Carl Chaney cut his teeth as a bank mergers-and-acquisition attorney in the 1980s, helping clients buy failed banks in Louisiana, Texas, and Oklahoma during the oil bust. Later, he advised banks as they acquired seized institutions from government regulators during the early-90s thrift crisis. It’s grim work, he says, but also a necessary part of the clean-up process in an industry that seems prone to post-boom busts. And it can turn out to be extremely profitable for the buyers.
As the CEO of $6.8 billion Hancock Holdings Corp., Chaney is hoping to leverage that experience in the year ahead. Hancock is the rare regional banking company that has remained profitable throughout the real estate bust, credit crisis, and ensuing recession. In the third quarter, the Gulfport, Mississippi-based company’s nonperformers accounted for just 1.06% of assets and it earned $15.2 million-about the same as a year earlier.
In October, Hancock leveraged that relative strength to raise $175.5 million in a heavily oversubscribed common equity offering. Chaney has earmarked much of that war chest to cash in on what’s expected to be a flood of failed-bank sales by the Federal Deposit Insurance Corp., and spent part of 2009 educating his board on the kinds of opportunities he expects to see in Florida, southern Louisiana, and Hancock’s other southeastern U.S. markets.
In December, Hancock’s board made its first strike, agreeing to acquire failed Peoples First Community Bank in Panama City, Florida, from the FDIC. The deal, which gives Hancock 29 Florida branches, $1.6 billion in assets, and $1.7 billion in deposits, includes a loss-share agreement with the agency. Company officials say it will be “immediately accretive” to earnings.
“You might see a handful of live-bank deals, but 2010 is already in the books as a year that will be heavily, heavily dominated by failed-bank transactions,” Chaney says. “We want a seat at that table. We think we can grow our balance sheet by $3 billion through FDIC deals and still maintain a high tangible equity ratio.”
Welcome to the world of bank M&A, circa 2010-one that, like 2009 before it, will be starkly colored by concerns over asset quality, capital, and survival. By December 7, just 139 traditional whole bank and thrift deals were announced in 2009, involving $88 billion in assets and a total value of $2.4 billion, according to SNL Financial in Charlottesville, Virginia.
Compare that to the halcyon days of bank M&A-say 2004, when deal values hit $131.5 billion-and you get a sense for just how rough things are out there. Even 2008, considered lethargic with 179 deals valued at $38.5 billion, looks rip-roaring in retrospect.
Could things get any worse this year? Oh, yeah-at least when it comes to live-bank transactions. Most bankers and advisors agree it will be at least 2011, and perhaps longer, before we return to an M&A market that looks familiar. Somewhere down the road there could even be a surge of consolidation, with a rebound in valuations. “We could see a lot more traditional deals after the new normal [arrives], as boards ask themselves, ‘Do we like what we are?’” says Richard Davis, chairman and CEO of $265 billion U.S. Bancorp in Minneapolis. “But that new normal is still a ways off, because of credit quality.”
That doesn’t mean there isn’t plenty of strategic thinking and tire kicking going on in bank boardrooms. Nor does it mean that a lot of banks-predominantly smaller ones-won’t change hands. Indeed, most agree that 2010 could be a very active year for FDIC-assisted deals, as regulators accelerate their efforts to clear away banks that don’t have much hope of surviving.
“The name of the game right now is recapitalizing the banking system, and the subplot is consolidating it. You’re seeing the capital markets funneling money to the banks that, in partnership with the FDIC, will consolidate all these zombie banks back into the system,” says Andrew Senchak, vice chairman of investment bank Keefe Bruyette & Woods in New York. “It’s all about finding the capital and platforms to absorb this mass of zombies.”
The backdrop for all this is a banking industry that is headed into its fourth year of serious trouble and is still on life support. The problems began with residential real estate and are still rooted there. According to the Mortgage Bankers Association of America, in the third quarter, 14.11% of all mortgages in the country were either delinquent or somewhere in the foreclosure process.
The follow-on recession, with its double-digit unemployment rates, has spread the credit troubles to basic retail and commercial loans, as well. Net chargeoffs on commercial loans, for instance, jumped 117% in the third quarter versus a year earlier, according to the FDIC. Perhaps most daunting, the industry faces the potential of a replay of the housing woes on the commercial real estate side-a particularly big area of exposure for community and regional banks. In Florida alone, banks boast CRE exposures equal to more than 400% of risk-based capital, according to SNL Financial.
“The quandary we’re in today is rooted in a real estate decline that brought on a recession. We had a credit collapse first, and a recession second. That’s different from anything we’ve seen in my lifetime. Usually, a recession brings on credit issues,” explains John Kanas, who led a group of private equity investors in a 2009 takeover of the failed BankUnited, a $12.8 billion institution in Miami, and is now its CEO. “There are people who think the end of this is predictable, and we’re in just another cycle, but I’m not convinced.”
The basic math of the crisis is simple: relatively good asset quality, rooted in past conservative underwriting practices, begets profitability-or at least lower losses. That curries favor with the regulators and investors, and makes it easier to raise capital. A bank with enough capital can weather what’s left of the storm and position itself to take advantage of other institutions’ woes, and become stronger heading out of the recession.
Among the early winners: U.S. Bancorp, PNC Financial Services Group, BB&T Corp., IberiaBank Corp., and First Niagara Financial Group, all of which have been able to attract the capital needed to purchase failed or distressed banks at terms that seem to carry unusually low risk for the potential rewards they offer.
On the other end of the spectrum are those with enough bad credits on their books to strip them of their capital, the so-called zombies. The worst of them tend to be younger institutions, created to take advantage of building booms that have since gone bust and funded mostly with brokered deposits-think a small or mid-sized construction lender in California or Florida-but older, more-established institutions are candidates, too. Liquidity is often a major concern: Headlines describing bad loans, capital woes, and regulatory actions tend to scare off depositors.
Through early-December, the crisis had claimed 130 banks; hundreds more remain on life support. The FDIC listed 552 banks on its so-called “problem list” at the end of the third quarter, but the troubles extend deeper than that. Some pundits, including New York-based Sandler O’Neill & Partners’ senior managing principal
Jimmy Dunne, have predicted that as many as 1,000 banks will fail before the crisis ends.
In the middle lie hundreds of other banks with asset issues bad enough to crimp their operations but not quite enough to kill them. The boards of those institutions are in a sort of purgatory-drained and tired after years of struggling with loan problems, capital needs, and shareholder displeasure, and perhaps in need of new management.
While they might love to dump the whole mess on someone else, they face a conundrum. The prevalence of FDIC-assisted deals, with their loss-sharing agreements and other sweetheart terms, has effectively set a ceiling on M&A pricing that’s below what they’re comfortable presenting to shareholders. According to SNL, the median price-to-book ratio of announced deals in 2009 was just 108%.
“If you’re marketing a bank now, you’re competing against the FDIC,” says Bill Hickey, another Sandler principal. “Your bank might be in a little better condition than those FDIC properties, but the assisted deals have set the pricing expectations.”
Would-be buyers, meanwhile, are having a tough enough time getting a handle on their own asset-quality issues. They’re hesitant to strike deals: Why stretch precious capital by taking on the unknowns of someone else’s balance sheet, especially when their willingness to sell could indicate bigger problems to come?
“Most banks that are in position to do a transaction are there because the board is pretty conservative,” says Mark Kanaly, a partner with Alston & Bird, an Atlanta law firm. “It takes a lot of convincing to get them to warm to the idea of an acquisition.”
To be sure, traditional deals are getting done. The buyers just need to be aggressive about raising capital and a little creative to mitigate their risks. At First Niagara in Buffalo, New York, CEO John Koelmel and his board have capitalized on the industry’s turmoil with two transformational deals in the past year-neither of them FDIC-assisted.
In part, that’s because First Niagara’s northeast markets aren’t expected to see as many banks go bust. It’s also because its board sees an advantage in proactively pursuing carefully crafted deals with going-but struggling-concerns, as opposed to “jumping into the fray of an auction and the assisted-deal structure,” with the compressed timelines that go with the territory, Koelmel says.
Last April, First Niagara paid $54 million to acquire 57 former National City Corp. branches in Pittsburgh after the latter’s forced sale to PNC. PNC is already the dominant bank in the Steel City, and was forced by regulators to divest the branches. Few suitors stepped forward, and First Niagara was able to land the franchise-and a No. 3 market share in Pittsburgh-for a deposit premium of just 1.3%.
Significantly, the PNC branch deal was negotiated with an option for First Niagara to tap $150 million in debt capital from the much-larger PNC. Koelmel raised $1 billion in three 2009 capital offerings. Even so, when the branch deal closed in March, “we didn’t know what the market would look like later,” he explains, “and we wanted to be in a position to stay at the table.”
Having access to that capital gave First Niagara’s board the flexibility to pursue an aggressive whole-bank deal for $5.6 billion Harleysville National Corp., a Philadelphia company with more than $100 million in nonperforming loans that was under regulatory pressure to raise capital.
Harleysville CEO Paul Geraghty was courting rescue capital from private equity firms in July when Koelmel offered to pay $237 million, or about $5.50 per share (Harleysville shares sold for $20 in 2008.) “He said, ‘I know you are exploring private equity, but that could be dilutive. Why not consider a strategic deal?’” Geraghty recounted to a Philadelphia newspaper.
First Niagara’s capital creativity didn’t end with PNC’s senior notes. Harleysville’s credit problems require an additional $150 million in recapitalization charges, bringing First Niagara’s total investment to just under $400 million. With no FDIC loss-sharing agreement to fall back on, Koelmel’s team built its own downside protection into the deal. “If their credit deteriorates and we have to pony up $200 million in extra capital, instead of $150 million, the extra $50 million will come out of the pockets of Harleysville shareholders,” Koelmel explains. “We fixed our [total] cost at about $400 million.”
Koelmel says he’s looking to serve as a white knight for other struggling banks, rather than wait for them to fail. “We don’t want to just ride this out and clean up the pieces that are lying on the floor,” he explains. “We’re happy to catch a falling knife, as long as we can do it with discipline and diligence.”
For most would-be buyers, however, lingering in the emergency room lobby, waiting for the next FDIC-assisted deal, is the more attractive option. “To be frank, right now a bet on a non-FDIC-assisted deal is a bet on real estate valuations. We’re not ready to make that bet yet,” says Kanas, who says he will eventually pursue traditional deals, just not now. “If there’s a perception that the government will need to cough up more guarantees to move failed institutions, it’s a big impediment to free-market transactions.”
While not technically mergers, the net effect of such transactions to the outside world is similar: The buyer winds up with another bank’s customers, employees, and facilities. Behind the scenes, however, it’s another story. The balance-sheet issues, the way the deal is priced, structured, and accounted for, the amount of risk taken on by the buyer, and other financial details are markedly different.
Most, but not all, FDIC deals come with loss-sharing agreements attached. The agency will typically offer to cover 80% of the losses up to a certain level, and then 95% of the losses after that. What changes from deal to deal is the cutoff between the 80% and 95% guarantee, which depends on the failed institution’s size, and the size of its problems. That’s set by the agency, and is non-negotiable.
Before a bank is seized, the FDIC alerts preapproved potential buyers via e-mail and makes its financial details available via a secure online data room. An auction occurs, with the terms of the competition centered around how much the agency will need to pay a bidder to take on the problem bank. It’s a rapid-fire process that typically takes about four weeks from start to finish.
For a bank with capital strength, the appeal is undeniable. When USB struck a deal with the FDIC in October for the failed FBOP Corp. of Oak Park, Illinois, it added $15.4 billion in deposits, $18.4 billion of assets, and about 500,000 customer relationships in Arizona, California, Illinois, and Texas to its portfolio. What did it cost USB? Not much. The agency paid it $500 million in cash to take on the operations. It also agreed to assume 80% of the first $3.5 billion in losses on FBOP’s $13.8 billion loan portfolio and 95% of the losses above $3.5 billion.
“It was almost completely in-market for us,” says Davis, who has completed several FDIC deals over the past year, gaining $35 billion in assets and $28 billion in deposits. The Texas operations will be sold. As for the rest, the dispersion of FBOP’s 150 branches over five big markets “allows us to distribute our energies and makes it more easily digested.”
The competitive implications of such deals can be immense. BB&T, the $165 billion Winston-Salem, North Carolina-based company, positioned itself to fill a vacuum left in the southeast by failed rival Wachovia Corp. (acquired in a distressed sale by Wells Fargo & Co.) with an assisted deal for Colonial BancGroup. Colonial, a $25 billion Montgomery, Alabama bank, ran into trouble with Florida construction loans.
The FDIC agreed to cover 80% of the first $5 billion in losses on Colonial’s portfolio and 95% of the losses above that; BB&T gets a No. 5 market share in Florida, No. 4 in Alabama, and a good toehold in the Dallas-Fort Worth market. “It was an unusually good deal for us,” says BB&T CEO Kelly King. “As I told my board, there aren’t too many times in your career where you get to do a merger that is strategically compelling, has minimal risk, and is immediately accretive. That just doesn’t happen too often.”
Similar tales are playing out at smaller levels and often the deciding factor is capital-or at least the ability to raise it. In November, Los Angeles-based East-West Bancorp acquired the assets of the failed UCBH Holdings, getting the nod from the FDIC over rival Cathay General Bancorp because of its ability to quickly raise $500 million in capital. UCBH, an $11.2 billion San Francisco company, was loaded down with problem assets and operating under a cease-and-desist order that required it to raise additional capital-something it couldn’t do. The deal allows East-West to leapfrog Cathay General as the largest Chinese-American bank in the country.
The process is brutally Darwinian: the strong get stronger, while the weak perish. Think of it as a requisite cleansing of the system-one that’s being managed to a large extent by the regulators, through the signals they send to markets about an institution’s staying power.
For banks facing trouble, capital is the key to surviving the carnage. Federal regulators have begun upping capital requirements for their charges, and some state agencies have taken that a step further. In Florida, for instance, the Office of Financial Regulation announced that it was requiring all institutions to have a minimum 11% risk-based capital ratio by the end of 2009.
After a sluggish end of 2008 and first quarter of 2009, banks leveraged the Treasury Department’s stress tests to initiate a capital haul. Through November 23, the industry had raised $186 billion, including $72 billion in common equity, $50 billion in preferred equity, and $32 billion each in trust-preferred issues and senior debt, according to SNL.
The numbers were dominated by big banks, but also saw activity rebound for smaller institutions-a trend that slowed abruptly after third-quarter results. When lack of interest forced Bank of Florida Corp., a $1.5 billion lender in Naples, to abruptly postpone a scheduled $75 million November public offering, analysts worried its future was in doubt. “[U]nexpected third-quarter losses reported by Florida-based bank holding companies that raised capital in the third quarter [has] adversely impacted the capital raising environment,” CEO Mike McCullan said in a statement. “It appears that public investors are back on the sidelines for the very near future.”
Capital levels are a front-of-mind concern for most boards, but often still aren’t approached thoughtfully enough. Alston & Bird partner Mark Kanaly, says he’s seen boards contemplate capital raises, conclude the pricing would dilute shareholders too much, and wind up failing a few months later.
He’s also seen boards that have been told by advisors that their asset-quality and capital ratios are good enough, “and suddenly the regulators come in and begin requiring more capital. … By the time you get to that point, people aren’t very excited about investing in your bank.
“The big question you need to ask is, ‘Are we being honest enough with ourselves about the size, shape, and feel of our bank? Do we really believe that our current capital position is stable?’” says Kanaly, who has advised on some failed bank deals in Georgia. “It’s a lot easier to raise capital when you’re strong than when you’re weak.”
By the time regulators begin to demand additional capital, it can be too late. Lawyers, investment bankers and other advisors that usually get paid commissions for helping out on capital raises, for instance, suddenly begin demanding up-front retainers. If a bank is under a cease-and-desist order, however, regulators often won’t approve such payments.
“Right at the time when you need outside advisors the most, you can’t get their help,” Kanaly says. Regulatory agencies “begin asking if you’re just costing the deposit insurance fund another $500,000 when the bank looks like it’s going to fail anyway.”
For small banks in trouble, the best capital-raising options often start in board members’ pocketbooks. “You need to pass the hat, and demonstrate to the people you’re asking that the board is willing to put its money where its mouth is,” says Craig Mancinotti, co-manager of investment banking with Austin Associates LLC in Toledo. “If the board commits 20% to 30% of the proposed offering amount, your likelihood of success increases exponentially.”
That doesn’t always happen. Ken Thomas, an independent bank consultant in Miami, tells of one small bank client faced with a requirement to raise $20 million in capital. Directors didn’t personally pony up, and when they went to existing shareholders, “they didn’t even come back with $1 million,” he recalls. “The investors had deep pockets, but they didn’t want to reach in and double down on their bank investment.”
Private equity is another possible alternative. Kanas partnered with the Carlyle Group, W.L. Ross & Co., and the Blackstone Group to pump $900 million in fresh equity into BankUnited. In December, the board of $4.5 billion Anchor BanCorp Wisconsin Inc. in Madison agreed to sell a 95% stake to a group of private equity firms, dubbed Badger Holdings, led by Steven Hovde, CEO of Hovde Financial LLC in Chicago.
Anchor was operating under a C&D from the Office of Thrift Supervision, requiring it to raise additional capital. The $400 million investment “preserves Anchor as an independent company that can continue our mission of being a viable and healthy community banking organization,” says Chairman David Omachinski.
But PE has been burned by bank investments before. In 2008, Corsair Capital led a group that paid $7 billion for a about 70% of Cleveland’s National City Corp., only to see the entire company sold six months later for $5 billion. Washington Mutual, the big Seattle thrift, received $7 billion from a private equity group led by TPG before becoming the biggest bank failure in history.
“Private equity doesn’t want to fill holes anymore, it wants to provide offensive capital to an organization that is in decent shape and can take advantage of FDIC opportunities,” Mancinotti says. “If your NPA trends are increasing and you have an operating loss, the capital markets-private equity included-are for all intents and purposes closed.”
Banks have an advantage when competing with private equity for deals. Rules established in 2008 allow a PE firm to own 33% of a bank without having to register as a holding company, but no more than 15% can be voting stock. That can be a big disincentive for PE firms, which promise their investors big payoffs and like to have control.
Regulators also prefer to work with banks. “If there’s a strategic bidder that can match a PE bid, the nod will go to that bank,” says Rick Maples, head of the financial institutions group at Stifel Nicolaus in St. Louis. “There’s a lot of negative goodwill-equity-being created in these transactions, and the FDIC would prefer to keep that capital in the system.”
For the buyers, the payoff from FDIC deals can be substantial. The Colonial purchase was immediately accretive to BB&T, adding two cents per-share to third quarter earnings. But they’re not risk free. Before jumping in, boards need to educate themselves about the process and ask lots of questions-many the same questions they’d ask as in any M&A deal:
How will the company’s asset-liability mix be affected by the deal? Do directors understand the implications of the target’s credit problems, and will additional capital be required to digest future balance-sheet issues? Does it help the company achieve its long-term strategic objectives? Is there a plan to retain jittery customers and employees? Does management have the ability to execute on that plan?
In the short due diligence window, USB’s Davis says his team focuses much of its energies on culture. “If the company has been unhealthy for a long time, or if the reputation has really been damaged, then you [worry] about the direction and momentum of the balance sheet, the customers, and the employees,” he explains.
Boards in a position to take on FDIC deals must be light-footed and prepared. “Maybe the biggest difference between FDIC deals and normal bank M&A is that you have zero control over the timetable,” says Hancock’s Chaney. He recently brought in investment bankers to walk his board through a three-hour presentation on the ins and outs of these transactions. The directors engaged in “a lot of back and forth” with advisors and management. Much of the discussion centered on the process surrounding loss-share agreements and challenges of the four-week timeline.
From there, the group went through a detailed assessment and prioritization of 20 markets where Hancock’s management anticipates failed banks might be available. “We listed the top 10 banks in market share in each city, and then we prioritized which banks might be attractive to us,” Chaney says.
Strategic questions were debated, too. “What are we going to do if Bank A comes up in Florida one week, and we’re about to submit a bid when we get notice that a Louisiana bank that’s higher on our priority list comes up? Can we handle two? How will we ensure that we’re not biting off too much?” Chaney recalls one director asking.
When it was over, Chaney was satisfied that his board understood the pros and cons of FDIC transactions. “If I’m an outside director, I’m going to be uncomfortable with such a short learning curve,” he says. “We want them fully apprised about how the transaction works and which markets we’re interested in so that when we get notice from the FDIC that a bank is available, we can pull the trigger easily.”
One decision out of that discussion: The creation of a three-member M&A committee, headed by Anthony Topazi, 58, CEO of Mississippi Power Co. and a three-year director, charged with reviewing and giving management an initial go-ahead to pursue a transaction. The full board still must sign off on the deal.
Hancock also has a due diligence team in place. It includes high-level finance and credit executives who review virtually every loan, as well as human resources, IT, and retail managers to assess everything from employee morale to how much it would cost to convert systems. Some will make visits to branches and other facilities, often posing as auditors. Because the FDIC likes to keep failures secret until they’re announced, “you’re not allowed to come in with logos or even a bank pin or notepad,” Chaney says. “Everybody on the team brings back their information and plugs it into our pricing models to make a final bid scenario.”
The terms of the bidding for a failed bank center mostly on how much of a discount-or the price paid by the FDIC-a potential buyer is willing to take on the assets. It’s a blind process, so while a board can surmise who the competition might be, details aren’t made public. Some failed banks are in such bad shape they don’t garner any bids. First Bank of Beverly Hills, a $1.5 billion commercial lender in California, is among a handful that have been seized and simply liquidated-their insured deposits returned to customers.
Most failed banks rate a bid-even if it’s just a pure asset play. A winning bidder also gets a 90-day option to pick and choose among office equipment, branches, and other physical assets of the failed institution. Whatever the bank decides to keep, it pays fair market value; the FDIC liquidates the rest.
The process moves quickly: Bids are typically submitted on a Wednesday, with the winner announced two days later. At the close of business that Friday, the new team takes over. Even so, boards of bidders should review the purchase-and-assumption agreements carefully. The contracts explain in detail just what the institution is buying and what it’s not. Sometimes surprises emerge. Mancinotti tells of one board that believed it was buying only one-to-four family residential mortgages. A $2 million commercial loan was tucked into the fine print.
“They didn’t want it, but the P&A didn’t promise it would be all mortgages, and because of the way the document was worded, they couldn’t get out of the purchase,” he recalls. “A board has to make sure the entire document is read in detail.”
These are crazy, unsettling times. A market for traditional bank deals will eventually reappear, though not until the backlog of struggling banks is cleared. But the system has endured other crises, and it’s a good bet that after Davis’ “new normal” emerges, some of the banks that are playing offense today will rank among the industry elites.