Playing Their Cards Right

There’s and old adage in banking that says the economy is the hand of cards financial institutions are dealt, but how that hand is played-in other words, the quality of individual strategies and how well they’re executed-ultimately determines who wins. History has shown that’s certainly the case. Even so, as any poker player will testify, it’s a lot easier to take the pot when you’re dealt aces instead of deuces.

That’s one of the story lines to emerge from this year’s Bank Performance Scorecard rankings. Five of the top 10 performers in this year’s ranking are located on the Pacific Coast, their markets enjoying relatively robust job and population growth. Three others are either west of the Mississippi or in the Southeast. Meanwhile, a disproportionate share of the laggards comes from the Rust Belt, Puerto Rico, or from overheated real estate markets, such as Florida.

The stark difference in regional performance marks a big change from recent years, when no one part of the country seemed to have an edge. “The economy is playing a bigger role this year,” says Mark Fitzgibbon, director of research and a principal at Sandler O’Neill & Partners L.P., a New York investment banking firm that specializes in financial services. A weaker dollar has fueled both exports and foreign tourism in places like the Pacific Northwest and Hawaii, he says, stimulating job growth and giving those economies a boost. “Clearly, the banks in those places are benefiting from some economic tailwinds.”

Even so, it takes more than good cards to win at poker, and the same is true of banking. For board members, the results of this year’s Scorecard-and the characteristics of the institutions that fared well-offer some valuable lessons. The top performers are generally not jack-of-all-trade institutions; rather they’re focused on specific product or service niches, such as commercial real estate or technology, which allows them to leverage strong connections and expertise and differentiate themselves from their competitors to win business.

All boast what are considered by outside observers to be strong management teams; their boards tend to be engaged without micromanaging-willing to allow executives to run the business while crafting incentive packages that retain those people and reward them-and in some cases, frontline workers-for jobs well done.

Operationally, most have strong core deposit franchises and underwriting teams-both especially valuable in shaky economic times. “In order to have performed well over the past year, you’ve had to have had a very strong credit culture,” says Jackie Reeves, a managing director for Bell Rock Capital, LLC, a Paoli, Pennsylvania investment adviser. The top performers generally do an above-average job of controlling costs, as well, which is important in a market where revenue growth appears to be slowing.

Not surprisingly, given the times, most also have avoided an overreliance on the residential mortgage business. Santa Monica, California-based FirstFed Financial Corp. is in our top 10, largely because of a strong capital position and a prescient decision in 2006 to rapidly pare shaky loans from the books when the housing market began its slide. “Instead of trying to grow through the downturn, or to fight through it, they decided to shrink the company’s size and retain the best-quality assets and liabilities,” Fitzgibbon explains. At $7.7 billion in assets, FirstFed was 30% smaller this June than it was a year earlier. “But what remains is a much more vibrant company,” he adds.

By and large, the institutions that performed well aren’t all that big, which makes them more nimble and easier to manage. Six of the top 10 performers have assets of less than $10 billion, even though the list includes $1 trillion megabanks. The biggest of those top dogs is $145.9 billion-asset Capital One Financial Corp. in McLean, Virginia, which acquired North Fork Bancorp in 2006, but still gets two-thirds of its net income from its monster credit-card business, and less than 20% from traditional banking.

The winning hands

The Bank Director Bank Performance Scorecard measures the country’s 150 largest banks and thrifts across a wide range of indicators, assigning each a rank. Those ranks are then totaled to come up with a final score for each institution.

Two key profitability metrics-return on average assets and return on average equity-each get a full weighting, based on the assumption that profitability is the single most important performance measurement for any public company. The Scorecard assigns half weightings to Tier 1 capital and leverage capital ratios to gauge an institution’s effectiveness in managing capital. It also gives half weightings to a bank or thrift’s ratio of nonaccrual loans and other real estate owned to total loans (the nonperforming asset ratio) and to the ratio of loan-loss reserves to total loans-both considered measures of asset quality.

Bank Director developed the Scorecard in consultation with Sandler O’Neill, which uses publicly available data to perform the calculations and compile the final tally. The ROAA and ROAE calculations are based on data from four linked quarters-in this case, the last two quarters of 2006 and the first two quarters of 2007. The capital and asset-quality measures are based on figures that were reported at the end of the second quarter of 2007.

In contrast to many other measures, the Scorecard’s purpose is to identify banks that generate good profits without leveraging their balance sheets or taking excessive lending risks. Institutions that rank high on the list typically exude good corporate governance practices. And in the past year, they’ve needed every bit of management and board savvy to confront one of the most trying 12-month periods in recent industry history.

The year ending June 30 was colored by worries over depressed margins and a flat (and occasionally inverted) yield curve. Just as those concerns began to ebb, the subprime mortgage industry imploded, focusing attention on a liquidity crunch and deteriorating asset quality that threatened to spread beyond the housing market and perhaps into higher-quality credits. “The two biggest risks for banks have always been interest rate risk and credit risk, but we’ve rarely had a period when both of them bore down on the industry in such a short period of time,” Fitzgibbon says. Credit quality, he adds, has “declined far more rapidly and significantly than anyone anticipated. … It’s really been a perfect storm.”

The increasingly difficult operating conditions-especially when contrasted with the low-rate, easy money days of preceding years-were reflected in the overall numbers among these 150 large banks. While some individual banks improved their standing, the group as a whole saw key metrics decline versus the previous 12-month period: Mean ROA fell to 1.05%, from 1.18% for the year ended in June 2006; mean ROE was 11.12%, compared to 13.04% in the earlier period. Nonperforming assets jumped to an average of 0.79% of loans and leases-not bad historically speaking, but a significant spike versus the 0.47% reported the year before. Reserve levels jumped slightly and-perhaps as a result-Tier 1 capital ratios declined, to an average of 10.12% from 11.26% a year earlier

“The industry has had the wind at its back for years in terms of easy deposits and limited credit losses,” says Brett Rabatin, an analyst for Cleveland-based FTN Midwest Research. “In the past year, that’s begun to change. Core deposit growth is almost nonexistent, and margins and profitability are under pressure.”

Steady performers, and a couple surprises

Despite such challenges, some institutions continued to perform well. Indeed, one of the more remarkable nuggets from this year’s Scorecard is that five of the top 10 companies are holdovers from last year. The top overall performer, however, is newcomer Frontier Financial Corp., a $3.6 billion, 51-branch bank based in Everett, Washington, which emerged as one of the 150 largest institutions after adding some $400 million in new loans since last June, and promptly moved to the head of the Scorecard class.

Frontier CEO and director John Dickson says a strong local economy, fueled by the likes of behemoth employers Boeing and Microsoft, has buoyed the real estate market-housing prices in nearby Seattle rose 9% over the past year-a good thing, given that 78% of Frontier’s loan portfolio is devoted to construction, land development, and commercial real estate. “The economy is creating jobs,” Dickson explains. “That’s helping grow the population, which is driving the housing market.” (See profile story, page 30).

So while there are plenty of banks in the Puget Sound area, Frontier sets itself apart from the pack, partially due to the board’s willingness to stretch its loan portfolio despite pressure from regulators to scale things back. The company boasts a loan-to-deposit ratio of 115%-an admittedly high level, but one that directors feel comfortable funding, in part, through wholesale sources. That approach helped produce an ROA of 2.23% (tops among all banks) and ROE of 18.75%. Meanwhile, Frontier’s efficiency ratio, in the mid-30% range, also contributed mightily to returns. And a board-backed culture that returns 9% of net income to employees through profit sharing and equity compensation plans helps spur cost savings. “When employees are also owners, their attitude toward expenses is different,” Dickson says. “It really motivates the troops to focus on growing profits.”

While geography is a key theme, location means different things to different institutions. The No. 2 bank, $4.7 billion Glacier Bancorp in Kalispell, Montana, boasts 87 branches spread across rural Rocky Mountain communities. Some of those markets aren’t necessarily booming, but Glacier-a supercommunity banking franchise with 12 distinctly branded subsidiaries-doesn’t face the same competitive pressures as its big-city kin. That’s allowed it to build loans and core deposits at a nice clip without succumbing to irrational pricing dynamics common elsewhere-a fact evidenced in a net-interest margin of 4.36%, up 2 basis points from a year ago. “They’re able to gather low-cost core deposits in some of the slower-growth rural markets, and then deploy that funding into commercial real estate in the faster-growth areas,” Rabatin explains.

For No. 3 Hancock Holdings, a Gulfport, Mississippi company with $5.9 billion in assets and branches spread along the Gulf Coast from Louisiana to Florida, the Hurricane Katrina rebuilding effort has brought a surge of insurance and government money into its markets and boosted loan activity. No. 4 FirstFed is the only thrift in the top 10, and one of just three in the top 50. No. 5 Synovus Financial Corp. is a $33.2 billion company based in Columbus, Georgia that operates some 40 community banks across the southeast-and gets about 30% of its revenues from an 80%-plus ownership stake in card transaction processor Total System Services.

SVB Financial Group, parent of $6.6 billion Silicon Valley Bank in Santa Clara, California, ranked sixth. It benefited from a rebound in the technology sector that’s centered in its namesake core market, which provides a healthy core-funding base. Silicon Valley also holds more than 1,200 equity warrants on its young-company clients, a typical part of its lending arrangements, and reported a net gain of $6 million on those warrants in the first half of 2007. “They’ve been seeing some benefit from that warrant portfolio,” Fitzgibbon says.

No. 7 Capital One is followed by Honolulu-based Bank of Hawaii Corp. The $10.7 billion bank doesn’t have a neighboring state to expand into, which is a problem, but it has been able to cash in on a good core deposit franchise, as well as a lack of competition. “They control costs well, have very conservative underwriting criteria, and they dominate their market,” Bell Rock Capital’s Reeves explains. “It’s a powerful combination.” (Another Hawaiian institution, Central Pacific Financial Corp., ranked 12th on the Scorecard, its numbers powered by nonperformers of just 0.03% of loans and leases.)

No. 10 City National Corp. in Beverly Hills, California is known tongue in cheek as the “bank to the stars” for the number of Hollywood clients it serves. Its main business centers on serving high-net-worth clients. “Because it’s lending to ultra-rich people, the risk of loan losses is relatively low,” Fitzgibbon explains, saying also that they usually have good collateral to offer. Those customers often use loans “as a money management tool because it makes financial sense, not because they need the money,” he adds. The 10th-best performer on the Scorecard is San Rafael, California-based Westamerica Corp., a $4.6 billion conservatively managed bank that has the second-highest ratio of reserves to loans (2.12%) on the Scorecard, and is ranked among the top five in ROA and ROE.

According to the Scorecard, the best-performing traditional bank with more than $100 billion in assets is No. 14, U.S. Bancorp. Based in Minneapolis, $222 billion USB is a big retail and business player in several Midwest and western states that generates a lot of fee income through an industry-leading payments business and a growing wealth management operation. Its ROA (2.14%) and ROE (22.19%) both ranked among the top five. The only other megabank among the top 30 is $540 billion San Francisco-based Wells Fargo & Co.

Perhaps the most surprising of the top 10 performers is last year’s No. 1, Corus Bankshares, which finished in ninth place this year. The Chicago-based company made plenty of hay in recent years as a national condominium lender-a business once so strong that in June 2006 it reported no nonperforming assets. A year later, its NPA level ballooned to a whopping 6.71% of the portfolio. Yet prudent capital management and an efficiency ratio of just 21.8%-combined with the fact that $9.6 billion Corus had thus far recorded only one significant chargeoff, valued at $13 million-left both its ROA and ROE among the industry leaders.

Fitzgibbon doubts that Corus will make a repeat appearance at the top of next year’s list, noting that per-share earnings declined 25% in the first half of the year. Even Corus’s management seems to agree. “It would not surprise us to see an even greater impact on earnings over the next several quarters, or even years, depending on when the market improves,” CEO and director Robert Glickman warned in an unusually blunt July letter to shareholders.

Rolling the dice in 2008

Analysts agree that the coming year may hold changes for many banks on our list. While different banks are built for different times and operating conditions, few are equipped to perform better when job growth sags and the economy hits the skids. For those that aren’t vigilant, poor credit quality can become a big enough distraction that it diverts the attention of even the best board and management away from otherwise sound strategies. That could lead some institutions high on our list to slide down, while others may emerge-all of which might even lead to another wave of M&A activity as differences in management skill and performance are exposed.

“The next year will really separate the men from the boys. Some banks will get marginalized or fail because of their lending practices,” Fitzgibbon predicts. He says bank boards that want to avoid that fate should focus their attention on credit quality to ensure their institutions ride out the storm. The good news: Already, bankers report seeing signs of more rational loan pricing, which should improve margins and the bottom line. “Those boards that are disciplined and build a war chest to fortify their balance sheets should be in a good position to step in and take market share once we get past this difficult period,” Fitzgibbon says.

That’s a bet worth taking.

View the complete results.