The New Math Of Bank M&A

Back in the early days of the financial crisis, Hudson City Bancorp got a lot of press as an old-style thrift that had not only survived, but thrived, with a time-tested formula of making mortgage loans and holding those loans on its books.

“I like telling the story,” CEO Ron Hermance, Jr., said in 2009. “America needs to see what the basics look like and how you can get rewarded for them.”

The tale didn’t have the wonderful ending that Hermance, 65, might have envisioned. While his Paramus, New Jersey-based thrift’s asset quality and capital held up well enough during the recession, its mortgage-heavy business model was done in by the Federal Reserve’s attempts to jumpstart the sluggish economy by keeping interest rates low, pursing a monetary policy of quantitative easing.

The Fed’s actions sparked a wave of prepayments, creating a mismatch on $42-billion asset Hudson City’s books between low-rate loans and higher-cost funding that ultimately culminated in a loss of $736 million in 2011. “It wasn’t the problem that killed us,” Hermance says. “It was the solution.”

Its options limited, the board in August agreed to sell to M&T Bank Corp., the $81-billion asset, Buffalo, New York-based regional banking company that came through the crisis relatively unscathed and has been one of the industry’s top performers in recent years.

The $3.8 billion deal could be a market-changer in the northeast, creating a $123-billion asset banking company with 900 branches stretching from upstate New York through Virginia.

Perhaps more importantly, as the biggest banking deal of 2012 through mid-December, it has been being hailed as a sign that the broader market for non-government-assisted acquisitions might finally be heating up after five years in the deep freeze.

Activity near the top of the food chain often reverberates through the systemu2013both by setting a pricing benchmark for others, and by providing some psychological inspiration to smaller buyers.

Both Hudson City and M&T claim satisfaction with the outcome. But if the pricing of this deal is a benchmark of sorts for the rest of the industry, then the growing list of bank boards that are weighing a sale might need to swallow hard.

The deal took months to complete, and valued Hudson City at an uninspiring 81 percent of book value. Hermance concedes he was disappointed in the pricing. The saving grace, he says: M&T, priced at 1.2 times book, looked undervalued, as well. The cash-and-stock structure allowed the seller’s shareholders to share in a 25 percent rise in M&T’s stock price during the two months following its announcement.

Whether such mathematical compromises are enough to move the needle on the bank M&A market in 2013 remains to be seen, but it might be too soon to get excited.

On the surface, the banking industry looks primed for a major consolidation boom. Tight margins, weak loan demand, the loss of key sources of fee income and higher compliance costs all are putting pressure on the bottom line.

“We have too much capacity for the current environment, too many banks chasing not-enough business,” says Joseph Morford, an analyst with RBC Capital Markets in San Francisco. “Many bank boards, if they are being honest about their assumptions, have to conclude that their outlooks as independents are pretty challenging.”

The toxic operating environment is hitting acquirers, as well.

“You have sellers looking at their own businesses and saying, ‘I can’t grow my earnings in this environment. How is our continued independence helping shareholders?’” says William F. Hickey, co-head of investment banking for Sandler O’Neill + Partners in New York.

“And you have buyers who are saying, ‘I have enough capital. My business is okay. But I need more growth,’” Hickey adds. “One of the best ways to put that capital to work and grow revenues is through acquisitions.”

It sounds like the proverbial match made in heaven. Some observers predict that the ranks of U.S. banks, which today number approximately 7,200, could be halved within five years.

“You can argue whether consolidation is good or bad for the industry,” says H. Rodgin Cohen, a partner and senior chairman of Sullivan & Cromwell LLP, the New York law firm. “But if you believe that the industry has meaningful earnings problems because it’s overbanked, then consolidation is the only logical way to attack it.”

The question is, when will the pieces begin to fall in place?

Daryl Byrd, CEO of Lafayette, Louisiana-based Iberiabank Corp., a $12-billion asset company that has been among the Southeast’s most active acquirers, thinks an M&A boom is close, driven more by seller desperation than buyers’ growth aspirations.

“A lot of companies just don’t have any real value propositions anymore, and what they’re asking is, ‘Are things going to get any better?’” says Byrd, who is being approached more often nowadays by bankers looking for an exit. “In the near-term, probably not.”

For now, however, the pace of activity remains sluggish. Through December 3, 213 bank sales had been announced in 2012, with a total deal value of $12.9 billion, according to SNL Financial, a Charlottesville, Virginia, firm that tracks industry statistics.

Both figures are roughly on par with levels of recent years, but look downright anemic alongside, say, 2006, when 278 deals were struck at a total value of $108 billion and pricing of three times book value was commonplace.

A lack of willing buyers is the primary holdup.

As the industry recovers, a growing number of banks have the capital and management strength to consider bulking up. But they often lack enough confidence-in the economy, a target bank’s loan portfolio, future regulatory capital requirements and their own due diligence capabilities-to pursue deals.

Even healthy banks with an appetite for deals fear making a fatal misstep. “Buyers are terrified of what they’re going to pick up,” says Walt Moeling, an Atlanta-based partner at the law firm Bryan Cave LLP. “They know if they do one lousy deal and pick up more problem assets than expected, it’s going to kill their prospects going forward.”

The dearth of buyers starts at the top. Bank of America Corp., JPMorgan Chase & Co., Citigroup and Wells Fargo & Co., the four largest U.S. banks each with more than $1 trillion in assets, are too preoccupied with regulatory and operating issues to consider any big deals, or are bumping up against the deposit cap.

None of the four has completed a U.S. bank transaction since 2008, and no one expects them to do anything in the near future.

“It’s difficult for the market to get rolling when the guys at the top aren’t buying,” Morford says. “But it’s also hard to imagine in this environment that regulators would allow a too-big-to-fail bank to get bigger.” All four mega-banks fall well within that category.

Large regionals such as M&T, U.S. Bancorp, BB&T Corp. and PNC Financial Services Group have shown moderate interest, but only on their terms. Generally speaking, they’ve been more willing to participate in government-assisted deals than to shoulder all the risk themselves through the acquisition of a live bank.

Smaller regional banks, such as $20-billion asset Hancock Holdings Corp. of Gulfport, Mississippi, $12.5-billion asset Iberiabank Corp. of Lafayette, Louisiana, and Wintrust Financial Corp., a $17-billion asset player in Rosemont, Illinois, have been slightly more aggressive.

Iberiabank alone has done three live-bank deals in the last two years, following five government-assisted transactions early in the crisis. “We like the south, from Texas to Virginia, and we like urban markets,” Byrd says.

But such smaller deals don’t move the needle much. After M&T-Hudson City, the next biggest transactions of 2012 were UnionBanCal’s $1.5 billion purchase of $5.8-billion asset Pacific Capital Bancorp, an institution in Santa Barbara, California, and Cleveland-based FirstMerit Corp.’s $1.3 billion deal for $9.7-billion asset Citizens Republic Bancorp in Flint, Michigan.

The majority of deals fall below that level: 12 of the 20 mergers announced in October of last year, for instance, involved targets with assets of $200 million or less.

The lack of competition among buyers holds down pricing, much to the disappointment of potential sellers. The average price for a 2012 bank or thrift deal was about 112 percent of book value, according to SNL.

Many directors of potential sellers got into banking as an investment. They recall the pre-crisis days, when prices of three times book value were the norm, and continue to dig in their heels, hoping for valuations to rebound.

“You’re seeing some of the better-positioned banks saying, ‘I’ve made it through the cycle and I have some profits. Things aren’t great. But why should I sell now, when the pricing might improve?’” says Christopher McGratty, an analyst for Keefe Bruyette & Woods Inc., in New York.

The regulatory climate is another headwind. “The regulators, quite frankly, are scared,” says Peter Weinstock, a partner with Dallas-based law firm Hunton & Williams LLP. “They’re flyspecking every deal, and seem to be afraid of everything.”

Some deals are taking six months or more to win regulatory approval. Other deals are getting shot down by the regulators before they get out of the gate if they don’t involve two healthy banks, or if one of the participants has Bank Secrecy Act troubles.

“The buyer needs to be at least a CAMELS ‘2’ rated bank, and the combination needs to be a ‘2,’ or it’s a full-stop,” says Rick Maples, co-head of investment banking for Stifel Nicolaus in St. Louis. “The agencies won’t allow it.”

Representatives of the Office of the Comptroller of the Currency and Federal Reserve declined interview requests, but observers say the added scrutiny and uncertainty about the new regulatory scheme and capital requirements in the works under both Basel III and the Dodd-Frank Act have had a chilling effect on the market.

The pressures play out in different ways. Some banks, such as $9.4-billion asset MB Financial Inc. in Chicago, for instance, have refrained from doing deals to avoid crossing the $10 billion size threshold when additional costs, capital requirements and rules are required under Dodd-Frank.

“MB’s management has made it pretty obvious they’re trying to stay below that level,” says McGratty, who covers the company. “It takes them out of the buyer pool.”

Others are fearful of inheriting a target’s hidden liabilities. Maples notes the ongoing problems that Bank of America inherited when it acquired the troubled mortgage lender Countrywide Financial Corp., and that JPMorgan Chase & Co. assumed when it took over the ailing investment banking firm Bear Stearns.

“Those banks are defending themselves on a continuous basis for things that happened at the targets before they were purchased,” Maples says. “The regional and community banks see that, and it makes them uneasy.”

All this apprehension has transformed the M&A process into a stultifying affair that only vaguely resembles the efficient, assembly-line approach of years past.

“There really is no such thing anymore as an easy-form merger,” Weinstock says. “Even good, quality sellers have issues. It might be a compliance issue, or an asset-quality issue or a risk-management issue. And the buyers really need to structure around those issues.”

Would-be acquirers are digging deeper, conducting all sorts of reviews that were not part of the equation in the pre-crisis days, hoping to avoid getting surprised by an asset quality or compliance issue in a target’s past.

“When Bank A buys Bank B, the board needs to be very comfortable that Bank B didn’t do something compliance-wise three years ago that they could wind up needing to defend,” Maples says. “It impacts buyer confidence.”

Some buyers are taking things a step further, stress-testing target portfolios under the scenarios employed in the Fed’s Comprehensive Capital Analysis and Review process, which was implemented to ensure that large bank holding companies have adequate capital.

“These days, anyone who is in position to be an acquirer is pretty clean, and the target usually has some issues,” says Steve Powell, owner of Steve H. Powell & Co., a Statesboro, Georgia, consultant that performs due diligence for many acquirers.

“The clean bank doesn’t want to muddy its waters. And if there’s a negative impact in the deal, it needs to be taken into account in the cost of acquiring,” Powell adds.

This can throw a wrench into some deals. While sellers might rely on their own in-house loan reviews when marking their loan portfolios to market, for instance, a buyer’s due diligence is typically more rigorous and uncovers additional problems.

Powell offers the example of a $400,000 home equity line of credit originated by a Florida bank in 2006. The line, which requires only interest payments, was underwritten at an 80 percent loan-to-value on a $500,000 house and has been fully drawn for three years.

The borrowers have never missed a payment, so it hasn’t been classified or downgraded. But they haven’t paid it down either. And the value of the collateral property has dropped to $250,000.

“As the acquiring bank, you have the opportunity to say, ‘If the borrower wanted to borrow $400,000 on a $250,000 house, we wouldn’t make that loan,’” Powell explains.

When those types of loans emerge, it’s common for buyers to ask for price reductions-and for sellers to push back. This inevitably can lead to conflict, hard feelings and more time.

“It used to be that these were small matters, worked out in the course of events,” he explains. “But the times have made these issues bigger and a lot more material.”

Such dynamics have made the entire M&A process much more labor-intensive than in the pre-crisis days. Melanie Dressel, CEO of Columbia Banking System Inc., an acquisitive $4.8-billion asset company in Tacoma, Washington, says she’s spending 50 percent more on deal-related professional services than five years ago.

In September, Columbia announced that it would buy $2.4-billion asset West Coast Bancorp in Lake Oswego, Oregon, for $506 million. The deal is valued at about 145 percent of book value, a relatively healthy price, and gives Columbia a long-coveted strategic foothold in Oregon. But it wasn’t easy.

“Before the recession, the due diligence efforts focused almost exclusively on the credit piece,” Dressel says. “Now you really need to do a deep dive into every possible area. You want to make sure there are good safety-and-soundness measures within the bank, you want to understand the credit philosophies.”

The costs and time have potential purchasers declining to perform due diligence if they’re not clearly the seller’s preferred option. Some eschew competitive situations altogether.

“As a buyer in this environment, we wouldn’t even consider a bidding process,” explains M&T Chief Financial Officer Rene Jones, who has been part of a team that has struck three significant live-bank deals during the crisis, including a $350 million purchase in 2011 of $10.4-billion asset Wilmington Trust Co. in Wilmington, Delaware.

“You have stress-testing to do. You’ve got to perform an in-depth assessment of the target and how it might change the profile of your bank. You need to look at the governance process,” Jones says. “And then you have to spend a lot of time with regulators to get them comfortable that the deal might be better for the system.”

“The old idea of putting in a bid on Monday and announcing it on Friday doesn’t work today,” he adds.

For all that, the pressure to marry up is increasing for buyers and sellers alike, and many observers predict that deal volume will grow as sellers’ willingness to compromise on pricing coaxes more buyers into the market.

After years of waiting for a turnaround in performance and/or deal pricing, plenty of bank boards are coming to the realization that neither is on the horizon.

They’re tired of the long hours and the low returns. A growing number would like to cash out and put their investment dollars to work somewhere else. Now, they’re getting more assertive in strategic planning sessions, challenging management’s growth assumptions and inviting outside experts to compare the bank’s return expectations with what could be gained in a sale.

“Strategic planning used to be very tactical,” Moeling says. “Now it’s much simpler: Buy, sell or hold?”

Adds Hickey: “There’s a sense of fatigue setting in. Even boards that have been staunchly independent start to challenge their own thought processes.”

They might not be capitulating, but they are bowing to the hard truth of a realistic assessment. Florida Gulf Bancorp Inc., a $350-million asset lender in Fort Myers, weathered the housing downturn better than most other banks in the Sunshine State, but still found itself under pressure from competitors and regulators.

“The margins were getting skinnier and skinnier in a no-growth market, and almost every [regulatory] exam we had would end with, ‘You need more capital. You need to put more people in compliance. You don’t have enough resources dedicated to [the Bank Secrecy Act],’” recalls Bill Valenti, Florida Gulf’s CEO.

The board looked for additional capital, but didn’t like the terms offered by investors. When representatives from Iberiabank called last spring, Valenti was willing to listen.

After several months of back-and-forth discussions, the two sides agreed on a $44.5 million deal that valued Florida Gulf at about 1.35 times book value.

“If this conversation were happening in 2004, we might feel like we were giving it away,” Valenti concedes. “But when we looked at comparable deals, it became pretty clear that a healthy bank hadn’t sold in Florida over the past three years for more than book.”

There also are signs that potential buyers are gaining more confidence. In some limited cases, competition is returning to the M&A market, which has the potential to drive up pricing multiples.

Weinstock points to several recent bank sales in the northeast that have fetched above two times book value for the sellers.

One example: Norwich, New York-based NBT Bancorp Inc.’s acquisition of $1.4-billion asset Alliance Financial Corp. The $230 million all-stock deal, announced in October, values Alliance at 2.12 times its tangible book value.

“Eighteen months ago, we didn’t see that kind of pricing,” Weinstock says. “The situation is improving. If we can get some clarity on the economic front, I think buyers will show more interest.”

Kamal Mustafa, chairman of Invictus Consulting Group in New York, predicts more-perhaps much more-consolidation activity, but only when there’s more clarity on capital adequacy standards under Basel III and Dodd-Frank.

Invictus recently conducted stress tests on all 7,200 U.S. banks, combining publicly available data with projections of capital requirements under the new standards. The analysis concluded that 1,953 banks would have such a toxic combination of low capital levels and poor returns that the best thing they could do for shareholders would be to sell.

Uncertainty about final capital standards is “the sword hanging over the banking community, and the M&A market,” Mustafa says. “It’s slowing down the inevitability of banks recognizing” that they need to sell.

At the same time, another 3,659 stronger institutions deemed by the Invictus analysis to have adequate capital will be pushed to weigh acquisitions to find growth and higher returns, the report concludes.

When the merger wave comes-Mustafa predicts it will kick off roughly six months after the Dodd-Frank-mandated capital levels are released for banks with $10 billion or more in assets-the action will be fast and furious, creating a rush for the door that will push seller pricing down even more.

“Given the high fixed costs of compliance and new capital requirements, size will start to make more of a difference,” he explains. “Banks that are left out of the mix won’t be able to compete,” which will prompt them to look for deals, creating an even larger supply of banks up for sale.

“If you think your bank will be a seller, the smart strategy is to put yourself up for sale right now,” Mustafa adds, “before prices drop.”

That was the conclusion reached by Hudson City’s board. Confronted with some stark funding challenges and operating under the restrictions of a Memorandum of Understanding with its primary regulator, directors weighed a costly strategic overhaul that would have involved hiring up to 250 new commercial bankers, and taken three years to implement.

The board also entertained three serious suitors over the course of about a year, according to Hudson City’s Securities and Exchange Commission filings.

M&T was the last entrant in the sweepstakes, beginning its assessment in May. It spent nearly four months digging into loan portfolios, seeking assurance from regulators on compliance issues and haggling over pricing and more to find comfort in a possible deal.

Top M&T managers also met with Hudson City’s brass at Hermance’s home. As a seller, he had questions, too. “Most of my questions revolved around their relationship with the regulators,” he explains. “You have to ask if the deal can get approved.”

While it carries some risks, the market judged the deal as a winner for M&T. For Hudson City shareholders, the deal pricing values shares at less than half of what they were worth in 2009. But it’s also an opportunity to hitch a ride with a strong company that has a reputation as a strong integrator and aims to transform the old thrift franchise into a commercial bank.

“I wasn’t happy with the price,” Hermance concedes. “But my thinking was, ‘We don’t know where this thing is going over the next two or three years.’ M&T is knocking the ball out of the park, and now we get to be a part of that.”

Perhaps Hudson City’s story will have a happy ending after all.

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