The Economy's Shifting Sands
John R. Engen

Banks will need to watch their footing and aim for solid ground as they march forward in a landscape that features eroding real estate and asset-quality values at every turn.

The board of Umpqua Holdings Corp. in Portland, Oregon, schedules its annual retreat nearly a year in advance. Directors and members of the executive team spend months carefully choreographing a program of presenters and reviews aimed at making board members full partners with management as they contemplate together the long-term strategy challenges facing the company.

It’s a big effort. But when pretty much the entire agenda was scrapped just weeks before last October’s gathering, there was little, if any, dissent from directors. The reason was simple: Just as the date approached, the impact of the subprime mortgage crisis and related housing-price implosion was becoming clear. While $8.2 billion Umpqua didn’t have much to do with creating those troubles, it sure was beginning to feel their effects in terms of asset quality and funding. The threat of an economic downturn and eroding credit quality in other lending areas, such as commercial real estate, meant things could get worse. “The wheels were starting to come off a little,” recalls David Frohnmayer, president of the University of Oregon, and an Umpqua director since 1996.

The board needed time to discuss and consider the implications and to plot a response. By fate, the retreat’s timing made it the perfect vehicle for those deliberations. “We junked the entire program and rearranged the discussion topics on the spot to make everything relevant to the situation at hand, and the decisions we wanted management to make,” Frohnmayer, 67, says. “The focus of the entire retreat shifted clearly to how we were going to work through this.”

A month later, Umpqua’s board held a rare special meeting to grapple with many of those same issues. About the same time, the audit committee began holding more telephonic meetings to monitor the ever-shifting economic sands, while weekly loan approval meetings took on a greater sense of urgency. By January, the board was ready to sign off on a $17.8 million loan loss provision, recorded in the fourth quarter, which slashed per-share earnings to 16 cents for the quarter, versus 42 cents a year earlier—a signal to shareholders that the company was serious about taking on the issues confronting it.

“We decided not to dribble out bad news a little at a time,” Frohnmayer explains. “We said, ‘let’s prepare for the worst case, and not get stuck in a state of denial thinking we can somehow escape a tidal wave that’s affecting the entire industry.’”

Combined, Frohnmayer judges, the enhanced vigilance has “demonstrated a high degree of suppleness and flexibility” on the part of directors. While board members have asked plenty of probing questions, the overall tone has been one of support for long-time CEO Ray Davis and his executive team as they battened down the hatches and communicated with shareholders. “It’s about guidance and providing management with a reality check,” he says. “The economic situation right now is permanent whitewater. The board can provide some perspective, and a second set of eyes on important decisions.”

Umpqua’s board is far from alone in piling on extra hours, resources, and brainpower in responding to turmoil in the financial markets. The housing-price bubble, liquidity crisis, and accompanying mortgage meltdown have hit many banks’ operations and income statements hard. In the fourth quarter of 2007, the industry’s net income was $5.8 billion—its lowest since 1991, and down 83% from the $35.7 billion earned in same period a year earlier, according to the Federal Deposit Insurance Corp.

Larger banks were most affected—25% of banks with more than $10 billion in assets reported losses. But more than half of all banks and thrifts saw an earnings decline compared to the year-earlier quarter, while the average return on assets for the industry was a meek 0.18% , versus 1.20% a year before. The biggest culprits: Net charge-offs, which almost doubled in the quarter to $16.2 billion, and loan loss provisions that ballooned to $31.3 billion, the largest gain in 20 years.

Share prices have been pummeled in the process. For the year that ended on February 29, the Keefe Bruyette & Woods Bank Stock Index fell more than 23%, with some high-profile companies that boasted large mortgage exposures, such as Citigroup, Washington Mutual, and E-Trade Financial Corp., falling by more than half.

With an additional 1.7 million adjustable-rate mortgages slated to reset to higher rates in the next two years, most experts agree we’re not out of the housing woods yet. In 2008 alone, some $355 billion in ARMs will reset, $260 billion-worth of them held by subprime borrowers least able to afford higher payments, according to a study by Deutsche Bank Securities. Another $30 billion lie in the low-documentation alt-A category.

How bad could things get? Nouriel Roubini, a respected economics professor at New York University’s Stern School of Business, predicts that home prices could decline nationally by as much as 10% in 2008, and by nearly 30% in total before the housing slump is done. That would leave as many as 15 million homeowners with “negative equity,” their houses worth less than the amount of their mortgages, who would have a great incentive to simply walk away.

Forget the simple notion that consumer spending will slow because people can no longer use their homes’ equity as piggy banks. That’s kid’s stuff. Under Roubini’s scenario, total mortgage defaults could approach $1 trillion.

Already, the effects are spilling over into the broader economy, and other asset classes—commercial real estate, auto and credit cards among them—are showing signs that they could follow the path of mortgages. “Every day we obsess about how bad it could get,” Richard Fairbank, CEO of credit-card giant Capital One Financial Corp., told investors in a January conference call of the potential for losses. Nearly $2 billion had been set aside to cover bad loans, Fairbank added, but that might not be enough. “The real answer is, nobody knows.”

Want to get really scared? Roubini predicts that before it’s over, a large regional or national bank might fail, followed by a wave of corporate defaults, hedge fund failures, and other calamities—what he calls “a vicious circle of losses, capital reduction, credit contraction, forced liquidation, and fire sales of assets at below fundamental prices.” Total length of a severe recession: Six months, minimum, and maybe much longer. There is, he asserts, “a rising probability of a catastrophic financial and economic outcome.”

This might sound alarmist, but the FDIC is girding for the worst. In February, it brought some 25 former employees—many veterans of the savings-and-loan crisis—out of retirement to help out with what’s expected to be a crush of bank failures. One industry observer, who asks not to be identified, predicts that “well over 100” banks and thrifts will go belly-up by the end of 2009, with particularly high concentrations in Rust Belt states, such as Michigan and Ohio, and those with once-high-flying real estate markets, including Florida and Nevada.

It’s been nearly two decades since the industry has faced turmoil this widespread and pervasive. For bank directors, the majority of whom have taken on their roles in an era where growth was subtly valued over risk-management, today’s tough operating conditions and gloomy outlook are both uncomfortable and frustrating; the rising sense of risk, palpable.

Some feel embittered, perhaps rightly so. Brad Rock, chairman and CEO of $1.1 billion Smithtown Bancorp in Smithtown, New York, and present chairman of the American Bankers Association, notes that the bulk of community banks—including his own—didn’t participate in the subprime fiasco. “We’ve never done a single subprime mortgage. We’ve never done an alt-A loan or a 2/28 loan with a teaser rate,” Rock says.

Nevertheless, plenty of banks are getting caught up in the fallout, and must prepare for and respond to the likelihood that the credit contagion could spread to other lending areas. “Some of the smaller banks that didn’t cause these problems are feeling hurt, there’s no doubt about it,” Rock says. “But a little bit of mud is getting on everyone, whether they’re responsible for causing the problem or not.”

This could—and probably will—turn ugly for some directors. Ralph Sharp, head of the financial services risk management and compliance group at Venable LLC, a Washington, D.C. law firm, predicts that regulators will be wielding civil money penalties and other enforcement actions more liberally against individual directors and boards whose failures to follow through leave banks vulnerable to calamity.

If a bank suffers big losses—or worse—regulators will likely examine such factors as attendance and the minutes of full board and committee meetings, looking for evidence that directors asked appropriate questions, understood the risks and were willing to challenge management decisions. “Directors have to keep in mind that, at the end of the day, they could be on the hook with the regulators if things go wrong at their institutions,” Sharp says.

Look for more lawsuits, too. In January, directors and officers of National City Corp. were slapped with a class-action suit, alleging that the big Cleveland-based banking company issued “materially false and misleading statements” in early 2007 about the risks of subprime holdings in its portfolio. Big earnings declines in the third and fourth quarters of the year were followed by a cut in the quarterly dividend, to 21 cents from 41 cents, and a 60 percent drop in share prices from early-2007 highs.

Board members at several other banking companies, including Washington Mutual, E-Trade, Huntington Bancshares, and BankAtlantic Bancorp, also have been hit with suits related to the mortgage mess. And that could be just the beginning. “We’re going to see more class-action securities suits, more suits from borrowers who can’t pay their loans back,” says Ron Glancz, head of Venable’s financial services group. “In terms of litigation, it’s going to be a lot like the S&L crisis.”

Expect additional pressure during this year’s proxy season, as well. Unhappy with big drops in earnings and share prices, some investor groups are specifically targeting board risk-management committees at Citigroup and Wachovia, among others, demanding they justify their institutions’ large exposures to subprime mortgages. Wachovia’s per-share earnings plummeted to 3 cents during the same period, versus $1.20 a year earlier.

Wachovia’s board “signed off on management’s decision to substantially increase exposure to mortgage risk in 2006” through its acquisition of Golden West Financial Corp., a big California thrift, says William Patterson, executive director of CtW Investment Group. “This proxy season, shareholders will demand accountability, starting with the individual directors most responsible.”

While Umpqua’s board hasn’t been sued, KBW analyst Matthew Clark says institutional investors that own more than half of its shares are getting restless. Directors say they’re satisfied that the company is moving in the right direction, but clearly they are feeling the heat. “We’re all aware of a heightened share of responsibility and risk,” Frohnmayer explains. “More of our waking hours—whether we’re conversing with each other or not—we’re thinking about these issues, trying to ensure that the bank is on top of things.”

So what’s a smart board to do to help its institution navigate this kind of terrain? And what should individual directors do to protect themselves from vulnerability? The specifics of an individual board’s posture depend largely on the institution and the things that make it unique—its business lines and geography, its past risk-management practices, the CEO’s demeanor and directors’ tolerance for risk going forward. No matter the circumstances, however, it’s clear that greater director care, diligence, and time is mandated.

Most board members already are devoting more time to oversight, in the form of both extra and longer meetings, and many are getting more hands-on with operations and strategy. They are sharing their own individual skill sets, experiences, and connections, offering insights on local economies and individual clients with a bit sharper edge than in good times.

Frohnmayer, for instance, regularly taps the forecasting prowess of economists at his school, bringing those analyses to the board, and takes comfort from fellow board members’ backgrounds in key industries like timber and communications.

Board members also are reviewing with closer scrutiny everything from the quality of individual loans and the cash flows of those borrowers to broader risk-management practices. The nine directors of Grand Bank & Trust of Florida, a $490 million real estate lender in hard-hit West Palm Beach, Florida, are feeling the pressure.

Russell Greene, Grand’s CEO and a director, says the climate in his market “is all gloom and doom.” Two years ago, the loan committee used to meet every week to approve new loans. Now, the pipeline is dry, and directors on the committee spend their time reviewing loans and borrowers, reappraising properties and the like, looking for trouble. Some directors have gone so far as to offer individual advice to troubled borrowers. “When I organized the bank nine years ago, I told them to expect to spend one hour a month being a director,” he says. Today, most average 12 to 15 hours. “I lied,” he says. “It’s become a part-time job.”

Managing shareholder expectations, directors say, is difficult. In many cases, there’s not much to be done beyond focusing on the business. “We’re performing well, but as a public company, we’re caught in the market’s view of small-cap banks,” says David Bochnowski, 62, chairman and CEO of Northwest Indiana Bancorp in Munster, Indiana. Northwest’s share price was recently riding about 20% off of its 52-week high.

Ken Daly, CEO of the National Association of Corporate Directors, says some boards are responding to investor concerns by reworking employment contracts with CEOs to add claw-back provisions that allow the company to recoup bonuses and other pay earned by strategies that look good in the short-term, but turn out to be longer-term busts. “When things collapse a couple of years down the road, the loss usually falls on shareholders,” he explains. “You want a mechanism so that when people do incredibly risky things that blow up, and get rewarded for it, you can get some of that money back.”

To be sure, the pain isn’t uniform. Some are capitalizing strategically on the turmoil, seizing upon recent Federal Reserve rate cuts—and the relative lack of competition from mortgage brokers—to bulk up on high-quality housing loans. “We’re having our best year ever, and it’s almost directly because of the mortgage problems,” says William Donius, CEO and a director of $1.2 billion Pulaski Financial Corp., a big thrift in St. Louis. Pulaski boosted its capital levels by $500 million in 2006, and originated $1.6 billion in mostly high-quality housing loans last year.

“I don’t want to sound cocky, but our business model is doing very well in this environment,” Donius says. “Having less competition has helped us gain market share, and it’s given us some pricing power, which is helping margins.”

For others, the present situation carries a whiff of opportunity. United Western Bancorp in Denver reduced its exposure to the mortgage business a couple of years back, which has left it in relatively good shape—at least for the time being—and poised to jump on a growth opportunity if the right one presents itself. “Yes, we’re hunkering down a bit with respect to underwriting standards and credit quality,” says Robert Slezak, a former chief financial officer for online brokerage Ameritrade Holdings Corp., and now chairman of $2.1 billion United Western’s audit committee.

But, “suddenly, we’re faced with the prospect that some of our competitors’ stocks have been hit hard and they’re weakened,” Slezak adds. “That could present us with an opportunity to expand through acquisitions or to move aggressively on their market.”

There are other pockets of relative prosperity around the country. And it’s almost always true that one company’s calamity is another’s opportunity. Even so, be careful not to be duped.

Smart directors realize that the world and its financial systems are simply too interconnected today for problems in one geographic or business-line area not to somehow spill over into other sectors. Liquidity markets are global, asset-quality is slipping across the board and capital has become pricier and harder to come by—even if your bank has done nothing at all to lay the groundwork for today’s troubles.

Frohnmayer says some competitors in Umpqua’s markets are “in a state of denial,” about just how rough things could get. And judging by the feedback from consultants and analysts, the same dynamics appear to be at play elsewhere, too. With mounting signs of deeper economic trouble—the dollar’s weakness, rising energy prices, the mounting costs of the Iraq war, the trade and federal budget deficits, not to mention all of the lending troubles—this is no time to be complacent or lazy.

Board members aren’t expected to run the business—that’s something best left to management. As fiduciaries in a regulated industry, however, they are expected to provide crisp day-to-day oversight, and ask the really tough questions. Banking’s role in the economy is simply too central to expect anything else. With credit problems plaguing the marketplace, those queries need to be more hawkish, especially when it comes to such sensitive issues as liquidity, securities portfolios, and asset quality.

Aggressively challenging management’s strategy and assumptions is an uncomfortable notion for some directors, especially at the community-bank level. Many, especially those at smaller institutions, are what Eugene Ludwig, a former comptroller of the currency and now CEO of Promontory Financial Group, a Washington, D.C. consulting firm, calls “community worthies”—civic leaders with good intentions who often lack strong financial backgrounds and took their board seats to gain business contacts and prestige, or out of a sense of local obligation. Many were invited to join the board by the CEO.

“These are very polite people who aren’t accustomed to pressing for answers, and they get embarrassed asking questions that they think might sound naïve,” Ludwig explains. Yet in the present environment, “you can’t be embarrassed. If you don’t understand something, it probably means there are other people at the table who don’t, either.

“If management can’t explain something to you in plain English, it usually means they don’t understand it themselves, or are dissembling,” he adds. “As a board member, you really have an obligation to get answers that leave you satisfied.”

Trust your instincts. Outside directors might feel more at home in a manufacturing plant or retail store, but most have enough business experience to sense when something merits closer examination. Supplement that with plenty of reading—of newspapers, financial publications, and board materials—and come prepared to ask enough questions to satisfy yourself that the institution is on the right path. “You need to make sure you’re educated and understand the exposures and the risks, and how the bank is protecting itself,” Sharp says.

The specific lines of questioning will vary by institution, but some broad basics should be addressed: Does the institution have a plan to address further liquidity squeezes? Are capital levels and the overall balance sheet strong enough to withstand a prolonged downturn, or is proactive action required? Is the bank positioned to withstand fluctuating interest rates? What would happen if a couple of large loans went bad?

“You ought to be asking, ‘Is our allowance adequate? Is our capital adequate? Is our funding adequate?’” Glancz says. And if you’re not getting good information from management, “then you ought to look externally—to auditors or lawyers—to get the answers.”

One area drawing a lot of attention is commercial real estate. In a January speech to the Florida Bankers Association, Comptroller of the Currency John Dugan noted that more than one-third of all community banks have CRE exposures of more than 300% of capital. The OCC has been sounding alarm bells for nearly four years about the high concentrations, yet many bank managements and boards have dismissed those warnings. Now, 3.34% of all construction and development loans in Florida are classified as nonperforming, and the figure is expected to rise. The national average is about 2% . “We see clear signs of CRE credit quality declining,” Dugan said, which could mandate added regulatory action.

For boards, Glancz says, this amounts to a call to action, in the form of obtaining new appraisals, bumping up loan-loss provisions and closely monitoring capital levels. “It’s a shot across the bow. The Comptroller is saying that if you don’t do something about this, we will,” he explains. “Directors need to make sure their internal controls and audit functions are up to the task, and that they’re getting good information from management, or they could find themselves in trouble.”

A handful of other hot-button areas also are drawing a lot of attention, including capital management and the uncomfortable options available for raising more capital to strengthen balance sheets. Citigroup, for instance, has caught some bad public relations for taking capital from government-run sovereign investment funds in the Middle East and Singapore, with some critics charging that there’s a political motive behind those infusions.

For smaller banks, the pricing of trust-preferred offerings has risen sharply in the past year. “I price it constantly, and the rates have nearly tripled,” says J. French Hill, chairman and CEO of $220 million Delta Trust & Banking Corp. in Little Rock, Arkansas. “Investors aren’t stupid. If you need capital right now, the thinking is that you’re in trouble.” For some banks, that leaves shrinking the balance sheet as the only real capital-management tool available—and not an attractive one, at that.

Securities portfolios are another big topic of interest. Most banks own bonds backed by mortgages or municipalities and had good reason to believe they were sound investments: Not only were they given high marks by ratings agencies, such as Standard & Poors or Moody’s, they also were insured. Now, many of those ratings have proven to be flawed, and some big insurers, such as Ambac Financial Group, are teetering.

“Across the gamut, we’re looking harder at investment securities,” says Delta’s Hill. “The board is asking management to be cautious about the ratings and structures of what we’re putting into that portfolio—especially with regard to fixed-income securities that have ratings enhanced by bond insurance. … Directors are definitely staying abreast of the news and how it impacts their own fiduciary obligations.”

For directors whose institutions are faced with trouble now, experts say figuring out what went wrong is a necessary prelude to cleaning up the mess and preparing for an uncertain future. Was the bank’s strategy flawed? Was there a breakdown in governance or oversight? If so, what—or who—was responsible?

As delinquencies have risen, Grand Bank’s Greene says his board has placed a special emphasis on not trying to assign blame. “We’ve said, ‘no finger-pointing,’” he explains. “There’s no, ‘Who brought this loan in?’ We’re all in this together. … Nobody wants to get blamed.”

In some extreme cases, boards have acted swiftly—under intense shareholder pressure—to change the bank’s leadership. Citigroup (Charles Prince III) and E-Trade (Mitchell Caplan) are among the companies that have ousted their chief executives after reporting big losses. Smaller banks are feeling the pain, too. At $2.5 billion Vineyard National Bancorp in Corona, California, CEO Norman Morales resigned in late January. While no reason was given for the move, it came just six days before the company reported a whopping $4.11 per-share loss in 2007.

Ellen Hexter, director of the Conference Board’s Integrated Risk Management Center of Excellence, says, generally speaking, the subprime woes are the result of governance breakdowns at the bank board level—failures to keep tabs on key functions like strategy and risk. “Banks are in the business of buying and selling risk, and they ought to be good at pricing it,” she explains. Yet during the housing boom, many boards lost their discipline, authorizing management to chase yields in a hot market that simply wasn’t sustainable, and thus, got burned.

The NACD’s Daly, a former financial institutions auditor with accounting giant KPMG, says many of the boards he’s seen were spoon-fed information by management, but “didn’t really understand the strategies being undertaken by their institutions well enough to provide proper oversight.”

Looking to the future, board members need to learn from those mistakes to “ensure that connections are drawn across different kinds of risk in the company—market risk from your trading desk, your asset-liability mix, etc.,” Hexter says. “You need to look at the full array of risks strategically, and get more involved in monitoring the various kinds of risk a bank faces.”

Scenario planning can be extremely useful—both as a tool for peering into the future and as a foundation for deeper questioning and discussion of key issues and challenges. A good scenario analysis can help directors to understand the challenges the bank faces and provide some comfort that management’s assumptions about, say, the economy’s direction or asset-quality trends, match up with their own.

Ludwig tells of a recent meeting with the board of one large bank, which went through a variety of management-led bad- or worst-case scenarios to examine how they would impact the business. “They were stress-testing for different circumstances,” he recalls. “What if housing prices drop another 10%? What happens if we have increases in our commercial loan book? What happens if credit-card delinquencies increase?

“It was a very impressive and helpful exercise,” Ludwig adds, and one that left board members feeling that they had a better grasp of where the bank stood and how it would respond to shifting economic conditions.

Hexter says one of the biggest dangers presented by the current environment is overreaction. Many boards have been reining in management on expenses and risk-taking, which is fine, but not so much that long-term growth opportunities are lost. “You want the pendulum to swing back, but not too far,” she says. “As a board member, you want to be strategic and forward-looking. You need to react to the situation, but the worst thing you can do is lose sight of the future.”

Daly says directors need to be more assertive and demand greater and more detailed discussion of strategy, so they understand what the institution is doing. “The real question is, what kind of information are the directors getting, and from whom, to help them understand the risks they’re taking?” he says.

“Look at your meeting agendas,” Daly suggests. “If all of your agenda time is taken up by Powerpoint presentations and talking heads, then the likelihood of you having the necessary in-depth discussions about the risks of your strategy is minimal.”

And if you ask all the right questions and don’t feel comfortable with the answers you’re hearing? Speak up, Glancz says. “If you don’t agree [with a decision endorsed by the majority of the board], it’s important to bite the bullet and say, ‘I want to go on the record as opposing the action the bank is taking.’” It might not make you the most popular director at the table, but getting such a statement in the minutes could help stave off liability if the decision turns out to be a bust.

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