After a small profit rebound in the first quarter of 2009, insured banking institutions recorded another aggregate net loss in the second quarter. The $3.7 billion loss was primarily related to sharply increased loan-loss provisions, write-downs of asset-backed commercial paper, and increased deposit insurance assessments. The commercial paper write-downs contributed to a $3.3 billion increase in extraordinary losses. And, higher deposit insurance comprised a good part of the industry’s $1.7 billion increase in non-interest expenses.
More than 28 percent of insured institutions recorded a second quarter loss; in the year-ago period, 18 percent were unprofitable.
Bright spots: noninterest income, NIMSome banks partially offset the rash of higher expenses with improved net interest margins (NIM) and higher noninterest income. The average NIM rose 9 basis points to 3.48 percent, and larger banks were the primary recipients of this improvement. Noninterest income increased by 10.6 percent or $6.5 billion. Other positives included reduced realized losses on securities, higher gains on assets sales, higher servicing fees and improved trading revenues.
Records set: net charge-offs, noncurrent loan rate Net charge-offs spiked to $48.9 billion in the second quarter, sending the net charge-off rate to a record 2.55 percent. In dollars, charge-offs rose more than 85 percent from the second quarter of last year. Commercial and industrial loans (C&I) and credit card loans were the categories with the largest charged-off amounts in the second quarter.
Noncurrent loans and leases rose 14.3 percent, marking a thirteenth consecutive quarterly increase. The increase was driven by 1-4 family residential mortgages, real estate construction and development loans, and loans backed by nonfarm, nonresidential real estate. The noncurrent loan rate rose to 4.35 percent, the highest level on record, despite a record decrease in loans 30-89 days past due. All major loan categories contributed to this decrease, with real estate loans accounting for 83.5 percent of the improvement.
Capital improves, assets decline
Equity capital grew to 10.56 percent, its highest level since the spring of 2007. On average, capital ratios improved, although this improvement was concentrated in fewer than half of the insured institutions.
While 57 percent of insured institution increased their assets in the quarter, the industry average showed an asset decline of 1.8 percent. More than half of the decline was related to loans and leases. C&I loan balances were down, as were 1-4 family residential mortgages, and real estate construction and development loans. Small business loan balances also declined industry-wide.
Problem list The FDIC’s problem list now includes 416 institutions, making it the largest problem list since 1994. Twenty-four institutions failed in the second quarter and thirty-nine were merged into other banks. Only twelve new charters were approved.
Insurance fund At quarter-end, the FDIC imposed a special assessment on insured banks totaling 5 basis points of each institution’s assets less Tier 1 capital. Some 89 institutions with assets of $4 trillion were assessed 10 basis points of their second quarter assessment base.
During the second quarter, total deposits at insured institutions increased by 0.7 percent. Over the prior twelve months, total domestic deposits grew 7.5 percent.
Brokered deposits exceeding 10 percent of a bank’s domestic deposits are now included in the FDIC’s assessment calculation. At quarter-end, 1488 banks had brokered deposits exceeding 10 percent of their domestic deposits. Aggregate brokered deposits decreased by 5.8 percent in the quarter.
The Deposit Insurance Fund (DIF) declined 20.3 percent during the second quarter to $10.4 billion. Factors that reduced the fund balance included:
• Increased loss provisions of $11.6 billion
• Unrealized losses on available-for-sale securities of $1.3 billion
Factors that increased the fund balance included:
• Accrued assessment income, including the special assessment, of $9.1 billion
• Interest earned, realized gains on securities, debt guarantee surcharges from TLGP of $1.1 billion
The DIF reserve ratio was 0.22 percent at quarter-end, vs. 1.01 percent at the end of last year’s second quarter.
The Congressional Oversight Panel (COP), tasked with monitoring the Treasury's progress combating the financial crisis, has released an update on the continued risk of troubled assets in the banking industry. While the report doesn't address bank organizing groups specifically, its content does emphasize the challenges of evaluating target banks during this financial crisis.
Those challenges include valuing the target bank's troubled assets and identifying the reasons why those assets became troubled in the first place. In the general sense of the term, troubled assets are loans or securities that no longer meet (or perhaps never did meet) acceptable underwriting standards. The credit risk on these assets exceeds acceptable levels, repayment is questionable, and the aggregate asset value is far lower than originally assumed. Troubled assets commonly include:
Mortgage-backed securities
Whole mortgages in the bank's portfolio
Securities backed by credit card receivables
Securities backed by commercial mortgages
Community banks generally have more exposure to troubled whole mortgages.
Underlying causes
The bank organizing group does have a certain level of negotiating power when the target bank's balance sheet is weighted down with too many troubled assets. That's where the advantages end, however. Even before the negotiating begins, organizers must identify the underlying causes of the bad assets:
Were these assets bad from the start, due to lax underwriting or borrower fraud? Did the bank willingly overlook missing documentation or red flags on credit histories? Was it simply an over-reliance on the assumption that collateral values would continue to rise over time?
Or did these assets become troubled over time due to extreme weakening of collateral values or borrowers' credit qualifications?
Procedural changes and capital requirements
The organizing group is then tasked with devising the underwriting, workout and procedural standards that will:
maximize the return on existing troubled assets
add new, high quality loans to the portfolio
minimize the addition of new troubled assets
Obviously, these are relatively complex objectives in this economic environment. Unemployment is still rising and the outlook for property values, particularly commercial property values, remains uncertain. Excessively timid underwriting can minimize the creation of new problems, but it's counter-productive; banks have to make loans to survive. The new management team simply has to find a way to originate loans that make sense.
Setting appropriate capital requirements is also a key step in evaluating the target bank. Ample capital can be a buffer for future loan losses, but organizers have to balance the capital needs with the availability of investor funds. Under current conditions, it is possible for organizers to meet their capital raise targets-but it isn't easy. The process takes planning, knowledge and expertise.
Next week, we'll discuss the accounting for troubled assets, as discussed in the COP report. You can access the full COP report here: http://cop.senate.gov/documents/cop-081109-report.pdf
Underserved and underbanked communities are well documented in the banking industry: the FDIC and others have published numerous reports, surveys and case studies on the topic. And, the FFIEC produces an annual list of underbanked communities, segmented by county and state.
As capital flows into the banking industry via bank acquisitions, many new business plans are incorporating programs to attract and retain underserved/underbanked consumers. Some bank acquirers are even selecting target banks based on their locations relative to known underserved communities.
Creating a planA bank purchase, like a bank start-up, has a rigorous regulatory approval process. Part of that process involves documenting and defending a viable business and marketing plan for the target institution. This is no small undertaking, particularly when an underserved community is being addressed. Studies have repeatedly shown that underserved consumers do not respond consistently to traditional bank marketing programs.
Earlier this year, the FDIC completed a survey to identify initiatives and programs that had successfully attracted underserved consumers. Effective outreach efforts incorporated the following actions:
• Early identification of suitable underserved populations
• Early commitment to serve the targeted underserved population
• Launch of educational programs, teaching consumers about managing their finances
• Partnership with established community organizations
• Off-site outreach visits and programs (at high schools and/or community organizations)
• Providing educational pamphlets and brochures
• Marketing specifically to certain demographics (such as Hispanic Americans)
• Empowering bank employees to welcome underbanked customers
The FDIC study concludes that educational programs, community partnership and off-site visits are among the most effective strategies. Subjects most commonly addressed in educational sessions are basic banking and savings programs. While the development of financial pamphlets and brochures is a popular strategy among banks, it is not considered one of the most effective methods.
Widening the service set An effective underserved outreach program must also include the establishment of services for noncustomers, such as:
• Check cashing
• Money orders
• Bill-pay
• Reloadable, prepaid cash cards
A challenge in offering these services to noncustomers is setting effective identification policies. Underserved customers are less likely to have traditional forms of I.D., such as a driver’s license or state-issued I.D. card. Also, the goal in developing relationships with noncustomers is to transition them into accountholder status over time. Banks must therefore establish identification policies for account openings as well. Lack of identification is a common reason new account applications are denied. Other reasons include negative results on a check screen and a low credit score.
Assuming noncustomers can be converted to accountholders, these entry-level customers will also have specialized service needs. Banking services to consider for this customer segment include:
• Checking and savings accounts with no balance requirements
• Accounts with less severe overdraft penalties
• Short-term, unsecured loan facilities with specialized eligibility requirements
For further insights on working with underserved customers, read the full FDIC survey, available here:
http://www.fdic.gov/unbankedsurveys/unbankedstudy/FDICBankSurvey_Report.pdf
The decision to acquire a bank in an underserved community is ultimately based on the investment value of the target bank. But determining that investment value is a tricky proposition; a low-income neighborhood may not offer much appeal currently, but infuse that low-income neighborhood with capital, and the situation might look quite different.
Residents of underbanked communities typically have their financial needs fulfilled by payday loan stores, check cashing establishments, and even unlicensed predatory lenders. The expense associated with these services creates inefficiencies in the cycling of cash within the community. In other words, predatory lenders can drain more money out of the community—through high finance and service charges—than they put into it.
A banking institution, however, can have the opposite effect. When a bank reaches out to underbanked consumers and educates them on the advantages of keeping a deposit account, that bank is also compiling assets that will be returned to the community in the form of loans. Those lend-able funds are the building blocks of home ownership and local business development.
Financial education creates financial efficiencies Studies have repeatedly shown that financial education is a huge component of attracting and retaining underbanked consumers. A bank that operates effectively in a previously underserved community isn’t limited to showing consumers how to reduce their finance charges, however. The bank can also initiate programs to help consumers develop more efficient budgeting, spending, savings and even tax planning habits. Over time, those cumulative household savings can also be directed back into the community, through discretionary spending.
With a creative vision and effective outreach and education programs, then, a newly acquired bank can anchor a turnaround within an underserved community.
Overcoming the failures of previous banks The challenges in initiating such a turnaround are large, but not insurmountable. If the target bank is already located within the underserved community, the bank organizers need to understand why that institution wasn’t previously effective. The product and service set, the brand image and the marketing programs (to name a few) need to be overhauled to address the needs and wants of local consumers.
If the target bank is to be relocated to the underserved area, the bank organizers must try to gain some insight from the history of banking in that community. Did previous banks or branches fail? If so, why?
Underserved communities and unbanked consumers obviously aren’t the low-hanging fruit of the banking industry. However, initiating real and positive change within a community is an endeavor that can be both rewarding and profitable. And, because there are many underserved locales in the U.S., the group of bank organizers that defines a workable model for one community has ample opportunity to roll out variations of that model to other areas.
Next week, we’ll discuss marketing strategies for attracting and retaining underbanked consumers.
An early decision bank organizers must address is whether to buy an existing bank or create a de novo bank. The right choice among these two options is always dictated by the particular set of circumstances faced by the group. At times, as circumstances and opportunities develop, bank organizers may even switch strategies in the middle of the process.
If the decision is made among the organizers to buy a bank, certain steps must be completed in order to get the transaction finalized. While each bank acquisition is unique, the steps generally fall into four major phases.
Phase One: corporation formation Once the decision is made among the organizers to buy a bank, the group members create a stand-alone corporate entity. The newly formed corporation has two purposes: to purchase a bank and manage the organization’s funds. Other steps that are completed during this phase include:
• Identification of the target bank
• Negotiation of the purchase agreement
• Sourcing and hiring of executive officers
• Selection of a new bank location, as dictated by the business plan and/or assess the condition of the existing bank location
Phase Two: application After the target is identified and the stock purchase agreement is in place, the group begins on the change of control application. The business plan within the application includes 10 separate sections; these sections are broken down and worked on until each is at least 80 percent or more complete.
Typically, each organizer must also complete an Interagency Biographical Financial Report (IBFR). This can be one of the most difficult sections; it must include each organizer’s personal and financial records for the previous two years and the current year, as well as projected records for the next year. The organizers should be compiling this information while the other sections of the application are being completed.
Phase Three: pre-file and comment letter Once the business plan is 80 to 90 percent complete, the organizers schedule a meeting with the regulating agency. At this meeting, the organizers must explain and defend their business plan to the regulators.
After the pre-file meeting, the group fine tunes and completes the business plan and sends it off to the regulating agency. The agency then has 30 days to make comments and request additional information. Once that request is made, the organizers have 30 days to compile the requested data.
Phase Four: Sell stock/capital and open doors Often, when a bank is being purchased, a substantial amount (greater than 75 percent) of the capital must be raised by the time the application is filed with the regulators. In the current economic environment, regulators only want to approve “sure deals.” They are so busy with all the banking issues, that capital uncertainty is one issue they do not want to worry about in a purchase transaction.
For this reason, the organizing group is typically left with a private placement offering as the simplest way to raise the capital. Often this is done amongst the organizing group plus a few outsiders. The amount of capital required is dependent on the business plan approved. Typically, the regulators will require additional capital above the purchase price of the target bank to ensure that the new business plan has enough capital to succeed.
Once the capital has been transferred to the sellers of the bank, the doors may open “under new ownership.”
This is just a broad overview of the bank purchase process; each deal has unique circumstances that must be addressed. These circumstances could be legal in nature and involve counsel. Others are small details that can be easily overlooked by organizers. De Novo Strategy, Inc. has the experience and dedication to make the bank purchase project a reality and to help with every step.