2010: A Game-Changing Year for Bank M&A

Roundtable participants

John Duffy, Keefe, Bruyette & Woods

Ron Janis, Day Pitney LLP

Bill Hickey, Sandler O’Neill & Partners

George Mark, Grant Thornton LLP, roundtable sponsor

Michael McClintock, Friedman Billings Ramsey

At the 2010 Acquire or Be Acquired Conference, Bank Director gathered two panels of industry experts to discuss the landscape for financial institutions in the coming year and the most critical issues facing bank boards. The highlights of these M&A roundtable sessions, sponsored by Grant Thornton LLP, are presented in the two reports that follow.

Let’s begin by talking about the major developments that occurred in the last year and how you each might describe the new environment for the banking industry.

Bill Hickey: There were a lot of interesting things that came up in financial services that we haven’t seen in years-different participants that no one would have dreamt of four or five years ago. The way that private equity has participated in the recapitalization of the sector is a major development, and the FDIC gearing up to essentially replace the old RTC is another example. So 2009 was exciting and I don’t think 2010 is going to be categorized as normal either.

John Duffy: Eventually, I think 2008 and 2009, and maybe 2010 will be looked at as a bridge period and right now, I don’t think any of us really knows where this is going. Eventually, we’ll have a little bit more clarity about what the future really looks like. But a lot of what is happening to change the industry is going to be dictated by Washington, and so far they’ve been slow to adopt reform. It’s a whole new game.

Ron Janis: I just don’t think Congress is going to ever get anything passed because they’re so busy fighting with each other. In the meantime, the regulators are the ones who are changing the landscape, but I don’t think they’re changing it in a uniform way. I think the Federal Reserve Board is more accommodating than the OCC and the FDIC. So right now, unfortunately, it’s an uneven landscape.

George Mark: It’s pretty clear that it is a new game, but in the next couple of years there’ll be new players, too. We saw private equity coming in this year, and next year who knows what type of players we’re going to see? But it’s clear that the strong will get stronger, and capital and liquidity are key, and they always have been key. But we have new players, in a new game.

Janis: But I don’t think that private equity is going to be as big a factor as everyone thought it would be, because the FDIC and the Fed just don’t want it.

Duffy: It may be one of the things they have to resort to at some point in time. Most of us were surprised that private equity didn’t get a chance to play more than they did, but we’re not out of the woods yet, so I wouldn’t throw dirt on them yet.

Michael McClintock: Well, first, the government got much more involved in 2009. Second, the regulators are definitely sending mixed signals, both to the banks they cover by not seizing all the ones that have really high nonperforming assets, as well as by changing how they evaluate the banks. Based on what we see, I believe that private equity players are going to get more involved, because the government is definitely welcoming their involvement.

Mark: I agree that private equity might well continue to flow into the industry. They’re trying to get in and figure out ways to “skin that cat,” based on the high level of ROI.

Hickey: To the extent that there aren’t strategics that are willing to play, there’s no choice but to allow private equity in, because they’ve got the money! Now what will be interesting, as you play the clock forward, is when the early accretion runs out and private equity is running the institution with their managers, and at some point more money has to be put in. That’s what has always scared the regulators about allowing private equity in: If more money is needed, will they be writing checks? That’s the big question.

Duffy: That’s why I don’t want them overcapitalized coming out of the gate.

McClintock: Only if it makes sense. The private equity guys will only make a follow-on investment if it makes sense.

Janis: If it makes sense from the point of view of returns-that is the question. This is not an industry where you can make returns easily.

Duffy: No, but it is an industry where there have been huge returns made at particular points in the cycle. And we’re presumably at one of those points.

So with few opportunities for acquisitions this year that don’t involve a failed or weakened bank, alternatively, do branch acquisitions make sense?

Hickey: We are seeing some, but they’re extremely difficult, primarily for two reasons. First, the sellers of branches are competing with the FDIC, so in essence, why pay a premium when you can do an FDIC deal essentially for no premium? But the more difficult issue is, those that are selling branches have to put something on the asset side of the balance sheet along with the liability side, which becomes very challenging.

Duffy: Plus, I don’t think the regulators are the biggest fans of branch sales. The regulators don’t necessarily want a bad management team peeling off perhaps the best part of the franchise and getting a modest premium for it, thinking the company may not make it anyway. So the regulators wind up owning the company, but it’s not as desirable as it would have been without peeling off those good assets. So I agree wholeheartedly, it’s not as easy as it should be, and the lack of liquidity is the major stumbling block.

Hickey: As long as the government is in the business of selling banks, branch sales are going to be hard to accomplish. And John’s point is a good one: The regulators are not enamored with branch divestitures. They view it as selling the crown jewel, and if it’s salable, they want the franchise to be kept intact, in case they have to sell the whole institution at some point.

Let’s shift over to capital. In your opinion, do you think banks are doing all they need to do to stabilize their capital structures, and are they ready for the losses that will inevitably occur as the recession continues to play out for the next 12-18 months?

McClintock: Reserve coverage is only about 50% of the nonperforming assets, so we think a lot more capital has to be raised. If we have a double-dip recession, I think a lot of banks are going to go under that look like they’re only going to bump along on the bottom today.

Mark: Capital is going to be a key, and I’m not seeing an end to any cycle. I think the cycle is going to continue for a while, and as the losses continue to grow, you’re going to need more capital to fund those losses. The margins increased slightly this last quarter, but they can only increase so much.

Duffy: Significant capital needs to be raised in terms of the industry having made progress, and the industry seems to have learned that if its capital is in trouble, the way to fix it is to restore the tangible common equity, and then you may be able to build on that at some point. But those other markets, such as trust preferred, are shut. So in general, the capital needs are enormous, even if you don’t believe we’re going into a double-dip recession.

Hickey: I agree boards and managements have a more enlightened appreciation concerning their own capital needs. They’ve seen what happened to the bank next door or down the street and they don’t want to be in that position. So as painful as it is to raise capital at the present valuations, they better understand why they need to raise capital, because any number is better than zero.

McClintock: I call it crossing the river-survival versus dilution-where someone says, “We don’t want to get diluted, we don’t want to get diluted …” and then they say, “Wow, I think we’d rather survive!”

Hickey: But while we all talk about the need, I don’t know whether any of us can answer the question of where all that capital is going to come from. We’ve all talked about this with a lot of folks in the public markets and the private markets. And I think the potential exists to raise capital at some point in the future, when we think we’ve hit the bottom. I mean, you could make the argument that we’re probably at or near the bottom on the residential side because the rate of decline has slowed down and we’re basically bumping along the bottom. This doesn’t mean you’re at the absolute bottom, but you’re probably in the same area code. But in terms of what commercial real estate is worth, I would argue we’re not going to know that, definitively, within the next four to six quarters.

Aside from closures, what are the other major implications for banking this year?

McClintock: The specialty finance businesses need leverage, and there’s very little leverage. No warehouse lines, very little funding available for nonbank financial services. That is only slowly creeping back, and financing outside the banking system is something like two-thirds of all financing in the country. So we really need that in order to spur growth.

Duffy: In my mind, it’s really a twofold question of when does the securitization market come back and what does it look like?

Mark: And the cost of capital is very high for specialty finance companies. We have got to figure out a way to reduce the pipeline so the capital flows more freely to the specialty finance companies.

Hickey: When you think about it, we’ve seen staggering core deposit growth in the industry over the course of the last 12 months. And as things get a little bit better, it will be interesting to see how these banks handle deposit flight and what it does to the cost of funds and profitability. I tend to be an optimist, but we’ve got a very bumpy, long road ahead. Once we get through this recapitalization issue, we know rates will go higher and the curve will tend to flatten. That’s going to create some challenges that all but the most proactive bankers aren’t thinking about right now.

Janis: It’s all going to be difficult, and I think specialty finance is going to come under even more regulation. Certainly there is an impetus, just as in the residential mortgage area, to bring that area under a federal umbrella.

Mark: We need to get more consistencies in the whole regulatory framework that we’re operating under. Right now, there is a lot of regulatory uncertainty. There has to be some type of change and some type of consistency so that the industry can have a level playing field where institutions can understand what it is they have to comply with.

Hickey: Plus, I do think that there needs to be a little direction from the top on how field regulators examine their constituents, because different field regulators can treat two banks with the same problems entirely differently.

Finally, what do each of you believe are the best opportunities for companies that are looking to pursue a growth strategy for the next 12-18 months?

Duffy: The current environment provides a once-in-a-career opportunity for some banks to move the market share needle. I also think there’s a high level of frustration among some bank employees who will consider a career move to a smaller institution just because they feel it’s less encumbered. So I think smaller institutions will have the ability to attract talent out of some of the larger institutions to a degree we really haven’t seen much of in the last 10 to 20 years.

Mark: I think there are going to be a lot of opportunities, and the thing that institutions need to realize is that it’s “buyer beware” in many cases. There’s so much opportunity but you’ve got to make sure that it’s properly vetted, and that you understand what you’re getting into.

McClintock: I agree, it’s an unprecedented opportunity for banks that have the management and the capital to take advantage of the FDIC auctions and their weaker competitors. For example, during the last crisis, an old client of mine, Medford Savings Bank [Medford, Massachusetts], bought The Bank for Savings in Malden next door-same size-so in essence, it doubled its size and took huge market share in both towns. That’s completely available now to people who are in the position to do that.

Duffy: And the cost saves if you can do an in-market deal like that are off the chart.

Hickey: And cost savings drive any dilution away as it relates to capital that has to be raised. So the one thing that managers should consider as they evaluate these huge opportunities in a target-rich environment is to be very patient and cautious. One thing we all know-and it’s certainly been illustrated in a lot of the FDIC deals that have been accomplished-is that investors are happy to invest money in smart transactions. So if there is a glimmer of hope in the M&A market, well-priced, smart deals will attract capital. That may mean you have to bring an investor or two under the tent in the context of merger discussions, which none of us in this room ever like to do, but that’s the kind of creativity that the market is going to need. Once you get one or two of those deals done, there tends to be a herd mentality in the banking industry, and that may breed some more deals, so there may be some hope there.

Janis: I agree with the investment bankers. There are opportunities. I think that if you are not risk-averse you’re going to be able to handle this situation. But if you sit still, you might be outmaneuvered by others.

Duffy: My concern is not so much how risk averse they are, but in many instances, my concern is that the management depth is not there or the executive management is not convinced its team can really execute on an opportunity. I also think bankers are concerned about the operational risk of greatly expanding the franchise in a short period of time. There are some banks that certainly could have been more opportunistic than they’ve been in the last six or nine months and, who knows, maybe they’ll get there. Maybe they’re just being patient. But I get the sense some of them feel they have dodged a bullet, and they really don’t have as much confidence as you might assume they have-as well as the troops to be able to double the size of their institution-to take advantage of whatever the opportunity might be.