits while leaving jumbo retail depositors to hang, awaiting the bank's final resolution, is a story for another day.
