There are defining events in the lives of most companies and the people who run them, and for Western Alliance Bancorp. that experience was the collapse of the residential housing market in 2008. The bank was heavily exposed in Phoenix and Las Vegas-two of the hardest-hit markets in the country-and it ended up taking a $236 million loss for the year, nearly twice its combined profits of the previous five years.
The bank’s leadership team was already worried about a softening real estate market before before the housing bubble burst. Robert Sarver, who was Western Alliance’s chairman and chief executive officer at the time, raised the alarm with his board in 2007. “Robert said, ‘I’m not comfortable with where the market is going. We’re going to start taking out the bottom 5 percent of our customers,’” recalls the bank’s current president and CEO, Ken Vecchione.
As he relates this story, Vecchione is sitting in his office at Western Alliance’s headquarters in a downtown Phoenix high-rise building. Seated next to him is Dale Gibbons, the bank’s vice chairman and chief financial officer. Vecchione continues. “In retrospect we should have done …,” but Gibbons playfully cuts him off and suggests a much higher percentage: “55!” Implying that they should have taken out more than half of their customers was meant as an exaggeration, of course, but there’s some truth to it. Sarver himself once said the only bad housing market Western Alliance missed during the financial crisis was Florida.
Vecchione smiles, then continues: “Well, let’s just say the bottom 15 percent. We didn’t move quickly enough.”
More losses would follow-$151 million in 2009 and $17 million in 2010-before the bank managed to generate a modest $15 million profit in 2011. Much better years would follow. Indeed, over the past decade, $23.7 billion asset Western Alliance has rebounded to become one of the top performing banks in the country.
Banking is a numbers game, and Western Alliance’s numbers in 2018 were stellar. The bank reported net income of $436 million, a 34 percent increase over 2017. Of course, a reduction in its effective tax rate under the Tax Cuts and Jobs Act, from 28 percent in 2017 to 14.6 percent last year, boosted its profitability-as it did for most banks. But the management team at Western Alliance also did a great job of executing. Total loans grew 17 percent in 2018, to $2.6 billion. Total deposits grew 13 percent, to $2.2 billion. The bank’s net interest margin (NIM) was a robust 4.68 percent. And its efficiency ratio was a low 42 percent.
For the year, Western Alliance’s revenue growth was two and a half times greater than the growth of its noninterest expenses-which gave it tremendous operating leverage. “We’ve learned how to put a nickel in to get 25 cents out versus many other banks that just know how to take a nickel out,” says Vecchione. “We know how to invest wisely.”
But the real story of Western Alliance’s phoenix-like recovery lies behind the numbers. Paradoxically, the bank is less concentrated today but more focused than it was prior to the financial crisis-the result of a deliberate change in strategy after that defining experience. It developed a portfolio of niche lending businesses that are national in scope while exiting some consumer activities. Both steps helped drive its impressive NIM. “They probably decided, ‘You know what, we think we’re really good spread lenders. Let’s not try to be all things to all people and [instead] focus on what we’re good at,’” says Brad Milsaps, an analyst at Sandler O’Neill + Partners.
Western Alliance’s strong performance in 2018 earned it a first place finish out of 131 banks in Bank Director’s 2019 Bank Performance Scorecard for the $5 billion to $50 billion asset category. The Scorecard is a ranking of the 300 largest publicly traded U.S. banks, broken into three asset size categories, and the banks are ranked on five metrics that measure profitability, capital strength and asset quality. (For a full explanation of the Scorecard, click here.) When all 300 banks are ranked against each other, Western Alliance was the seventh best performing public bank in the country based on 2018 financial data.
Western Alliance is a business-focused bank with a small consumer operation. Commercial and industrial loans comprised 44 percent of its $16.8 billion loan portfolio at the end of last year, followed by commercial real estate at 37 percent, and construction and land development at 12.6 percent.
One of the advantages of having lots of commercial loans on the books in 2018 was the opportunity to reprice many of those loans in a rising rate environment. Commercial loans tend to have variable rate structures tied to the London Interbank Offered Rate (LIBOR) or the prime rate, and when the Federal Reserve raised interest rates by a total of 100 basis points last year, it enabled Western Alliance to increase the pricing on about two-thirds of its loans. That helped drive its performance.
“On average, (every) three to three and a half years our [loan] portfolio is turning over,” says Vecchione. “As we always say here, we like to date, but we never like to marry. We get the chance to make the same credit decision again on the same company depending on a different set of facts.”
Western Alliance is the creation of Sarver, a serial entrepreneur who grew up in Tucson, Arizona, and started working at his father’s savings and loan when he was just 16 years old. In 1984, at the precocious age of 23, Sarver founded the National Bank of Tucson (later renamed the National Bank of Arizona) and sold it 10 years later to Zions Bancorp. Sarver stayed on at Zions for a few years as an executive vice president and led its acquisition of Sumitomo Bank of California in 1998. After he left Zions, Sarver acquired BankWest of Nevada in 2002, changed its name to Western Alliance and over the next seven years expanded its operation in Nevada through a series of acquisitions, while also moving into Arizona and California through de novo startups. The company went public in 2005, listing on the New York Stock Exchange, and moved its corporate headquarters to Phoenix in 2010.
When the financial crisis hit in 2008, Vecchione was serving on Western Alliance’s board of directors. He later was president and chief operating officer from 2010 to 2013 before leaving the bank to run a specialty finance company, although he continued to serve on the Western Alliance board throughout. When Sarver, who is also the managing partner of the Phoenix Suns professional basketball team and owns a Phoenix-based real estate development company, decided to step back from active management at Western Alliance in 2018 to become executive chairman, Vecchione returned as CEO.
“Ken is not new to the company,” says Tim Coffee, an analyst at Janney Montgomery Scott. “He’s highly analytical. He’s very, very smart. That’s one thing I like about Western Alliance. Ken, Dale and Robert are exceptionally bright people.”
Both the Arizona and Nevada economies were severely impacted by the Great Recession-60 percent of the bank’s operations were in Nevada, which at one point had the highest unemployment rate in the country-and it spent a couple of years digging out from under a pile of bad real estate loans. The bank’s management team might have misjudged the intensity of the coming storm in 2007, but they reacted quickly once its magnitude became more apparent. They began by raising a combination of debt and equity capital, including $140 million from the federal government’s Troubled Asset Relief Program.
“We worried more about supporting our customers and our clients than we did about dilution, because it was all about having liquidity to fight the next battle the next day,” says Vecchione. “With the incremental capital that we were able to raise, we kept on lending. We didn’t stop being open for business. We did that while we also addressed our credit issues.”
In some respects, the crisis provided Western Alliance with the imperative to improve its execution in ways that would materially enhance its future profitability. “We had to be what I call an ‘and’ company, [where] you have to do two things at once,” says Vecchione. “We did that up and down the P&L. We said that we’re going to grow deposits and bring down cost of funds. We did that. We said we’re going to bring in more loans and increase our yield. We did that. We said we’re going to provide better service and take out operating expense. We did that.”
The bank also substantially changed its business focus, getting out of low-margin businesses like mortgage lending, credit cards and investment management, and focusing more directly on its commercial lending franchise. Beginning in 2010, the bank launched its National Business Lines initiative that now includes homowners associations, hotel franchise finance, public and nonprofit finance, technology and innovation, and mortgage warehouse lending. These niches offer substantially greater profit margins because there tends to be less competition, which allows the bank to charge higher rates on its loans, and customers can be serviced efficiently without a lot of infrastructure, which provides the bank with positive operating leverage.
Vecchione is always looking to add more specialties to the bank’s lineup, particularly if it can leverage something it’s already doing. A perfect example is mortgage lending, which the bank recently got back into. Vecchione says the industry is closer to the end of the rate cycle in mortgage lending than at the beginning, and there is an opportunity to buy higher-rate residential loans. Those could be bought in bulk from a large money center bank or from its existing warehouse mortgage lending clients. The bank opted for the latter. “It deepens the relationship with them, and we don’t have the upfront costs of a branch system,” he says.
The bank added over $1 billion in mortgage loans in 2018 using just two people, which contributed to its low efficiency ratio. “Two people, we grew $1 billion-that’s a good day,” says Vecchione. At year end, mortgages accounted for 5.6 percent of the bank’s loan portfolio. That production at attractive rates also gives Western Alliance some margin protection going forward. The opportunity to reprice loans will diminish as the economy approaches the top of the interest rate cycle, especially if the Federal Reserve holds rates steady or even lowers them this year over concerns about slowing economic growth. “We’re increasing the duration of our assets to anchor them down, so that if the next move is lower we won’t be compressed as much as we otherwise would,” says Gibbons.
Spread lenders like Western Alliance need to have a robust risk management process in place to protect themselves from a change in the credit cycle, and Vecchione says the bank has made a substantial investment in strengthening its program since 2007. The development of the national lending niches also helps Western Alliance diversify beyond its regional base. But Western Alliance still has to prove that unlike the last time, its credit culture is strong enough to survive an economic downturn.
Another driving force behind Western Alliance’s performance is its deposit strategy. The vast majority of the bank’s funding comes from its commercial customers. With just 25 branches in Arizona, Nevada and California, consumer deposits account for less than 5 percent of its total funding base. “We have an average deposit balance per office of about $500 million, which is a multiple of what the industry average would be,” says Gibbons. “So that helps us also in achieving a high efficiency.”
Some of the bank’s lending niches also tend to generate high levels of liquid reserves that it can capture as deposits.
Vecchione describes homeowners associations as “a technology and service-oriented business line where we’re able to attract deposits at a relatively modest cost.” Another example is technology and innovation lending. Western Alliance acquired San Jose, California-based Bridge Bank in 2015. Located in Silicon Valley, Bridge Bank provides commercial banking services, including working capital loans and lines of credit, to startup companies and the private equity and venture capital firms that invest in them.
“We probably generate $2.50 to $3 in deposits for every $1 we generate in [technology and innovation] loans,” Vecchione says. “And by the nature of the business, you raise capital, the capital sits with us for a period of time. Before they draw down the loan, they spend that capital, or they get sold and that capital regenerates again. Warehouse lending is almost equal, $1 in loans, $1 in deposits. So we have some natural business lines that just generate a lot of deposits.”
Western Alliance also requires that its commercial customers give the bank their deposits. “No loan is made-there may be a few exceptions-but no loan is made without operating accounts. They must come,” Vecchione continues. “We also require minimum liquidity from each one of our borrowers. If you break that covenant, the interest rate on your loan will rise.”
The bank also incents its loan officers to bring in commercial deposits. “We have a pay-for-performance culture,” says Vecchione. “You bring in deposits, you get paid. But if those deposits grow also and you stay on top of your borrower relationship, you get paid for that as well.”
The Bridge Bank acquisition was by all accounts a home run for Western Alliance. Valued at $425 million, the deal was immediately accretive to Western Alliance’s earnings, and provided a platform for technology and innovation lending, which fits the National Business Lines model. Gibbons says these niche loan sectors attract fewer competitors and would have been difficult for Western Alliance to grow organically.
And in 2016, Western Alliance acquired a $1.4 billion hotel franchise portfolio from GE Capital for an undisclosed price. That deal gave Western Alliance another national business platform and was immediately accretive to earnings. “GE was a grand slam,” crows Vecchione. “It put us in a great product line, they gave us great people, gave us good technology, good analytics. We bought it … at a discount, so it ticked all those boxes.”
Western Alliance is open to doing additional M&A deals. States such as Florida, Texas and Colorado that have favorable attributes like net in-migration, low tax rates and a friendly regulatory environment are interesting, says Vecchione. And deals that give the bank another national niche lending platform would also get the bank’s attention. But Vecchione says there is no pressure on management to do another deal. “We like the homegrown, organic approach that we have,” he says. “Having that and executing upon that game plan allows us to be very particular as to what type of company we buy.”
However, there is an interesting twist to this M&A issue. Could Western Alliance itself be sold? Tom Brown, the CEO at the hedge fund Second Curve Capital, raises the possibility that Sarver, who owns 1.03 percent of the bank’s stock, might eventually be open to that possibility. Says Brown, “With him, you don’t know if he’s going to be a buyer or a seller.” And as Coffee points out, “He has done it before. This isn’t his first bank.”
When pressed on the issue, Vecchione doesn’t preclude the possibility of a sale. “We manage this business for it to be an enduring company to last through many different cycles and for a long period of time,” he says. “If opportunities come at us, then we’ll look at that in terms of total shareholder return. Is it good for investors? Is it good for our clients? Is it good for our people? Is it good for the communities that we serve? … If a deal comes in that’s way over the top, we’re going to consider it.”
Of course, given the bank’s size and strong performance, the list of potential acquirers is pretty short. Says Vecchione, “If we keep doing what we’re doing, it’ll be hard for people to pay up for us.”