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Bank Asset Quality

Posted by Wendell Brock on Tue, Mar 02, 2010

The Risk Management Association (RMA) just released 2009 Q4 figures showing that the downward slide of bank asset quality is beginning to level off.

The RMA is a nonprofit with 3,000 institutional members whose goal is to implement sound risk principles in the financial sector. Their Risk Analysis Service data report was released in conjunction with Automated Financial Systems, Inc., and is the self-professed only gauge of comprehensive credit risk. The data utilize figures from 17 top-tier banks.

Showing Signs of Recovery

From the press release: "The leveling off of the deterioration of commercial asset quality from the third to fourth quarter is a positive indicator that the economy is showing signs of recovery," said William F. Githens, RMA president and CEO. "However, the business banking sector continues to be a concern and is substantially underperforming the middle market and large corporate lines of business."

But while the rate of decline in asset value for big banks is only beginning to level off, specialty lenders are enjoying quicker successes. AmeriCredit, CapitalSource, Allied Capital Source, and CIT Group all posted 52-week high stock prices (TheStreet).


CIT Group, a commercial lender to small and medium-sized businesses, took its first bond to market on February 26 after emerging from a brief, month-long Chapter 11 reorganization in December. The bond, offered at $667.2M, represents a portfolio transition from commercial-paper-backed to equipment leases. Hopefully, this shift will lead the way to longer-term solutions to loan portfolio instability and vulnerability.

CIT's bond is issued through the Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF), also known as "Bailout #2." CIT got in on the Facility just before its rapidly approaching final monthly application deadline of March 4.

It's a start, but CIT needs to secure other, low-cost funding that doesn't come from the government. Their bankruptcy had followed on the heels of nine consecutive losing quarters that totaled over $5B.

Whether CIT Group-and other lenders-will be able to remain solvent after TALF's discontinuation remains to be seen. What we know, though, is that small businesses are counting on the success of CIT and similar lenders.

Word on the Street

A recent CIT report-auspiciously titled "Lessons Learned-A Case for Greater Optimism" -surveyed owners and executives of 220 American small businesses (as defined by annual revenues from $1M to $15M) about the close of 2009 and their views of 2010.

Key findings:

  • For 2009, 33% said their revenue "declined," and 26% said it "declined significantly"
  • 64% said it was harder today to manage their company's cash flow than it was 12 months ago
  • 90% agreed that current stimuli does not help them
  • For 2010, a whopping 53% expected their revenues to "grow," and 8% expected their revenues to "grow significantly"
  • 80% said they're now smarter about running their businesses
  • 70% said the recession made them better leaders

Bankers should look at a systems to stress test their loan portfolios in an effort to better manage the risk. There are systems in the market place that will stratify/custom grade loan portfolios, stress test the portfolio along various key data points (not just interest rate stress), provide the probability of loss a portfolio will incur. These systems offer many other items of information that are essential to managing the loan portfolio and its risk, to both the bankers and the regulators.

Topics: Bailout, Bank Risks, Bank Asset, stress tests, loan portfolio, Noncurrent loans, charge-offs

Bank Deals: FDIC-assisted vs. Unassisted Purchase Transactions

Posted by Wendell Brock on Thu, Jun 11, 2009

While the current economic and regulatory environment poses challenges for start-up banks, it also creates some unique opportunities for bank acquisitions.

A few years ago, comparing the potential of bank start-ups to that of bank acquisitions might have quickly led an investor to believe that de novo was the way to go. But as desperation and uncertainty in the industry rise, seller price expectations have fallen. Combine this trend with regulators’ increased scrutiny of new bank applications, and the scales are tipping in favor of buying a bank, rather than starting a new one.

Selective purchase, short timeline

Investing groups have two ways to go in a bank purchase: participate in an FDIC-assisted transaction or buy a bank without the government’s help. In an FDIC-assisted transaction, the buyer can acquire deposits, branches and, maybe most importantly, customer relationships, without getting stuck with bad assets. This is an advantage, but the buyer must also contend with public opinion related to the former bank’s failure. Once the transaction becomes public, those purchased deposits may shrink as customers head elsewhere.

Assisted transactions also present a very short window of opportunity. The FDIC notifies and collects blind bids from suitors within just a few weeks. Further, due diligence and negotiations occur before any public announcement is made.  

Trends in the FDIC’s “Problem List” indicate that the availability of FDIC-assisted transactions will likely increase this year. As of the end of the first quarter, the problem list included 305 banks and thrifts. That’s up from 252 at the end of the year and 171 in September of 2008.

Taking the bad with the good

Many insured institutions will remain off the problem list, but will seek a change in ownership or additional capital anyway. Opportunistic organization groups that are willing to dig in and evaluate asset quality, stability of deposits, and the competitive landscape, among other things, could turn up some workable deals. Unlike the assisted transaction, the unassisted deal rarely presents the chance to buy assets selectively. But, if the publicity is properly managed, buyers can minimize customer defections related to the “failed bank” stigma.

Clearly, due diligence in these transactions must be extensive. In the current environment, pricing cannot be justified by multiples; buyers are tasked with looking beyond book value and earnings to evaluate a bank’s incremental earnings power. This is no small task, given the uncertainty about economic conditions, collateral values and the regulatory environment. Since due diligence may actually lead to more questions than answers, buyers must be highly disciplined in valuating their prospective targets and ready to walk away from deals that don’t make sense.

FactSet Mergerstat LLC has reported that at least 285 U.S. financial institutions were sold last year, which is just 54 percent of the number of transactions reported in 2007.

Topics: Bailout, FDIC, Bank Opportunities, Banking, Bank Risks, Bank Regulators, Bank Regulations

What Must Be Done

Posted by Wendell Brock on Thu, Oct 02, 2008

With the continuing debate over the health of the U.S. financial system, Wall Street and the economy, everyone's talking about whether taxpayers should be responsible for the bailout. But perhaps the conversation would be more productive if we talked about what else we can do to avoid the bailout and shut down the power-grab that's currently playing out. And, yes I say power-grab because anytime the government gets involved , it takes power away from the people. Period. If our lawmakers give Wall Street the $700 billion, they are taking away the public's power to spend money as we wish-because we have to pay higher taxes to cover those bailout costs. The people who receive the $700 billion will have to untie the knots in the strings attached, just to get to the money. That reduces their freedom to make decisions in this new, less-than-free market.

For those reasons, we should be looking at other alternatives. Here are two things that must be done to alleviate the current situation:

1. Change how banks account for the assets on their books

 2. Repeal Sarbanes Oxley (SarBox)

Booked Assets

Several years ago, politicians determined that banks assets should be marked to the market. This means that the value shown on the books has to be the current market value, or the amount the asset can be sold for at that time. This doesn't work, simply because the underlying value of the asset may not change as fast as the market. For example, say a bank spends $10 million to purchase a mortgage-backed security or MBS (a bond), which holds the mortgages of fifty $200,000 loans at 5 percent. The fifty houses tied to those mortgages have value and that value moves up and down over time. But those value changes won't happen as quickly as the interest rate changes on Wall Street. After all, once the mortgages are turned into a bond, they are traded as other bonds; thus, the value is largely based on market interest rates. Of course, an MBS investor has the added concern of relying on fifty homeowners to make their payments, while a corporate or government bondholder only relies on one entity, the issuer, to make those debt payments. But this is part of the added risk MBS represent-that one or more people will miss a payment, or that a property falls into default and is foreclosed.

Because these MBS assets are market-traded, their value is constantly changing. And since the assets must be marked to market, their value on the bank's balance sheet should experience the same constant changes. This works out alright, as long as the movements are small. In the current environment, however, the downward pressure has driven the market value of the MBS so low that no one is buying or selling them. The market has essentially stalled. And that means the value of the MBS is close to nothing! Now, the fifty mortgaged homes underlying the MBS still have value, and perhaps all fifty homeowners are still making their mortgage payments as promised. So is the MBS actually worth nothing? No! But accounting rules require that banks reduce the value of these assets to something close to zero, because that is what the market will pay.

A better option would be to use a three-year rolling average of the value. Doing that would imply a far higher value currently, but it would be a value that is more reflective of the underlying assets (those fifty houses). Even though the homes' values may have fallen 10 or 20 percent, the MBS is still worth something, as long as those homeowners are making their payments. Even in a foreclosure situation, there is still value in the house. The rolling average allows for a smoother change in asset values (up or down) and provides time for banks to work out problem assets.

In an up-market, the rolling average allows for a slower climb up, which limits growth. This would provide a little distance and help keep values in perspective. Under this system, we most likely would not have seen the crazy growth in asset values that we saw in the past several years. Some people figure this could put $500 billion back on the books of banks!

The Repeal of SarBox

Sarbanes Oxley has failed in its purpose. It was passed in reaction to faulty auditing in a few big public companies that failed. This was supposed to help the public see into what is really going on in a company by making the financial statements more transparent. Obviously, this did not work. Fannie Mae and Freddie Mac, AIG and Lehman Brothers were all public companies and they failed, catching many investors off guard.

SarBox has succeeded in making the process of becoming a public company so onerous and expensive that companies are looking to other methods for capital rather than going public. This creates several relevant consequences for consumers and investors:

1. The number of available companies to invest in is reduced.

2. The value of current public companies is inflated.

3. The ability to bring good ideas to the market place is limited.

4. The number of people who want to be involved in public companies is reduced.

The extra regulatory expense of compliance is ranges from $100,000 to $3,000,000 or more annually, per public company. To pay this expense, the companies raise the prices they charge for their goods and services, which places the cost burden on consumers. Higher prices reduce sales and profitability of the companies. It's simple economics.

Monthly, millions of people invest millions of dollars in the equity market through their retirement plans. If there are no new businesses to invest in, the stock prices of the current businesses rise. Retirement savers are bidding prices up so they can own something, anything in the equity market. For example, say the stock market in 2004 consisted of 5,000 companies, and $100 million of new money poured in every year from retirement plans and investors. If 250 new companies were brought to the public market each year, the stock market today would have 6,000 companies absorbing investments of $400 million. In reality, that has not happened. So if the market stays at 5,000 and the same additional $100 million is invested annually, then the stock prices of those 5,000 companies would go up-simply because more money is being poured into the market. Has there been a change in the true value of these companies? No, the price was simply bid up because there was more money to buy. Many companies are not going public because of the SarBox hassle factor so there are fewer IPO's hitting the street.

The expense of SarBox also prohibits companies from coming to the market with their good ideas. Many people and their companies have chosen to find other methods of financing to avoid dealing with the added regulation of SarBox. One executive told me that it was just "too much of an expense and headache," because the company "would have to hire a compliance person at $60,000-$100,000 per year along with the added auditing expense of another $100,000 per year and the additional filing expenses another $20,000 or so." And, in the end, this executive didn't figure the expense was worth the problems. SarBox requires the board and management to take personal liability for all the problems of the company. People don't want to do that! Responsibility is critical in any business venture, but no CEO or board member knows every detail of what is going on in any company. And yet, these executives are personally liable for all activities of the company. Many people do not need the increased liability; this is akin to driving without insurance. This again keeps good companies from coming to the marketplace.

Modifying the mark-to-market requirement and repealing SarBox would bring billions back to the books of banks and strengthen their balance sheets. The result would be fewer bank failures, more companies in the marketplace, more choices for investors and, probably, lower prices. These are not the only solutions, but they are a major step in the right direction.

Topics: Bailout, Commercial Banks, Bank Regulation, Bailout Options

The $700 Billion Bailout Passes the Senate

Posted by Wendell Brock on Wed, Oct 01, 2008

In a major sweeping vote the senate passed the Wall Street Welfare bill this evening providing $700 billion to the street to help solve their problems in three easy steps, first $250 billion up front; another $100 billion upon presidential approval (which will be granted I am sure) and the last $350 pending congressional approval. And, the taxpayers pick up the tab! It is like going to a fancy restaurant with 20 friends and everyone ordering the top end meal; then the hat is passed. But, in the end there isn't enough for the bill and tip, and since you were closest to where the waiter laid the down the bill you get the opportunity to figure out how to pay - while everyone is leaving with their date!

One small bright spot is that the FDIC insurance will be raised temporarily (when does the government do something temporarily?) to $250,000 from the $100,000 current limit. This will give depositors more confidence in the banks. Regional banks worked hard to get the increase in deposit insurance limit. They hope this will give consumers more confidence in the smaller banks. The banks felt that consumers believed that the bigger banks were safer places for their savings - which is untrue.

This will also increase insurance premiums the FDIC can charge the banks; so for the extra $150,000 of deposit insurance the FDIC will charge the banks approximately $105 per account (depending on the bank's premium rate of course).  This will bring in billions of additional insurance premiums into the FDIC insurance fund.

The bill also gave the FDIC the unlimited ability to borrow from the Treasury, which is a major increase from the current limit of $30 billion.  The unlimited borrowing, again, is temporary - it expires in 2009.

Maybe it is time to call your congressman!!

Topics: Bailout, FDIC, Bank Regulators, FDIC Insurance Fund

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BankNotes© is published by De Novo Strategy as a service to clients and other friends. The information contained in this publication should not be construed as legal, accounting, or investment advice. Should further analysis or explanation of the subject matter be required, please contact De Novo Strategy at