Outlook for M&A: 2009

Bank Director sat down with some of the nation’s sharpest financial advisers to find out what effect the nation’s economic turmoil, market volatility, and political upheaval are likely to have on the banking business and the potential for institution growth and transactions in the year ahead.

In the following special report, we share the results of three separate roundtable sessions held in late January at Bank Director‘s annual Acquire or Be Acquired Conference in Phoenix. These sessions, sponsored by Grant Thornton LLP, covered the most critical topics banks directors and officers should be discussing as they consider their options for growth and how best to protect shareholder value in the current environment.

What Will Happen to M&A in 2009?

Strategic Opportunities (and Challenges) for Deals in the Current Market

Bank Director invited the nation’s premier investment bankers and lawyers to give an overview on the current market conditions and discuss what they see as the biggest challenges to growth in the coming year. Interestingly, for some banks, M&A will be a viable-even attractive-strategic option.

Session Participants:

David M. Burns, partner & Northeast Financial Institutions Practice Leader, Grant Thornton LLP

John Duffy, chairman & CEO, Keefe Bruyette & Woods

William F. Hickey, principal, Sandler O’Neill & Partners L.P.

Michael R. McClintock, managing director, Friedman Billings Ramsey

Let’s begin with an overview of the bank stock market and valuations, including some historical perspective to briefly set the stage.

John Duffy: The bank stock market is about the worst we’ve seen in 20 years. It’s difficult to get too optimistic about any recovery in the short term, given all the factors we’re dealing with. Asset quality in itself is probably the first three items we should talk about. Just like in real estate when they say “location, location, location,” when we talk about bank valuations now, it’s “asset quality, asset quality, asset quality.” With the economic statistics we’re all looking at, it’s hard to believe we’re at the bottom. So I think there’s more pain coming. The stock market is generally a leading indicator in that it usually leads upward five or six months before the economy turns. So if we have a painful year in the economy, that doesn’t necessarily mean we’ll have a year of pain in the stock market. An awful lot depends on what impact the Obama administration has from a fiscal perspective and also from a regulatory perspective in terms of the tone it sets. So I think it may be more difficult than usual in terms of trying to forecast where bank stock prices are headed over the next six to 12 months. I think we’ve got an ugly operating environment, but there are outside factors and it’s difficult to determine what kind of impact they will have. At KBW, we’re very cautious-there may be another shoe to drop.

William Hickey: I agree with John in a lot of respects. We’re certainly on a price-to-book valuation matrix; price-to-earnings is sort of out of the picture for 2009 and potentially for 2010. I think we’ll see some pressure on companies that are trading at premiums to tangible book value throughout 2009, just given credit quality concerns throughout all asset classes. The light at the end of the tunnel will be when we see companies trading at a predictable earnings multiple, and I think where we’ll see that is probably in the 8 to 10 times earnings range. That will be when people should think about investing again. Historically, if you bought bank stocks at 8 or 10 times earnings, you’ve done quite well. It’s just a question of whether we’ll get to a predictable earnings stream in 2010.

Michael McClintock: Our view at FBR is that there is a trillion dollar capital need in the banking system, which, every time I say that number, is still pretty breathtaking. And we think banks really need to raise common equity. After the first quarter earnings are announced, analysts will need to readjust down. We expect that reduced earnings estimates for 2009 will impact stock prices negatively.

David Burns: I’m not sure I can add much more from the standpoint of what’s going to happen to the market, but I will say Grant Thornton just completed our 16th survey with bank executives and, needless to say, it was very pessimistic. A large percentage of them-about 40%-believe that we’ll come out of this deep in 2009, but the lion’s share, about 45%, believe it will be 2010. So they’re clearly not optimistic!

Duffy: When you think about how much capital the industry needs, whether a trillion dollars is the right number or not, it’s going to be dilutive. And when you’re trading where most of the banks are, at a discount to book, or even a discount to tangible book, the guys who need the capital the most are the ones who are trading at the biggest discounts, which can be very dilutive to future earnings power. So that’s another reason not to be too sanguine about the stock price prospects for this group over the course of the next year. They’ve got to raise that much capital at arguably depressed prices, which is compounding the problem.

What will be banks’ biggest challenge to grow through acquisitions in the next year?

Duffy: Probably the headlining issue is TARP funding and government assists. When you look at the headline deals of the [fourth quarter 2008], it was Wachovia and Nat City, and I don’t know how many more of those are coming-it’s conceivable that there could be more. They are headline deals because of their size, and if there are more of those type situations, we are likely to see their resolution before the rest of the industry gets the courage to do more traditional deals.

Hickey: I think we’ve got significant governmental risk in the market right now, because what nobody knows is whether the government is going to get behind further transactions with companies that took TARP money. There certainly has been a groundswell of noise from Washington saying, “Hey, this money shouldn’t be used to buy companies, this money should be used to make loans!” Unfortunately, what some of our legislators are missing is the fact that we’ve got to start with a healthy banking industry, and then lending will take place. I think we’ve got to be very careful about the government putting pressure on these banks to not do acquisitions while simultaneously trying to create a healthy banking environment. That’s a big risk. If the government starts running the business of M&A, and they’re not going to allow anybody who took TARP money to use X dollars to buy another institution, that is going to prolong the problem, not resolve it.

McClintock: I agree with Bill. Whether it’s the policies of the new administration in relation to TARP or whether TARP comes first, at the end of the day, the government is going to be providing the guideposts for everybody in the industry to follow. It’s very difficult to raise capital now because everyone’s waiting for the government to finish with the TARP program, and yet they have hundreds of banks on backlog-many banks have received approval but haven’t actually received funding. So unless and until that is completed, it’s very difficult for investors to ferret out who the winners and losers are in the space and whether or not they want to invest and recapitalize them. Also, just because you got TARP doesn’t mean you’re not going to need more capital. The banks that got TARP early and got the cash are finding their stock prices are now significantly under the exercise prices for the warrants. So it’s going to be difficult for them to raise capital to offset the dilution from the government TARP. To further emphasize John’s point, more dilution is coming.

Duffy: It’s also going to be difficult for the government to realize the value of the warrants.

Hickey: But to your point, Mike, if it’s a trillion dollars that the industry needs, the government’s got to be involved. You can’t get there in the private sector.

Burns: If the government is going to let good banks use the money to acquire troubled banks, then it’s going to have to change the whole matrix of how much TARP you can get from the government. The TARP money that some of the larger community banks received is not enough to take on troubled institutions from a liquidity standpoint.

Duffy: The new administration may have a different focus here. I think there’s a sense that they’ve got to do something. If you go back to TARP one, it was, “How do we get movement among these assets to trade price discovery and actually get liquidity back into the system?” I think that effort is going to be refocused. It was put together quickly and it was almost abandoned as quickly as it was put together. Until you have some clearing in the housing market, a lot of other things that are backed up behind that aren’t going to get better. So I’d be surprised if the administration didn’t focus on that, as opposed to focusing on shotgun marriages in terms of how this capital is spent and whether they decide to form another resolution trust company, or on how these assets are going to get worked.

Hickey: You’re right. It’s either institute a new RTC or a bad bank strategy. And the government is the only entity that can fund the bad bank.

Duffy: I think we may see more open bank assistance. In essence, we’ve got it with Citi and BofA. We may find that dealing with banks that got into trouble is the best way to remediate individual credits rather than the government taking them over, going into those banks with another form of capital-more senior, more expensive, not a 5% discount-and diluting the common shareholders to keep those institutions alive. We may see both a resolution trust company and open bank assistance, because this problem is so big I’m not sure there’s one solution.

McClintock: One thing that makes me a little nervous is all this focus on preventing foreclosures and forcing banks to write down the underlying value of those mortgages to restructure the loans. A pretty significant percentage of restructured mortgage loans will default again. The prevention of foreclosures is artificially propping up prices of houses. But until you flush out the bad assets, we’re not really going to have the price discovery that everybody is talking about.

If you were meeting with a bank board that was considering a strategic acquisition as a path for growth this year, what would be the strongest case for moving forward with the deal? Give us some factors that should be in place for both buyers and sellers in the current environment.

Hickey: First, I do think we’ll see a fair amount of strategic transactions. Deals that will still work are low premium deals where there are significant cost savings between two entities that fall to the bottom line. So I think you’re going to see some of those deals-people like to call them “mergers of equals,” but there really is no such thing as a merger of equals. They are simply deals that are strategic in nature. So how would I advise a buyer? In the case I just described, there is not a buyer and a seller; there are two buyers. They are buying each other’s institutions, risks, and prospects. In those types of stock deals, everyone has to get comfortable with what they will end up with, knowing that they’ll have to make tough decisions and cut out some costs that will fall on the bottom line.

McClintock: Well, if you’re advising a buyer, you really have to dig into the seller’s asset quality and make sure that you have a good understanding of it, and then haircut it another 50%. Next, you really want to get deposits in this market-core deposits are critical. You see the big banks all scrambling like crazy to get deposits, so I think that should be a second focus. But I think the hard question goes back to what we spoke about earlier-people are going to have to expect that weak sellers will get almost no value for their bank, because if they don’t sell, they will be seized.

Burns: I agree core deposits are critical. When you look at potential targets that have quality core deposits and those deposits are customer-based, then you can look at cross-selling opportunities to increase that base. Instead of focusing on loan growth, they’ll need to focus on deposit growth.

Duffy: Right. Funding is key when you’re talking about growing the institution. Growing the asset side of the balance sheet in this environment without core funding support is asking for trouble. But going back to your question, I’ll just mention that I think when people use the term “strategic acquisition,” historically, it’s been kind of a misnomer. It’s usually an excuse for overpaying.

But I also agree with Bill that you’re going to see deals where people have realized they’ve got to get the expense base down because their ability to compete is limited. Their infrastructure costs may be too high. If they’re in the same market or contingent markets they may be able to get together, and that might make all the sense in the world, if, again, they can get comfortable with each other’s asset quality. I think there are going to be opportunities to grow, but buyers should use caution. The best deals for buyers today are government-assisted deals, where you don’t have to take on the asset quality risk. I’ve been surprised that there haven’t been a lot of deals yet, but the ones that have been announced, frankly, have gone at very modest deposit premiums. I think the highest I saw was the one out here in Phoenix, which was 4.3% of core. Those are numbers you can make work. If you get a real franchise and you’re paying less than 4% deposit premium, the return on that investment should be pretty good. I also think that says there are not a lot of buyers out there. They either don’t have the capital or they’re so focused on trying to clean up their own problems that they really have no expansionary thoughts.

Hickey: We don’t have an issue with a lack of sellers. We’ve got an issue with a lack of buyers and figuring out who the buyers are.

To sum up, what is the strongest positive message a bank board should be making to its shareholder constituents about what the company is doing to survive, and hopefully grow, during the next 12 to 24 months?

Hickey: A lot of banks haven’t met with investment bankers to evaluate what the issues are and what they should be focused on. So I think the best advice I could give to boards is to make sure you’re consulting with people who are active in the marketplace.

Duffy: That’s a great point. I think capital is the primary issue to address with investors, but I believe Bill’s point is better. Educating the constituency in terms of what the real options are is very important.

Burns: Unfortunately, the reality is there are a lot of bank boards that have the attitude that they don’t want to invite investment bankers into their boardroom because they’re afraid of what they might hear.

Duffy: Managements that have that kind of attitude are usually in denial or they’re hiding something and they don’t want their board informed, which is a very bad thing.

McClintock: First, I would just sum up by saying that in this environment, it’s in everybody’s best interest to get as much advice as possible for your own protection, if nothing else. You can always say “no” to someone’s advice. Second, I think banks have been generally nau00efve about what’s going to happen with this influx of highly skilled people into the sector, and the fact is, the regulators are going to get much more difficult, and they’re going to be writing down many more loans and requiring far more reserves than they did in the past. There were tons of banks that maintained their CAMELS rating last year despite declining credit quality. That’s just not going to happen anymore. They’re going to be cut, and it’s going to be in the regulators’ best interest to say that they were on top of the problem and proactive. So I think banks should be prepared for tougher sledding with the regulators, tougher sledding in the markets, and should definitely seek advice.

Execution Risk in Today’s Deal Environment
In this session, our roundtable panel gets to the heart of execution issues and offers guidance to board members on avoiding missteps and managing risk.

Session Participants:

Ronald H. Janis, partner, Day Pitney LLP

Arthur L. Loomis II, president, Northeast Capital & Advisory

Michael T. Mayes, managing director, Raymond James

Ben A. Plotkin, executive vice president, Stifel Nicolaus & Co.

Jean-Luc Servat, managing director, RBC Capital Markets

From a good governance standpoint, what steps should directors take to mitigate risks before entering a transaction today?

Ben Plotkin: Fortunately, compared with some of the challenges faced by larger peers, a community bank buyer can actually figure out what is on the balance sheet of a community bank today. So the first thing I would counsel a board to do from a good corporate governance standpoint is to take the time needed to do the acquisition. There should be no sense of urgency; a board should insist that very thorough valuation work is done. When I talk about valuation work these days, it’s with a focus on what the tangible book value of the pro forma company will be after a transaction.

Michael Mayes: The type of [community] banks we’re talking about are those where you can actually examine the assets, the loans, the investments, and at least know what’s there. That’s not the case with some of the larger, more complex companies. I would also add that, obviously in this environment, you want to have a lot of experienced advisers at your side-people who have been through this quite a bit on the banking side, on the legal and due diligence side, and on the loans and investment side.

Furthermore, a lot is going to depend on your own outlook for the broader economy over the next six to 12 months. If you feel the economy is going to continue to deteriorate, the problem you’re going to face is when you evaluate loans, you’re going to have a certain amount of good loans today that will go bad. The biggest wild card is what’s going to happen in the economy over the next year. In three months, six months, nine, because of the financial stresses in the economy, some good loans will become bad loans. So identifying the concentrations of risk in the portfolio is critical.

Jean-Luc Servat: We are really getting boards to pay close attention to the franchise, and that means taking a very, very hard look at the deposit side. What has probably surprised me the most is that over the last 12 months, it’s not so much the asset side, it’s the evaporation of the deposit side.

The other thing is, at what point do you really want to get involved in a situation? Is it worth jumping in now and spending the time and effort to go through the exercise? What’s been shocking is just how quickly the evaluations we made even a month ago seem to be shaken to the core.

Arthur Loomis: I’d spin it a little more opportunistically. In merger transactions, execution risk is always the key. Execution risk has always been high. The good news, however, is that prices are down, so actually, the risk/reward tradeoff has improved, compared to historical standards. And finally, if the deal is a good deal, the economy-while it is significant-probably could be argued to be irrelevant. That’s not to say that you ignore the loan portfolio and asset quality you’re acquiring, but a good transaction that is put together prudently and is located in a region of the country that is not being lambasted by credit quality concerns, should be extremely viable.

Ron Janis: I’m skeptical of acquisitions at the moment from an acquirer’s perspective, because I think most acquirers are looking at their own problems and are having to spend a lot of time on their investment-side problems over the last 12 months. Looking forward, I believe they should spend a lot more time on the loan side.

How do you feel about the potential for growth in deposits?

Plotkin: Well, relative to everything else, banks should gain deposit share from the fallout of the markets. If you think about it, the migration is going from investment banks to commercial banks; from uninsured to insured. I can think of many banks that have decent deposit growth relative to the overall economy. The savings rate is going to go up, which is the good news. The bad news is, people aren’t going to have a lot of cash. For now, NSF fees are going up, but soon that will be a diminishing source of fee income growth as well.

Servat: I think we may have seen the biggest benefits from the fear factor in mutual funds or the Street already, because clearly there was a period where big banks such as Wells Fargo or BofA benefited massively from the incredible inflow of deposits as customers tried to put their money in a safe place. But now it seems everybody’s calmed down and is mostly shopping for rates rather than just for a roof over their deposits.

Mayes: There’s a real lack of liquidity everywhere. Ben’s point on deposit migration is a good one. Relatively speaking, that’s an area where you can see banks getting some of the benefit, just in terms of the flight to quality. On the other hand, a lot of banks are going into the liquidity guarantee program for funding, as an alternative to deposits. Some of the bigger banks are raising hundreds of millions of dollars at 2% to 2.5%, government guaranteed, which is nice. But that’s for liquidity and funding, not for capital. Some of those larger banks feel these measures will help reduce deposit rates because it will bring more liquidity into the banks, but I see most smaller banks still struggling with liquidity issues.

Loomis: In Curtis Carpenter’s presentation [at the Bank Director Acquire or Be Acquired Conference] he said if you look at 2007 and 2008, or even trends over time, the median deal size involved a seller with assets in the $100 million to $150 million range, and the buyer’s size has come down from about $1.2 billion to roughly $600 million. The transactions are being executed, and boards are getting their arms around the risk. Now, the deposits being acquired in these particular transactions may not be as substantive as some of the other issues we’ve been talking about, but there is clearly an undercurrent of transactions getting done where they are accepting the execution risk, whether it’s a cash or stock transaction.

Plotkin: The interesting part is we still have too many depository institutions. With a slower economy and with a great evaporation of wealth in the United States and globally, I believe the problem of overcapacity is exacerbated. We have too much capacity in terms of the number of banks, especially as investment banks become banks. So although deposit growth is a plus, the fact is, there will be great consolidation as a result of the overcapacity issue.

With this issue of excess capacity, is there a stronger case to be made for MOEs at this time?

Mayes: I think so, and there are many boards and CEOs who feel that there’s strength in numbers, who feel that if they can get together and create a bigger company, they can better withstand problems. But MOEs remain difficult to do. Interestingly, for about the last 18 months, I have found so-called social issues in MOEs to be easier and financial issues to be harder. Boards and managements are willing to work through some of the social issues-the management and board issues, board composition, headquarters location, and so on-but now it’s coming down to dollars and cents and what the right exchange ratio is.

Plotkin: I actually think the driver of consolidation in the short term will be a shortage of capital for the banking industry over the next few years. This will be the primary driver, even before the overcapacity issues. It is going to be extraordinarily difficult to raise capital. The trust preferred and the common equity markets have effectively shut down. The impetus for consolidation is different from what we’ve seen over the last 15 years.

Servat: The tough part, though, is that it comes down to the financial issues, or at least the expectations. We’ve always lamented that, but today it’s even worse, because boards are still shell shocked. I think bankers are becoming aware of the reality around them and are starting to realize that there’s strength in numbers-that there’s a need to do something-but they still can’t bring themselves to face the reality of the current pricing. I can attest to the number of recaps that we’ve had turned down by boards only just to see the FDIC truck pulling into the bank a few hours later. Those people couldn’t accept a deal that would have saved them.

Janis: I think you’re going to see things continuing to turn down in New York, New Jersey, and Connecticut. You look around and see that things are getting worse all the time in terms of real estate, both commercial and residential, and with unemployment. For the first time in Manhattan, you could see five places on the block where a bank could open a branch-but no one’s opening any branches.

Servat: The challenge is, I think, that banks tend to lag in this turnaround process. They’re like the oysters in the bay: They’re the first ones to go down and the last ones to come back up. Depending on when the economy comes back up, whether it’s early 2010 or a little further out (though hopefully not), that’s going to have an impact in terms of looking ahead. And so the question is, can you make it through that time period? There are a lot of managements that are confident today that they are adequately capitalized and that they’ve got appropriate liquidity, but clearly they should build more of a margin of safety to make these statements.

What do you believe will be the catalyst for recovery and consolidation?

Plotkin: We all know there are consolidation pressures due to shortage of capital, overcapacity, and regulatory pressures. Yet the fact remains that there are a lot of risk-averse bankers who don’t want to buy another bank. So the acquisition activity, in my opinion, is going to be kicked into gear by people who have a bigger appetite for risk, which is in keeping with past cycles. In the past, we’ve had larger consolidators that were more entrepreneurial in nature. I believe there is private equity money on the sideline positioned to do rollups and fill the role of the consolidators. These new players have more of a risk appetite as well as access to private capital. It’s difficult for a public bank today to do any significant deal because it may not be able to replenish its capital positions. So I think the private equity catalyst will begin to flip that switch. Whether that’s going to flip a month from now or a year from now, I don’t know, but I think it’s going to be within the next year.

Servat: The one thing I find encouraging is that as I go around the various regions, I find that the stronger acquirers are now starting to talk about deals. They haven’t yet pulled the triggers but we’re seeing a backlog build on the buy side-certainly, people that are seriously looking at taking the step. So I think Ben is right. What could be the catalyst is if we see private capital finally coming in.

Janis: Yet the problem with the private equity deals is the way you have to structure them. They involve many competing egos running the organization, because you have to have four or five investors with you to avoid any one investor being a bank holding company. You can’t do it alone.

Mayes: Certainly there will be some amount of private equity money that will flow into the industry when they see the light at the end of the tunnel, but my opinion about private equity has always been that they don’t fully, until the last minute, understand all the regulatory issues. My sense is that whenever this turn comes, private equity will find better opportunities in other industries that aren’t regulated. There will be some, because there’s just going to be great opportunities in the banking industry, but it’s hard to get them the kind of returns they are looking for.

Plotkin: I don’t agree. I actually think most of them understand the regulatory stuff well at this point. And I believe there’s a recognition that retail funding is very valuable. Moreover, they will be able to achieve their targeted returns at unprecendented low valuation entry points.

Servat: There’s one fundamental issue that I think they still can’t get over comfortably and that is, in our sector, you either go to zero or 100. You get all your money back, or your assets are taken away. I think that’s an issue that even the most sophisticated private equity firms still have a hard time working with, because that’s just not the world they have come from.

Do you have any advice for boards of directors that are looking at private equity as a means for survival?

Plotkin: Obviously with private equity, there’s much more of a focus on exit strategy. There’s no discussion with a private equity firm that doesn’t include, “OK, what happens three years from now or five years from now?” Plus, they want a high degree of confidence that the board is going to support their growth strategies and performance standards for management, and most boards aren’t used to that type of conversation.

In short, I think these are extraordinary times in many respects because the shortage of outside capital will make banks consider things they wouldn’t have otherwise considered. Similarly, we are seeing the regulators do things we didn’t expect them to do. And the regulators are going to encourage private capital coming into the industry because ultimately, taxpayers are expecting to be paid their TARP money back. But for that to happen, all of us-investment bankers and the government and the banks-are going to have to get creative in finding ways to attract both private and public capital.

Mayes: If you’re on a bank board and you’re in a situation where you need to do something, and you’re talking to private equity players, you need to be extraordinarily careful with what’s being proposed. You have to do your best to have other alternatives that you can evaluate relative to that option. You need other alternatives to keep the private equity money honest, as well. But again, when you look at the mortality rates in private equity deals for banks, there’s a very high level of execution risk,-I would say a higher-than-normal level of execution risk, for all sorts of reasons. I think you’ve got to be very, very careful.

Loomis: Based upon the precedents of Washington Mutual and National City, private equity has become quite cautious. Stir in a dose of government changing the rules of the game frequently-for example, why save Bear Stearns and not Lehman, why wipe out the common and preferred stock of Freddie and Fannie, but not AIG-and I believe private equity is deservedly suspicious of the sector. As a result, my advice to a board would be to forget pursuing private equity as an alternative. It will become an option as the sector’s stock prices start to rebound, but most likely not before 2010.

The Banking Landscape: Regulatory Oversight and M&A

In this session, our three deal experts advise bank boards to maintain a strong hand on core values and capital at a time when financial institutions are receiving tough regulatory scrutiny.

Session Participants:

Steven D. Hovde, president and CEO, Hovde Financial

Stephen M. Klein, Attorney and chair, Financial Services Team, Graham & Dunn

Dory A. Wiley, president,Commerce Street Capital LLC

How does the current political environment that is pushing banks to lend contrast with the very real capital constraints many are experiencing and the need for banks to maintain tight underwriting standards in the wake of a global credit crisis?

Dory Wiley: It’s really interesting that you can’t get everybody on the same page with regard to this very difficult issue. The regulators are telling banks not to lend. Everybody in Washington is telling them to lend. At the end of the day, what they don’t realize is you can lead a horse to water, but you can’t make him drink, and you certainly can’t make these bankers lend just because you are giving them money. Now they are coming up with new incentives. [FDIC Chair] Sheila Bair is talking about tying consumer loans to TARP money or long-term bond money. I think this type of thing is really dangerous because when you look at what happened in the past, it’s this push for Washington to direct lending that helped get us in this mess, specifically with subprime and the expansion of Fannie Mae and the GSEs.

Steve Klein: First, I totally agree that there’s a huge disconnect between Congress and the regulators, with Congress wanting to promote lending and the regulators hammering banks for credit quality. Part of the solution to turn the economy around is a government-guaranteed lending program. All the banks I’ve been in say they’re not going to be aggressive in lending unless there’s some type of protection. So it probably would be more prudent to get the money out there sooner banks can lend to small businesses so they don’t go out of business and people don’t lose any more jobs.

Steve Hovde: I think there are other related issues, however, and one, notwithstanding what Congress is saying, is the data that shows that banks’ lending portfolios are actually up. So the belief that there’s no lending going on is just wrong. It’s a question of who those monies are being lent to. The second issue is, there are parties out there that simply should not get monies lent to them because that’s what started the problem in the first place. The third and major, problem is that many of the ideas that are proposed by Congress and our senior regulators don’t work. This whole concept of modifying the bankruptcy law brings to mind the old adage that you always have to look for the law of unintended consequences. Who’s to say that somebody is worthy of a cramdown?

Klein: I’m going to be a little more pragmatic. I believe in order for this country to turn the economy around, we’ve got to bottom out. There will have to be criteria, but let me use a California borrower as an example. Say someone bought a house for half a million dollars two years ago in San Diego, and they put in $100,000 in equity, which is a good amount of equity. That house today is down 40%, so it’s worth $300,000. Furthermore, they have an adjustable-rate mortgage that’s going up. Whether the government supports it, or the bank, or some combination thereof, I think a better way of doing it would be to reduce that obligation to $300,000, and then make any future appreciation in the house shared between the lender and the borrower. The reason I say that is if we do not stop foreclosures in this country, home prices will continue to go down, creating more foreclosures. And we must stop that, and we must get money into the system and into small businesses. In the past, the consumer has taken us out of recessions, and right now the consumer is tapped out. So we’re going to have to make unprecedented moves, even though it’s going to cost all of us as taxpayers. To me, the sooner you start the process, the sooner the turnaround, and the less expensive for all of us.

Wiley: While we’re on the topic of lending and capital, I think we need to make a dividing line between community banks and large-cap banks. The community banks, by and large, are not in near the trouble of the large-cap banks. And it’s the large-cap banks that will bring down the economy.

In my mind, the only way Congress can really fix this problem is by setting up a national “bad bank” to take a lot of the problem assets out of these big banks so they can delever, but even so, that’s going to take a long time. When you’re talking about banks that are 80 to 100 times leveraged with their off-balance sheets, you just can’t fix that overnight. It’s a big problem. So it winds up spreading to the community banks, even though the community banks didn’t start this problem.

Hovde: One other point Dory touched on is the disconnect between the senior regulators running the agencies and the line examiners. The line examiners are pounding on the banks, such that the natural reaction of the bankers is to stop lending or be pickier than they’ve ever been before, so they’re stuck between a rock and a hard place. If they try to lend, especially to someone with stressed credit quality, the examiners are pounding on them. On the other hand, the examiners are forcing greater and greater provisions and greater and greater chargeoffs, so the bank is stuck in a position where it can’t grow its balance sheet, because that would further stretch its capital ratios The banks have to shrink their balance sheets to preserve capital ratios. The line examiners are taking positions that are the exact opposite of what’s being preached in Congress or by Sheila Bair, so there’s a complete disconnect within the regulatory agencies themselves.

What about solutions to clean up weakened and failing banks-specifically the bad bank proposal.

Klein: Well, first of all, under the bad bank scenario, the regulators will have to make choices as to which banks have the capacity, both managerially and capital- and liquidity-wise, to work their way out of their problems and those that can’t. Right now all banks are being treated the same way, which is a problem.

Wiley: Yes, they’ll need to define that. If you look at any credit cycle in history, even going back 200 years, credit cycles can evolve into liquidity crises. They used to call them “panics.” I actually think that’s what we’re in, a full-fledged liquidity crisis panic. But the cure always involves two things: a lender of last resort and a degree of forbearance, which is what Steve [Klein] is talking about here. Part of the problem is that FASB 157 and other things like that are accentuating the situation. So there needs to be an orderly element of identifying good management teams that can withstand this crisis if we give them some forbearance.

Klein: And we haven’t talked about the other key element, which is the regulators’ position toward brokered CDs. When a bank gets into trouble, the FDIC will shut them down on brokered CDs. Now, you can argue the pros and cons of brokered CDs, but the reason the regulators take this position is because, from a liquidation standpoint, if that bank were to fail, there’s no value to the system, and the FDIC has to pay out the brokered deposit. Instead of looking at this as a going concern, the FDIC is looking at it from a liquidation standpoint.

Hovde: Moreover, the theory that brokered CDs are necessarily evil produces more unintended consequences because it forces banks to look for financing elsewhere. There has to be a rethinking on the part of regulators not to blame all the bankers; the problem is more a case of how the regulators approach the issue. And maybe the idea is to work toward a proper level of forbearance, which can be determined on a case-by-case basis.

Klein: Actually, I think the real theme should be not to blame regulators or bankers-everybody should share in some responsibility. I think everybody needs to work together to find a solution because what we have is a country in crisis. And regulators who are trying to watch their backs and blame the banks and take draconian methods are not solving the problem. I think we have to work together to find solutions that will turn this economy around, and that means making tough decisions rather than treating every bank the same way with mechanical ratings.

In your minds, is there a good plan that the regulators could carry out that would alleviate the current stress level?

Klein: In my opinion, the FDIC does not have the resources or the infrastructure to deal with all these problem banks and problem assets. This could be a monumental task beyond its capacity.

Turning toward the topic of mergers and acquisitions, banks are obviously going to be grappling with growth issues in this down economy. Is it a good time to buy?

Wiley: Absolutely, it’s a great time for buying banks, because there are very few competitors. However, you’d better make sure you’ve got a handle on the asset quality. I remember addressing this topic last year, and we talked specifically about not taking due diligence for granted, even then.

Klein: No more fly-by due diligence.

Wiley: Absolutely. But yes, it is definitely a buyer’s market, and it is going to become even more so. I think it’s wise to have good partners among your shareholders where you have ready access to just-in-time capital, so you can do deals on your own terms.

Hovde: As we’ve said, the key is due diligence, and if you can get comfortable with that-which is tough in today’s environment-then it’s a good time to do transactions, whether they’re outright buys for stock or cash. The only problem with cash right now is very few buyers want to give it up, because they don’t want to deplete their own capital. So I also think we’ll see some MOE-type structures, with companies saying, “Let’s come together, wring out some costs, support our combined balance sheets, and weather this for the next two or three years.”

The other issue, though, for healthy banks trying to find a buyer now, is that a lot of the active buyers are saying, “I’m going to go after FDIC-assisted deals. I may be interested in you in a while, but I’m going to wait and see what happens.” Take the buyers who are healthy in Southern California, for example. They’ve got their choice of going after a few healthy banks, some of the troubled banks, or what’s going to be a lot of FDIC failures. So until that supply is used up, it’s going to be more difficult for a healthy bank or even a semi-healthy bank to sell and find a partner, unless the deal just involves very low pricing and two parties coming together for the common good.

Wiley: That’s actually my favorite deal in this market. You take two small community banks, say $1 billion to $3 billion in size, and do an MOE where there’s no goodwill involved. Suddenly you’ve got some lending power, because if you’ve got a little size built up, you can take all the business you want from the large-cap banks. They are literally kicking it out the window.

Klein: Plus you’ve got some efficiency. I agree with that, and maybe that’s where the model’s going to be. We’re in the business of doing deals, and, unfortunately, it’s been a dry spell. I agree with Steve. The asset quality of the target is an issue, as well as the lure of the FDIC-assisted deal. I think one other problem that’s been exacerbated lately is that stock prices are so low, even good buyers are finding it very difficult to give up their stock. And as Steve said, they’re very reluctant to give up cash, even if they got TARP, because everybody’s worried about their own asset quality, and even if it’s in pretty good shape, it could deteriorate. So even though there are some good fundamentals for buyers, until there’s some stabilization in the market, it is going to be challenging to do deals.