Texas Proud

The year was 2000, and one of Southwest Bancorporation of Texas’s biggest corporate clients had been acquired by Enron, the then-high-flying energy giant. Houston was swept up in what some called “Enron fever,” and Southwestu00e2u20ac”a bank that caters to middle-market businesses but yearns for the big timeu00e2u20ac”was no exception. So when Enron officials asked Southwest to continue the $15 million line of credit used by its acquiree, what wasn’t to like? “We said, ‘We get to bank Enron? Sure. Absolutely,” recalls Walter Johnson, Southwest’s 68-year-old chairman.

The account was handed over to Randy Meyer, then an executive vice president, who began spending time at Enron headquarters. He met with the CFO, went over the books, and chatted with representatives from the likes of J.P. Morgan Chase, which had lent the company billions. A couple months later, Meyer came back to his bosses with a disturbing admission. “He said, ‘I’m just not smart enough to understand Enron. It’s too complicated. They’ve got all these operations off the balance sheet. And they seem highly leveraged,’” Johnson remembers. And then this: “I don’t think we should be lending money to someone we don’t understand, no matter who they are.”

Other banks might have questioned Meyer’s sanity, or even showed him the door. The budding relationship with one of the Fortune 500’s glamour companies promised untold riches. Why blow it? Instead, Johnson and CEO Paul Murphy Jr. followed the officer’s gut and severed the relationship. The rest, as they say, is history. Less than a year later, Enron commenced a slide that would make its name synonymous with corruption and leave its lenders trying to explain themselves to investors and regulators. Southwest, its decks clear of any Enron obligations, promoted Meyer to chief financial officer.

The story illustrates the balance between risk and growth that has helped make Southwest one of the hottest success stories in Houston. Under the guidance of a hands-on board, Southwest has mixed acquisitions, salesmanship, and technological innovation with balance-sheet conservatism and a pride for all things Texan to emerge as a leader in the race to recreate an in-state banking powerhouse.

“Walter set the tone for the bank,” says J. David Heaney, 55, a director since 1990 and chairman of Heaney Rosenthal Inc., a private investment firm. “We want things simple and straightforward, conservative and clear. That’s how we evaluate loans, and it’s how we evaluate M&A. We’re not trying to make money with smoke and mirrors.”

That’s not to say Southwest’s board doesn’t have lofty ambitions. In the Lone Star State, there’s no sin in thinking big, and directors aren’t shy about espousing Texas-sized dreams for their institution. “Our motto is to be the state champs by 2008,” says John Brock III, 71, a board member since 1992. “We’d like 100 branches in Houston, somewhere close to that in Dallas-Fort Worth, and to be moving into the San Antonio-Austin corridor.”

The only thing standing in Southwest’s way appears to be a handful of in-state rivalsu00e2u20ac”San Antonio’s Cullen/Frost Bankers, Texas Capital Bancshares in Dallas, and El Paso-based International Bank of Commerce among themu00e2u20ac”that share similar aspirations. Those banks, and a cadre of other independents that emerged from the ruins of a late 1980s state banking crisis, face stiff competition from national players, including J.P. Morgan Chase and Wells Fargo & Co., and envious outsiders, such as Wachovia Corp., eager to expand their footprints in one of the country’s most promising markets.

Few, however, have come as far, as fast, as Southwest. From modest beginnings as a $50 million, one-branch outfit when Johnson signed on as CEO in 1990, Southwest has blossomed into a $7 billion institution with 75 branches in Houston and five in Dallas. In 2003, assets grew 18%, while revenues jumped 13%. Nonperformers as a percentage of assets totaled just 49 basis points.

The ride hasn’t been totally without bumps, but shareholders have been rewarded nicely for their faith. The company went public at $10 a share in 1997 and now trades around $42. “It’s been one of the fastest-growing banks in the country, and one of the better performers,” says Brett Rabatin, an analyst with FTN Midwest Research in Nashville.Directors, all of whom own stakes in Southwest, have done even better. Brock says his cost basis for shares purchased in 1990 is $1.39u00e2u20ac”good for a 30-fold gain on his original outlay. “It’s been a fabulous investment,” he chuckles.

The 15-member board’s role as a strategic partner with management is largely credited for Southwest’s success. “This is a board-run company all the way. We’re not old buddies of the CEO,” Brock says. Murphy, 44, calls the group a “$90 saddle on a $10 horse,” a Texas euphemism, he explains, for “an extremely strong board for a bank our size.” It’s a close-knit group, one that celebrates birthdays and engages in recreational outings together. “I’ve always said, ‘If you don’t hunt or play golf, then you can’t really be on our board,’” jokes longtime director Wilhelmina “Beth” Robertson, 57, president of Westview Development Inc., a Houston real estate firm.

The board has overseen the purchases of six banks and two specialty finance companies over the past seven years, adding roughly $2 billion in assets to the balance sheet. Among those deals: this May’s $165 million purchase of Klein Bank, a $571 million institution with 27 branches in northwest Houston, and a $43 million deal for Reunion Bancsharesu00e2u20ac”the company’s first official foray into Dallas.

The remaining $5 billion has come mostly from organic growth, much of it inspired by directors who are expected to leverage their community connections to drum up business. At each board meeting they turn in a prospect report and receive updates on the status of referrals passed along at earlier meetings. In many cases, “we’ll ask them to make a call with us, on the bank’s behalf,” Murphy explains. “It’s considered part of serving on the board.”

More important, directors act as a sounding board for strategy and provide oversight. At Southwest, ideas flow from management, but the board is empowered to veto themu00e2u20ac”and sometimes does. One time, Johnson recalls, management wanted to buy an office building for the bank, but the board rejected the idea, arguing that a small bank “shouldn’t be in the real estate business.” (Later, when the company was larger, it bought a building.)

Another time, Johnson and Murphy brought an acquisition candidate to the board, only to have the deal shot down. “Here I was, the CEO and chairman of the banku00e2u20ac”the guy who brought in all the capitalu00e2u20ac”and I wanted to make a $50 million acquisition, and they wouldn’t do it,” Johnson says. “Do I think it was a mistake? Yeah. I’d still do [the deal] today. But you shouldn’t have a board if you’re not going to respect them and feel confident in their counsel.”

The board, in turn, has learned to trust management’s instincts. Southwest’s target niche is middle-market business (though it has recently begun pursuing retail clients, as well), and Houstonu00e2u20ac”home to a thriving energy industry, a large port, fast-growing tech companies, and state-of-the-art medical servicesu00e2u20ac”provides fertile ground.

In middle-market business, national banks are the chief competition. But being Texan goes a long way toward winning that battle. “Texas companies want to bank with Texans if they can,” Johnson explains. But clients won’t skimp on service or technology. Early on, the then-CEO lobbied the board to invest in a suite of treasury management and other technologies to level the playing field against those bigger competitors. In the region, Southwest had a distinct advantage: As a bank without big legacy systems, it was cheaper and easier to add new technologies. But the numbers were still large for a small bank, and the board had to be persuaded to overcome some misgivings over the costs before pulling the trigger. In the end, the fact that most directors were also customers helped. “It was something we, as individuals, wanted for our businesses. So we understood the importance of offering it,” Robertson says. The decision, however, was still difficult for some to swallow. “I’ll tell you, the first time around, there were some white knuckles in that boardroom,” Heaney says.

Such spending decisions, so crucial to Southwest’s growth, have become old hat. Several years back, Johnson was shopping for a new wire-transfer system. The company’s 200-strong tech team narrowed the choices down to threeu00e2u20ac”one cost $250,000, another $500,000, the third $750,000u00e2u20ac”and lobbied for the middle one. When the CEO learned that the priciest system was the same one used by Citicorp, he lobbied the board for itu00e2u20ac””imagine being able to tell clients we had the same system as Citicorp,” he saidu00e2u20ac”and the directors readily agreed. More recently, a new imaging process that helps hospitals better manage insurance payments has brought in several large customers.

Brock notes there’s a constant effort to remain a step ahead of the trendsu00e2u20ac”and the institution’s own growth. The board has embraced a push to implement the latest in customer-facing applications, such as online statements and imaging technologies, and has also put an emphasis on ensuring that it has the capacity to handle more growth. “This is a bank that’s way over the handlebars all the time,” he says, adding that directors are presently examining “what a $12 billion bank needs to be competitive.”

Directors who say this has all gone according to plan would be lying. Southwest traces its roots to 1982, when a group of Houston business leaders founded Northwest Crossing National Bank. It was a time when giants such as Texas Commerce, First City of Houston, and Allied Bank of Texas not only dominated the local landscape but ranked among the largest banks in the country. As the founders figured it, those institutions had become more worried about serving Fortune 500 companies than small-business clients, thereby presenting an opportunity.

“The environment was right for local de novo banks, and we had a good location on the northwest side of town and some directors with strong business contacts,” recalls John Johnson, the bank’s founding chairman and present chairman of Permian Mud Service, an oil services company.

The Texas economy back then was heavily reliant on energy. Banks, like the rest of the state, rode a wave of rising oil prices to untold riches. The giants cashed in big, as oil-related firms borrowed heavily to finance an unprecedented expansion, and every other sort of business piled in behind. “Oil was $40 a barrel and headed toward $100,” recalls Walter Johnson, who was Allied’s CEO at the time.

Then oil prices began falling, eventually settling near $10. Exploration halted, and the economy’s foundations began to crumble. New tax laws, instituted in 1986, made investment properties less attractive, lowering the value of collateral. Overnight, the state’s banking system began to teeter. Hundreds of banks failed in the late ’80s, and several of the big banks were liquidated, their customers falling into the hands of national giants. Texas bank directors, meanwhile, spent a lot of time in court defending themselves against regulators and investors.

Among the big banks, only two survived: Texas Commerce (later acquired by Chase Manhattan) and Allied. When California’s First Interstate Corp. bought Allied in 1989, Walter Johnson stayed on as CEO. “But they had bought the railroad, so I wasn’t really driving the train anymore,” he says.

Northwest Crossing felt the pain of the collapse, too. Its only saving grace was that its board was too conservative to have taken many risks. “Our business instincts were such that we wouldn’t allow the bank to become overextended,” John Johnson, 59, says. It remained an uninspiring, “tiny little bank” with $50 million in assets and that same single location, recalls Robertson, another one of the founders.

What happened next is the stuff of which legends are made. The two Johnsons, Walter and John (they’re not related), were brought together by one of Northwest’s former officers, and a deal was struck. Walter, one of the city’s most respected bankers, would join the company and use it as the foundation for building a new institution. John’s group, pining for growth, would embrace a vision built on Walter’s connections and know-how. “The idea,” Heaney recalls, was that Walter and his Allied protu00c3u00a9gu00c3u00a9, Murphy, “would go to their old customers and bag them one at a time, the old-fashioned way.” They’d start small, by necessity, and move up the ladder as the institution grew and lending limits increased.

For board members, the aspirations were so great that the bank’s name was changed from a local oneu00e2u20ac”Northwest Crossing reflected its location in Houstonu00e2u20ac”to one with a more regional feel. “The vision from the start was to build a new [regional] bank,” Heaney says. But even some directors harbored doubts. When he joined the company, “Walter told us, ‘I’d like to raise at least $12 million’” to recapitalize the bank, Robertson recalls. “We said, ‘Gosh, Walter, that sounds great. Good luck!’ But banks were closing left and right. We weren’t sure he had much of a chance.”

Walter Johnson understood the skepticism and didn’t even bother trying to hire an investment bank. “The whole town was being run by bank workout departments from other parts of the country,” he recalls. “There weren’t many people interested in investing in a Texas bank.” Instead, he pulled out his own Rolodex and began recruiting investors from the Houston business community who had risk capital to lose. “This was a risky deal,” he concedes, “and I only wanted investors who could hand me a check and not look back.”

Among them was Heaney, a former banking attorney who took a meeting with Walter Johnson as a courtesy to a former client, but had no interest in investing. “I heard Walter’s story, and I looked at his team,” he recalls. “And by the time I left, I had invested $300,000 and was on the board.” Others followed. In total, 125 investors put up $23 million.
Key to the plan was forging a board that could walk a tightrope between business development and oversight. The group included several directors from the old Northwest Crossing, supplemented by attorneys, accountants, and people with public board experience. “We wanted people with skills who weren’t afraid to stand up and say, ‘Don’t do this, do that,’” Walter Johnson says. Adds Heaney: “I was no close, personal friend of Walter’s who would do his bidding. I’m a guy who had some expertise he liked.”

To raise his comfort level further, Walter Johnson instituted controls to guard against a replay of the 1980s. Chief among them was a detailed analysis of every loan based on cash flow, not collateral. “In 1987, you’d go out and look at a little office building you’d repossessed and ask, ‘Who was the tenant?’ And it was a manufacturing company. But they made valve actuators for an oil company. So it was really an energy company,” he says. Today, “we classify loans by where the cash flow ultimately comes from, not the industry or collateral value.” Only 13% of Southwest’s loans have an energy connection, he adds.

Despite such restrictions, the bank has expanded rapidly. So, too, has the board’s role. Directors debate key issues, but rarely argue. Rather, the group seeks consensus before formal action is taken, and management works hard to ensure that board members aren’t surprised. Directors are apprised of pending and potential actions through a steady stream of phone calls, emails, and readings, and many swing by the bank’s headquarters at least once a week to check in. They’re also invited to management retreats. Those who can’t attend such gatherings are given a synopsis of what was discussed.

As the issues grow bigger and more complex, directors say their workloads and time commitments have increased. Being a board member of a fast-growing company “means you have to ride herd on the company’s operations like crazy,” Heaney says. “You can’t just go to meetings once a month and be effective. You have to think about it all the time.”

The full board continues to meet just four times a year, meaning more matters are handled at the committee level. Its reliance on outside experts has increased, as well. In 2003, for instance, the compensation committee reviewed executive pay levels, relying heavily on Hewitt Associates, a consulting firm, to provide comparisons to other banks in the $5 billion to $10 billion range, and advise on best practices. Given Southwest’s recent growth, the consultants found a need to “catch up,” says Brock, the committee’s chairman. “When you look at those numbers, there’s a clear correlation between the size of an institution and senior management compensation.”

The comp committee also has begun to look more closely at issues like succession planningu00e2u20ac”delving several layers into the upper management ranks to identify up-and-comers. “It’s the board’s role to ensure we’re developing guys on the benchu00e2u20ac”EVPs, senior vice presidentsu00e2u20ac”who are ready to step in and keep the ball rolling,” Brock explains.
Sarbanes-Oxley and new SEC regulations have raised the stakes as well, though not as much as with many companies. Southwest directors uniformly say that living through the harrowing 1980s in Texas provided more discipline than any law ever could to install proper controls. An internal auditing group has long been given free run of the organization, and several years ago, “we had a team [of outside auditors] scrub the whole bank,” Walter Johnson says. “They identified every risk and prioritized them based on which could be most expensive.”

Even so, being public has changed the shareholder base enoughu00e2u20ac”some 80% of shares are now owned by institutionsu00e2u20ac”that the board recently called on Charles “Hank” Still, a respected securities partner with Fulbright & Jaworski in Houston, to conduct a governance review. As a result, a “fine-tuning” of policies and committee charters, overseen and verified by the audit committee, was pursued. Using an outside law firm “was extremely helpful,” says Heaney, the audit committee chairman. “They reviewed everything and told us, ‘This is on track,’ or ‘You need to do more here.’ And they helped implement the plan.”

Growth also has raised some sticky issues for the board itself. Like many banking companies, Southwest employs both a holding company board and a bank board. Murphy says the two boards’ responsibilities “overlap a lot,” so both are kept in the loop on important matters. “As a practical matter, there’s very little difference,” he says. But it’s also true that the holding company board has broader strategic powers, such as approving acquisitions or key spending decisions.

Southwest’s model calls for recruiting directors from new markets, like Dallas, to help drive businessu00e2u20ac”something that could keep some deserving bank board members from jumping to the holding company body. “You could see where someone on the bank board could step back and say, ‘Wait a second. I’ve given this enterprise five or 10 years of service, and now they’re bringing somebody new into a position higher than mine?’” John Johnson says. “It’s a difficult issue, but we’re not going to accomplish what we need to accomplish without someone having their feelings hurt.”
Most banks would gladly take such problems. From an uncertain start, Southwest has ridden its conservative culture and forward-thinking board to results that not even Walter Johnson could have foreseen. “To be honest, I don’t think we’ve made any mistakes. Zero,” he says. The future, too, looks bright. Rabatin, the analyst, projects year-over-year EPS growth of 18% this year and 24% in 2005.

The only thing that might stop this ride in the near term would be an acquisition by someone else. Several Texas outsiders have already taken a run at the company, directors say, though the board’s response has been tepid. “We’re shareholders, so we’ll listen to anything,” Heaney says. “But we’ve been growing at such a fast rate that you can’t offer a 20% premium and interest us much. We’ll be at that price 12 months from now anyway.”
Besides, selling to an outsider at this point might be viewed as a betrayal by some local clients and would certainly amount to giving up the directors’ dream of being the “state champs” of Texas banking. “Our customers value our localness,” Heaney says. “If we gave that up, much of the magicu00e2u20ac”and the visionu00e2u20ac”would be gone.” That’s something few Southwest directors appear willing to sacrifice, regardless of the price.

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