Carpe Diem

Chairman and CEO of Clarendon Hills, Illinois-based MAF Bancorp, a $9 billion holding company and one of the Chicago area’s largest independent financial institutions, Allen Koranda has been aggressively expanding his franchise, adding several de novo branches each year. Strong earnings also have made MAF stock an attractive alternative to smaller community banks that have hit a growth wall in the face of an unprecedented invasion from some of the nation’s biggest banking companies. Last year, MAF paid $101 million in stock for Fidelity Bancorp, a $700 million-asset Chicago institution. “They were looking at the competitive landscape and recognized it was going to be hard to get to the next level,” Koranda says of Fidelity’s board. “We have the resources to compete.”

Koranda is comfortable playing the role of aggregator for now and says he’s “running the company with the idea that it will be around for a long time.” Still, he can rest assured that, some day soon, someone will likely make an offer his board can’t refuse for MAF’s 43 branches and $4.3 billion of deposits in the Chicago area, transforming the acquirer into acquiree.

Over the past two years, a virtual Who’s Who of big national playersu00e2u20ac”ranging from Washington Mutual and Bank of America Corp. to Fifth Third Bancorp and locally based Bank One Corp.u00e2u20ac”have announced their intentions to invade or significantly expand their presences in the nation’s third-largest market. While most of those plans now center around de novo branch launches, observers say that some banks eventually will need to acquire the critical mass required to compete. “With the nature of this market, I don’t think you can seriously hope to penetrate it without making a significant acquisition,” says Richard Soukup, a longtime banking consultant with Grant Thornton in Chicago.

That, in turn, has left MAF and a handful of other mid-sized homegrown playersu00e2u20ac”Wintrust Financial Corp., First Midwest Bancorp, Midwest Banc Holdings, and MB Financial Inc., among themu00e2u20ac”positioned to cash in on the big guys’ market share ambitions. Indeed, a recent analysis by investment bank Hovde Financial LLC projects that within five years, all of the market’s mid-sized banks could be part of larger institutions. “Every one of those banks has in the back of their minds a knock-your-socks-off price that will get a deal done,” Soukup says, “and they have franchises that can justify those kinds of multiples.” Koranda won’t say if he’s entertained any bids yet, but notes that his board has a fiduciary responsibility to weigh any reasonable offers. “If a buyer is willing to pay a certain price,” he says, “… I’m sure everyone’s a seller at some point.”

While there are no guarantees, observers anticipate two waves of consolidation in the Windy City. The first appears to be already under way, hitting some of the smaller community banking organizations unable to survive as independents in the face of overwhelming competition from many of the nation’s largest banks. In recent months, the pace of deals has picked up, and sources say the number of merger-related discussions is unprecedented. The second wave, targeting the same mid-sized players that now are considered the acquirers of choice for small banks, could commence sometime later this year, or in 2005, as some of the national giants determine that they must buy to get the market shares they desire.

Many of the consolidation pressures felt in Chicago are being duplicated elsewhere. Big banks, their stocksu00e2u20ac”and abilities to cut favorable dealsu00e2u20ac”rebounding after several years in the doldrums, are hungry for growth. After pledging their allegiance to alternative delivery channels in the late 1990s, they also have reversed course, concluding that branches are, indeed, the best way to land new customers. Washington Mutual is the poster child for this approach. Last year it opened 250 new branches across the country, and it plans to launch a similar number in 2004, including de novo saturation campaigns in Atlanta and Tampa.

Small banks, meanwhile, are being squeezed by low margins. They lack the fee income sources the bigger players have and are having difficulty managing the costs of stiffer regulation and new must-have technologies. To succeed, they need more products and more capital. But in many cases, investors are reluctant to pump additional resources into those institutions, dooming them to stagnation.

“There are a number of small banks out there that simply won’t be able to make the cut,” says Gary Umlauf, CEO of Advantage National Bancorp, a $100 million bank in suburban Elk Grove Village that sold to $4 billion Wintrust in October. “We’re in a commodity market today and margins are really being stressed. But if you can’t raise capital, you can’t grow and become profitable.” Throw in traditional community bank issues, such as aging managements and shareholders looking for liquid exits from their investments, and consolidation is bound to pick up nationally, says Hovde Financial CEO Steve Hovde.

All of this and more is at work in Chicago. The legacy of old Illinois unit-banking lawsu00e2u20ac”banks weren’t allowed to branch there until the 1970su00e2u20ac”has left the city’s $211 billion market the most fragmented of America’s large cities. The banking community here is known for its sense of entrepreneurship, (about 60 banks have been launched in the past decade), while customers are accustomed to dealing with smaller institutions. As of June 30, the Chicago metropolitan area had 243 banks and thrifts and 2,255 branches, according to Charlottesville, Virginia-based SNL Financial.

Hometown giant Bank One Corp. (itself born of a merger with the old First Chicago Corp.) is the single biggest player, but with $42.3 billion in deposits still rates a market share of just 20.01%. La Salle Bank Corp., owned by Dutch ABN Amro, ranks second with 12.13%; Harris Bank, a subsidiary of Canada’s BMO Financial Group, comes in third with 9.35%. Fourteen additional banksu00e2u20ac”ranging from big, out-of-town companies like Citigroup (4.03%) and Charter One Financial Corp. (3.12%) to locally managed Corus Bankshares Inc. (1.07%)u00e2u20ac”control at least 1% of the deposit market. Another 15 banks each boast in-market deposits of at least $1 billion, while more than 200 others have deposits below that levelu00e2u20ac”including nearly 100 with $100 million in assets or less.

For growth-hungry outsiders, that fragmentation, combined with the heft and demographics of the nation’s third-largest market, smells of opportunity. “It’s an attractive market in virtually every respect. There’s high growth on both sides of the balance sheet. It’s very dense geographically, which makes things easier to manage. It’s a good business town. And there’s no clear dominant playeru00e2u20ac”no one bank that’s considered the place to go for either business or retail banking,” says Anat Bird, head of SCB Forums, a bank consulting firm that works with several banks in the area. “Right now, everyone is saying, ‘I want a piece of that action.’”

The result is the type of competitive land grab rarely seen in the banking industry. WaMu has been the catalyst, opening 70 branches in 2003, with plans to add at least 50 more by the end of next year. Fifth Third, which entered the market in 2001 via its acquisition of Old Kent Financial Corp., wants to add 30 branches to the 74 it already has in the area. National City Corp. intends to almost double its presence to about 50 branches, while Bank of Americau00e2u20ac”a commercial, but not a retail player in the marketu00e2u20ac”wants to launch about 100 branches. Even local players Bank One and Harris have signaled their intentions to defend their turf by significantly boosting branch counts. “We intend to win here no matter how bloody it gets,” Bank One CEO Jamie Dimon said recently.

Add up these and other announcements, and the number of branches in metropolitan Chicago is slated to balloon by at least 500 during the next few years, a level Steve Hovde says is unsustainable. “It’s a large and healthy market,” he says. “But there are only so many customers, and the demographics simply can’t support that many new branches.”

In this environment, the only way for the newcomers to find growth is by stealing customers from rivals. That has sparked an intense battle for deposits, which is playing out on a variety of levels. One investment banker tells of a real estate developer who was offered $1.5 million by Bank of America for a prime suburban location valued at about half that much. Fifth Third, this same source says, recently paid $3 million for an old bowling alley and pizza restaurant in Barrington, a wealthy northwest suburb. “Banks are coming in and paying drop-dead prices for parcels of real estate to put up new branches,” says one developer, adding that real estate firms are “having a field day playing banks against each other for good locations.”

Five years ago, “everyone was saying there wouldn’t be a branch left in town because of the Internet,” chuckles Ed Wehmer, CEO of Wintrust, based in suburban Lake Forest. “Now, if you own a corner gas station, you stand to get rich. These big [banks] will pay anything for a good location.”

Marketing efforts and costs also are rising. In recent months, WaMu has been touting its trendy “Occasio” retail branches with edgy billboards prodding Chicagoans to “Reject Fake Free Checking” and offering free pizzas for opening free checking accounts. TCF Financial Corp., the market’s 16th-largest player, has been giving away George Foreman grills for opening a free checking account. Fifth Third is among the banks sending hit teams of bankers to call on small businesses. Bank One, meanwhile, has put its workforce on the offensive with a 29-page, in-house playbook that prods employees to defend the company’s home turf. Workers there have even been sighted on train platforms, offering $50 to people who sign up for new accounts. “We’re spending more on marketing than we ever have,” MAF’s Koranda says. “To the extent that your competitors are being more aggressive, you have to combat that.”

But perhaps the greatest threat to bank bottom linesu00e2u20ac”and, for some, their independenceu00e2u20ac”is pricing. Chicago has long been one of the nation’s most price-competitive markets. While net-interest margins elsewhere can average as high as 5%, here the figure is closer to 3%, Hovde says. Those margins are likely to erode even further as new branches chase deposit customers with sweetheart rates. “If you have 500 new branches, all intent on growthu00e2u20ac”and for them at this stage, growth is all that really mattersu00e2u20ac”they will have to bid up pricing on deposits,” Bird says.

National players can spread the pain of money-losing market share grabs across their diverse franchises and typically have healthy noninterest revenue streams to pick up the slack. WaMu, for instance, was recently paying interest of 1.1% on its top-tier platinum checking account in Chicago; the same product in Seattle paid just 0.2%. It also got 46% of its third-quarter income from noninterest sources. Local mid-tier banks are countering the competition, in part, by expanding themselves. Wintrust has moved aggressively into insurance and asset management; MAF in December closed on a purchase of St. Francis Capital Corp., a $2.3 billion Milwaukee bank. “The geographic diversity helps with funding costs when someone here wants to raise rates to attract deposits,” Koranda explains.

Most community banks, dependent on the local interest rate environment, don’t have that luxury. They claim that the strength of their customer relationships can offset better pricing. But as Koranda notes, most banking products today are commodities, and when the price differentials become too great, all but the most loyal of customers will bolt.

These and other factors have set the table for some tough decisions at community banks around Chicagoland. Over the past three years, more than two-dozen small banks in the area have sold out to acquirers, according to SNL. The most-active buyers have included the mid-sized aggregators, such as MB, MAF, and Wintrust, each of which have completed at least two deals. With the exception of Charter One, which has done two dealsu00e2u20ac”including the largest of the period, its $241 million purchase of $2 billion Alliance Bancorp in 2001u00e2u20ac”none of the buyers has been a big national player.

This modest number of deals camouflages what those familiar with the market say is near-constant consolidation-related banter among banks large and small. “There isn’t one bank out there that hasn’t been approached 10 times to sell,” Soukup says. “They’ve said ‘no’ 10 times, too. And they’ve done it for a reason. When that reason changes, that’s when they’ll sell.”

Now, it’s looking like that time may be close at hand. The first wave of consolidation is expected to hit the more than 100 community banks with deposits of $150 million or less. Those with strong local reputations and good operating and capital positions can survive. The rest could have trouble.

Many of these smaller institutions were started in the 1990s, and grew rapidly before stalling out. “With the rate environment and the competition, they’re making returns of 35 or 40 basis points on assets,” explains Wintrust’s Wehmer, who is regularly approached about potential deals by community bank leaders. “They need to continue building and marketing the bank, but they don’t have the capital. Investors say to them, ‘Make some more money first, then we’ll give you more capital.’ That’s exactly the wrong answer. Without that capital, they can’t maintain their momentum, and ultimately they have little chance of surviving.”

If the large banks’ de novo strategies are successful, then the profitability, and value, of those smaller banking franchises could be eroded significantly, Hovde warns. The silver lining is that, in the shorter term, valuations for some of those institutionsu00e2u20ac”especially those in desirable markets or with good locationsu00e2u20ac”could spike higher. Hovde says he’s already noting a pickup in both activity and pricing, as potential buyers position themselves for the emerging market-share battle.

Bank boards “need to ask themselves some tough questions,” says Joseph Stieven, a senior analyst who follows the market for Stifel, Nicolaus & Co. in St. Louis. Among them: “Can we compete in this environment? Is our franchise value eroding if someone can just come in and steal customers from under our nose with their own brick and mortar?” Adds Umlauf, who just sold his bank: “You’ve got to examine where your growth is going to come from, and whether you can afford it. Capital is critical. If you can’t raise it, you can’t build the business, and you need to consider if you have people who are dynamic enough to fuel that growth.”

For now, the most likely acquirers are local companies looking to fill out their franchises. Wehmer, who describes Wintrust as a “collection of community banks,” each with their own local brands, boards, and managements, says Advantage’s position in a thriving upscale market made it more attractive than most other banks. MAF’s Koranda makes it clear he is willing to buy more. “We’re looking for location: Is it in a community we want to be in? Is it across from a grocery store? And also the nature of the facilities: How big is it? Does it have the drive-ups and parking needed to build the business out?” he says.

Even some of the big players are dipping their beaks in the deal pool. In November, Harris, which aims to boost total branches to 200 from the 155 it has now, agreed to pay $34.6 million for Lakeland Community Bank, a two-branch, $171 million company in Chicago’s booming northwest suburbs. “This acquisition complements our existing expansion plans by giving us the opportunity to extend our presence in a very attractive market,” said Harris CEO Frank Techar. One investment banker reports that contacts at Bank One have discussed possible in-market deals, as well.
It’s uncertain how long this window of potentially attractive pricing will last. The best guess, however, is that it will continue as long as the uncertainty over the outcome of the big guys’ strategies gives smaller institutions some bargaining power. More anticipated is what could happen once results of the initial flurry of big-bank branching begins to crystalize.

For all the talk, pursuing a de novo branching strategy in a market like Chicago’s is easier said than done, especially for the outsiders. Costs, for example, could be heightened by local government resistance to so many new bank buildings sitting on prime real estate. Cities want high-traffic areas to be used for retail operations, because such usage generates more tax revenue, Hovde says. Already, some bank efforts are getting bogged down in bureaucracy. “Some of these towns are going to make it very difficult for banks to put these branches up very quickly,” he explains.

And then there are subtleties. Chicago banking, Soukup says, remains a parochial game, where neighborhood relationships still matter. Customers here “like to walk down to their local branch and talk about CD rates” with a banker they know. Big national outsiders could receive a warm welcome, but Soukup doubts it. Anecdotal accounts about national banks’ small-business cold calls meeting with cold shoulders ring true to many here. “There’s a fallacy in their strategies,” Soukup says. “With the nature of this market, I don’t think you can penetrate it without making any acquisitions.”

With the potential pie too small for all to have as big a piece as they’d like, most agree that eventually some of these national players will face a choice: make an embarrassing and costly exit from the market, or do a deal with one of the mid-tier banks to obtain the critical mass necessary to compete. “There’s no way all the banks can be as successful as they hope [with their expansion plans]. But with the commitments they’ve made, it would be very difficult to reverse course,” says Fred Cummings, an analyst with McDonald Investments. If that’s the case, he adds, “the only choice they’ll have is to buy.”

Already, some initial inquiries have been made on this front, investment bankers say. And the potential buyers include not only those now launching de novo branches, but also the likes of Wells Fargo & Co., which has indicated its desire to enter the market via acquisition. “Any bank that wants to be a national player has to have a presence here,” says one investment banker.

Such a deal wouldn’t be unprecedented nationally. In recent months, mid-sized institutions have been snatched up in markets such as St. Louis (National City’s $475 million acquisition of $2.5 billion Allegiant Bancorp Inc.), and Tampa-St. Petersburg (BB&T Corp.’s $436 million deal for $2.8 billion Republic Bancshares, Inc.)u00e2u20ac”but it likely would be considerably more expensive. While the Allegiant deal was valued at about 2.4 times book value, and Republic went for just over two times book, many of Chicago’s mid-sized players are already trading at higher multiples. At $46 per-share in early December, for example, Wintrust was priced at 3.2 times book, with a PE of 24. “If you’ve got any reasonable presence in the Chicago area, you’re going to get a pretty high [acquisition] premium,” Cummings says.

Soukup predicts that eventually one of the national players will pay up for a mid-sized player. The price could soar above four times book, analysts say, but someone will be willing to pay it. “The bigger their franchises, the more valuable they’ll be to a big company looking for marketshare,” Hovde says. Once the pricing is set for that type of franchise, Soukup adds, others could fall in short order. “It would set the bar for other banks that want to be well positioned in the marketplace.”

Wehmer and Koranda both agree with that scenario, saying it’s inevitable that, eventually, one of their mid-sized brethren will be bought out. While neither sounds outwardly eager to see his institution sold, both are aware that, at a certain point, it will be their board members and shareholders who must make the decision. “It’s not my company. I’m just a steward here,” Wehmer says. According to the company’s most-recent proxy filing, 12 of Wintrust’s 14 directors are outsiders. “So if anyone comes along and makes an overture that’s best for our shareholders, we’ll play it exactly right.”

Unlike some of its smaller counterparts, Wintrust’s board will at least have a choice.