Trying Times, Complex Solutions

During a July conference call introducing former Treasury Under Secretary Robert Steel as Wachovia Corp.’s new chief executive, Lanty Smith, the company’s chairman, made a somewhat humbling admission. Just two years after paying $25.5 billion to acquire Golden West Financial Corp., the big Oakland, California-based thrift, Wachovia’s board was conceding that the deal was a mistake. A bust. A big-time flop.

The acquisition, priced near the frothiest heights of the market, brought the nation’s No. 4 banking company a long-desired West Coast presence, but also fistfuls of risky California mortgage loans just as the real estate market was showing its first signs of weakness. During the late summer and early fall, Wachovia continued to watch its market capitalization drop to as low as $15 billion-well off the $100 billion figure of less than a year earlier, and just 60% of the price it paid for Golden West. It went through two rounds of capital raising to no avail. In the second quarter, the company reported a $9.11 billion loss and slashed more than 6,300 jobs, while CEO Kenneth Thompson, the deal’s architect, lost his job. “There’s been a complete recognition at the board level that Golden West was a mistake,” Smith told analysts and investors at the time. “We have to deal with the consequences of it.” By late September the writing was on the wall for Wachovia, which eventually agreed to sell itself to Wells Fargo & Co. for $15.4 billion, or about $7 a share.

As fallout from the mortgage mess threatens to spill into other asset classes and cause more pain, plenty of other boards will be eating crow. Through September, 12 banks had failed; analysts predict the tally could eventually rise into the hundreds-not quite so bad as the S&L crisis of the early-1990s, when more than 800 banks and thrifts collapsed, but still plenty enough to provide a stiff wake-up call to investors, regulators, and bank boards that caught a dose of complacency during years of steadily rising profits and little trouble.

Thousands of institutions are struggling with asset-quality problems, higher provisioning expenses, and reduced earnings, the result of a crisis that has its roots in the housing bubble and shaky lending practices earlier this decade. According to the Federal Deposit Insurance Corp., the industry’s second-quarter earnings plunged 87% from year-earlier levels, while more than 56% of all banks and thrifts reported lower earnings. Loan-loss provisions increased more than fourfold during that period, to $50.2 billion, and charge-offs soared to $26.4 billion-the highest level since 1991.

Things appear poised to get worse before they get better: At the end of June, 2.04% of total loans and leases were classified as “noncurrent,” a level not seen since 1993. And the trouble is spreading from residential real estate to home equity, credit cards, and commercial real estate-the latter, a bread-and-butter business for most banks. Several noted experts, including former International Monetary Fund chief economist Kenneth Rogoff, predicted earlier this year at least one “major” commercial or investment bank would go under; in September the industry witnessed the receivership of Fannie Mae, Freddie Mac; the bailout of insurance behemoth AIG; the fall of Lehman Brothers; and finally, the FDIC takeover of mortgage banking giant Washington Mutual, the largest failure in the history.

There’s blame enough to be spread around on what is now widely considered a systemic breakdown. Credit rating agencies signed off on loan pools without performing due diligence. The Federal Reserve kept interest rates low for longer than was prudent. Regulators reacted late to problems that, with hindsight, should have been evident. Washington lawmakers, in their quest to see higher levels of homeownership, were happy to see people get loans who normally wouldn’t qualify. Borrowers, believing home prices would continue to rise, eagerly took on unreasonable risks.

For all that, it’s the lenders themselves who will ultimately bear the brunt of the burden. And for bank directors, that’s not good news. The overall impression is that many bank boards were somehow asleep at the switch, either blissfully willing to accept unreasonable risks, or unable to comprehend-or unwilling to challenge-the strategic paths their managements were leading them down.

“Being a director is not supposed to be about sitting in a comfy seat around a mahogany table, flipping tabs in a three-ring binder,” says Karen Shaw Petrou, managing partner of Federal Financial Analytics Inc., a consulting firm in Washington, D.C. “We’ve seen a lot of boards that failed to ask, ‘If this unit or the bank isn’t performing as promised-or if the risks are higher than we were led to believe-why?’ If you’re not requiring management to validate its promises, then you’re not doing your job.”

The implications of the crisis will be daunting for most boards. Profitability could be squeezed for years to come, capital and liquidity will become more precious, and changes in the competitive landscape could lead to differences in what constitutes a winning strategy. Shareholders, bruised and battered by the industry’s collapse, are likely to demand alterations in areas such as CEO incentive pay and board composition. Even for the best-run banks, “what comes next is probably going to go a long ways toward defining what happens to bank directors in later years,” says John Beaty, a partner at Venable LLC, a Washington D.C. firm, and a former FDIC assistant general counsel.

In the short term, expect aggressive enforcement of tougher new rules by regulators and prosecutions of the worst scofflaws when deemed necessary. “You’ve seen a lot of directors who have signed whatever [management] put in front of them,” says Robert Clarke, a former comptroller of the currency and a senior partner at Bracewell & Giuliani, a Houston law firm. “That’s a terrible thing to do, because as a director you’re really painting a target on your back” in terms of regulatory sanctions.

Unlike other industries, the government employs agencies filled with people whose primary mission is to figure out what bank directors and management did wrong. Directors of some failed banks could face years of investigation and legal action, along with the potential for out-of-pocket financial penalties-or worse-as examiners pore over minutes looking for lack of due diligence or fraud. “You’re going to see a lot of pressure to get the bad guys-criminal investigations, serious D&O investigations, lawsuits. People will go to jail,” says Ron Glancz, chairman of the financial services group at Venable. “When people lose their homes in this country, that’s considered unacceptable.”

The threat of criminal penalties might pale next to the reputational damage that can come with a failure. “If you’re on the board of the local bank, a pillar in the community, and it fails, the personal embarrassment can be immense,” says William Isaac, chairman of the Federal Deposit Insurance Corp. between 1978 and 1985, and now chairman of the Secura Group, a Vienna, Virginia bank consulting firm. “If there are shareholders or depositors in the community who lost money, you don’t want to show your face. These are your friends and neighbors, and you’ve let them down.”

While most directors won’t have to confront a failure, that doesn’t mean they won’t feel fallout from the crisis. Many boards have been meeting more frequently, poring over outstanding loans for signs of trouble, and exercising greater caution and professionalism than just a few years ago. A Federal Reserve survey of senior loan officers released in August found that two-thirds of U.S. banks had tightened consumer loan terms, raising credit scores and setting lower limits on revolving debt. Commercial lending also shows signs of slowing. Economists worry that could hinder the recovery, and cause more trouble for lenders. But bank directors rightly argue they must mind their own shops first.

Torrey Pines Bank, a $755 million lender in San Diego, has dodged most of the trouble of the crisis, and in June reported a 32% jump in earnings. Loan growth has continued, says CEO and director Gary Cady, but “we’re focused more on the fundamentals of prudent lending-making sure we have both primary and secondary sources of payment, lowering loan-to-value [ratios].”

The story is much the same at First Chicago Bank and Trust Co., where the board has clamped down on speculative construction loans. “Any developer that’s coming in for new funding on properties, we’re tightening our standards,” says Patrick Arbor, 71, a director and a former chairman of the Chicago Board of Trade. The $1.2 billion company also has been reviewing all of its existing loans, stress testing and ordering new appraisals for those with real estate as collateral. If a property value’s decline brings loan-to-value ratios below acceptable thresholds, “the borrower is going to have to bring us more collateral, and he’s certainly not going to borrow anymore,” says Arbor, who is chairman of the board’s loan committee.

At $8.3 billion Umpqua Holdings Corp. in Portland, Oregon, several recent California bank acquisitions came with mortgage and development-loan exposure to one of the nation’s hardest-hit markets. Things weren’t a whole lot better in the Pacific Northwest. Over the 18 months ended in June, Umpqua set aside $82 million in loan-loss provisions, compared to $5 million for all of 2005 and 2006. During the same period, it charged off more than $73 million in bad loans.

That’s left the board doing a “reverse look to see how the organization got into this situation,” says William Lansing, 62, a director since 2001 and former CEO of Menasha Forest Products Corp. in North Bend, Oregon. One result: Directors have demanded less scripted meetings, with more time for “free-flowing” discussion among themselves, and not quite as much in the way of management presentations. The tone is more serious, and the questions are tougher-not just about loans, but also personnel, strategy, and tactics.

“We’re spending more time digging into critical issues, and we’ve learned to rely on each other’s intuition more and not allow the staff to formally organize how the meetings go,” Lansing says. “If you’re barraged with hours of eloquent discussion [from management], it’s hard to dig under that because most of us aren’t bankers. We want to talk more, and no subject is off limits.” One director, for instance, offered insights gleaned from a local chamber of commerce meeting in California, which touched off a 30-minute discussion; Lansing shared a story of visiting Bend, Oregon, where stacks of “coiled-up power cords and [uncompleted] sewer and water connections” lined the streets outside of halted developments.

Directors are sitting in more on meetings of committees they don’t serve on, too, seeking to better educate themselves “about the economics of banking.” They have added to the company’s internal audit staff, and hired a new compensation consultant to put more teeth in pay-for-performance measures. And they’re keeping close tabs on how fallout from the crisis-declining 401(k) account values, the bank’s dented reputation, etc.-is affecting employee morale through a regular “culture report” from the human resource chief. “The enthusiasm of front-line workers is what makes everything tick,” Lansing explains. “If you, as a board, are not demanding that information flow up from the staff about the culture and how it’s being impacted by this crisis, you’re not doing your job.”

Such introspection and diligence is healthy, although it might be reasonable to ask why it took a crisis to bring it on. It’s also prudent, given that financial institutions are all but assured of facing more scrutiny and rules-many of them targeted directly at boards-in the years to come.

To be sure, not all of the potential changes will be bad for banks. Many observers expect mortgage brokers, the source of many subprime loans during the boom years, to face greater regulation-perhaps even capital requirements-that could restore a sense of more rational competition to the marketplace (though that hasn’t happened, yet).

The securitization market, which left banks holding piles of loans on their books when it froze last summer, already is operating under tough new rules-due to a settlement with credit ratings agencies by New York Attorney General Andrew Cuomo-and might never return to the halcyon days of yore. That could limit some lending activities, but also might herald a resurgence of more traditional originate-and-hold lending-a throwback that could play into the hands of banks with solid balance sheets and deposit franchises.

For the strongest players, M&A opportunities could abound once the dust from the crisis begins to settle. At Prosperity Bancshares, a $6.5 billion company in Houston, second-quarter earnings rose slightly over year-earlier levels, in part because the board played it smart during the housing boom, steering clear of subprime mortgages while keeping its loan-to-deposit ratio below 70%. Chairman David Zalman says he has been fielding calls from shaky institutions, looking for an exit. He also foresees the possibility of picking up some branches-or an entire state franchise-from a big, out-of-state player that’s being forced by the crisis to sell some assets. The board is waiting for more clarity on loan quality-and for pricing expectations of sellers to come down a bit more-before pulling the trigger. “We’re eventually going to see some good opportunities to build our company,” he says.

Others that have fared relatively well, such as Minneapolis-based giant U.S. Bancorp, report success in cherry-picking corporate clients that are looking for strength and staying power. “We’re working every week on finding new organic revenue opportunities, as opposed to discussing which lines of business to get out of, or which people to fire,” says Chairman and CEO Richard Davis-something he calls a “huge luxury.” The $247 billion company saw its net income jump a tick in the second quarter, and boasts a healthy Tier 1 capital ratio of 8.50%. That’s helped it deepen some key client relationships. Commercial loans were up 14% for the quarter. “We’re seeing a real flight to quality,” Davis says.

Even so, the net effect for most directors promises to be more work and stress. Attorneys and bankers say examinations have taken on a testier tone as the crisis has worn on. Chris Cole, regulatory counsel for the Independent Community Bankers of America, says he’s hearing a lot of complaints about examiners ordering reappraisals of all real estate tied to loans, credit downgrades, and other remedial actions. “These are loans that are not in default, where the payments are being made on time, but examiners are saying, ‘Come up with a new appraisal or write it down,’” he says. “In some cases, they’re acting unfairly.”

Don’t count on getting much sympathy. Regulators have shown a greater willingness to dole out harsh medicine, lowering CAMELS ratings, slapping more lenders with memorandums of understanding or cease-and-desist orders. Through the first eight months of the year, the Office of the Comptroller of the Currency alone commenced 77 enforcement actions against banks, compared with 40 for all of 2007. Observers expect those figures to increase as examiners get more proactive about identifying potential problems. At the end of June, the FDIC classified 117 banks and thrifts, with $78.3 billion in assets, as “problem” institutions.

“The mood of boards is, ‘Why are the regulators harassing us so much? If they’d just step back, we could get this all fixed,’” says Petrou, who has served as a board member for several banks. She argues that boards of struggling banks got themselves into this mess by failing to ask tough questions, probe downside scenarios, and monitor management activities. Now that the worm has turned, they have little reason to gripe-especially since they were warned.

Consider commercial real estate lending. In December 2006, rising concentration levels prompted the big regulatory bodies to issue a joint warning that banks whose CRE exposures exceeded 300% of capital-and 100% in C&D and land loans-would face increased scrutiny. Many community banks dismissed those warnings, arguing that in an era of tough competition for retail business, CRE has been the only game in town. By the end of 2007, the average community bank had CRE loans on its books equal to 285% of capital-double the level of six years earlier-with many boasting much higher concentrations, according to Comptroller John Dugan. “Some of these boards have no one but themselves to blame,” Petrou says.

With time, Petrou expects the agencies and lawmakers to issue “buckets of new rules, along with expressed requirements for boards to be responsible for them.” That could include everything from stiffer capital and liquidity requirements-think more of each-to stronger consumer protection laws, the latter a nod to the struggles of millions of Americans suffering under the burden of loans that arguably should never have been made.

Already, the Fed has instituted new rules requiring that loans be underwritten on the basis of the highest rate a borrower might pay, not short-term teaser rates-an appropriate, common-sense move that many lenders did not adhere to during the boom. Regulators also seem intent on ensuring that bank boards have the appropriate policies and procedures in place to effectively manage third-party relationships.

“If you’ve got a vendor that processes your credit cards or offers a product or service in your bank’s name, you need to make sure they’re compliant with the laws and regulations,” the Secure Group’s Isaac says. This was already on the radar screen, but the subprime crisis-with banks buying loans from unregulated brokers-has heightened the sense of urgency. “If you’re buying mortgages from a broker, you will absolutely need to understand everything that broker is doing,” he continues.

Petrou also predicts that regulators will demand better enterprise risk management systems and processes-holding bank boards accountable for ensuring that their institutions grasp risks not only on a unit-by-unit basis, but also companywide. She offers the example of a bank that lent money to both homebuilders and homebuyers and got caught in a double whammy of risk when the market began to implode. “You need to understand the whole picture,” she says.

Many bank boards have been lulled by the costs and “quantitative complexity” of their risk management systems into believing that they have been getting a complete overview of the risks at hand. The present crisis has proven those assumptions to be flawed. “If it looks fancy and the bank has spent X million [dollars] on the consultant and the presentation, there’s a tendency to ignore the fact that losses are mounting” until it’s too late, Petrou explains. “We’ve seen quite a bit of that recently. Boards need to be more vigilant.”

Expect shareholders to be on the warpath, too. Through mid-July, the Keefe Bruyette & Woods Bank Index had plummeted 60% from its highs in February 2007. Activists have targeted banks ranging in size from London-based giant HSBC Holdings to tiny Cape Fear Bank Corp. in Wilmington, North Carolina, pressuring boards for strategic changes in the wake of the crisis. The plaintiffs’ bar also has been active. Of the 174 securities class-action suits filed during the last quarter of 2007 and first half of this year, 76 targeted financial services companies, according to the Stanford Law School Securities Class Action Clearinghouse. The list includes such big names as Citigroup, Wamu, National City, JPMorgan Chase & Co., and Wachovia, and also smaller players, like Newport Beach, California-based Downey Financial Corp., a big mortgage lender, and WSB Financial Group, a holding company for Westsound Bank in Bremerton, Washington.

Many of those suits include directors as defendants. “The fact is, the buck stops with the board,” Glancz says. “There’s tremendous personal risk in being a bank director. If you, as a director, didn’t understand what your bank was doing and didn’t do something about it, shareholders are going to come after you.”

Operationally, managing the damage from struggling loan books is a challenge, and rising loan loss provisions and defaults have made capital a chief concern. Take construction and development lending, a core business for many banks. At the end of the second quarter, 6.08% of the industry’s C&D loans were classified as noncurrent, with another 2.01% between 30 and 89 days delinquent, according to the FDIC. Ivy Zelman, CEO of Zelman Associates, a housing research firm, predicts that over the next five years banks will need to charge off at least $65 billion-and as much as $165 billion-in C&D and land loans alone. “If you do the math, it’s not hard to believe that we’ll have at least 10% chargeoffs,” she says. “It would almost be stupid to believe otherwise.”

Anticipating the need for higher loan loss provisions, but not knowing exactly how bad things might get, banks have almost uniformly begun hoarding capital. Most have halted share repurchases, and in the second quarter, 51% of the 4,056 banks and thrifts that paid dividends a year earlier had slashed those payments, including 673 institutions that paid no dividend at all, according to the FDIC. Total industry dividend payments for the quarter were $17.7 billion, down from $40.9 billion a year earlier.

Some banks are considering asset sales to fortify their balance sheets. In August, for instance, $111 billion Fifth Third Bancorp quietly began shopping part of its payments processing business, following an announcement that it would seek to sell “certain noncore businesses” to raise at least $1 billion in additional capital. The Cincinnati-based company also was reportedly providing information on its asset management business to prospective buyers. Fifth Third reported a $202 million loss in the second quarter, due mostly to charging off 1.66% of loans, and issued $1.1 billion in convertible preferred securities.

For the year ended in June, banks raised a total of $290 billion in new capital from a variety of sources-offerings of common stock or trust-preferred shares, private equity, foreign governments, and the like-according to SNL Financial LLC in Charlottesville, Virginia. Such moves typically dilute the holdings of existing shareholders and hurt returns on equity, but Kevin Fitzsimmons, an analyst with New York-based Sandler O’Neill & Partners LP, says the uncertainty has some fund managers demanding tangible equity ratios of more than 7% before they’ll invest, creating an awkward dilemma. “No one really knows how much capital is enough,” he says.

Rising provisions aren’t the only pressure on earnings. Sometimes the solution to one problem leads to another. Take liquidity, where regulatory agencies have been pressuring troubled banks to break their reliance on wholesale funding and boost core deposits. First Chicago’s Arbor is seeing the effects firsthand in the Windy City. Two institutions with strong local presences and heavy real estate exposures-Corus Bankshares and Washington Mutual-have been bidding up pricing on certificates of deposit. “They’re desperate for money, and it’s forcing us to pay up for deposits, too,” says Arbor. “That’s depressing our net interest margin and hurting our profits.”

Deposit insurance premiums will increase, too. As of June 30, the FDIC’s insurance fund had a balance of $45.2 billion-at 1.01% of insured deposits, well below the 1.15% at which point the agency is statutorily required to boost annual premiums beyond the 5.4 cents per $100 now charged. And it looks like there’s more to come. Chairman Sheila Bair said in August that the FDIC might need to borrow money from the Treasury to cover the costs of anticipated failures.

“Deposit insurance premiums will rise. The only questions are when, and by how much,” says Bert Ely, head of Ely & Co., a regulatory consulting firm in Alexandria, Virginia. “Conceivably, the average premium rate could double.” For a bank with $1 billion in deposits, that would be an additional $540,000 in expenses-not a small sum.

Throw in extra costs for internal controls and risk management system upgrades, and many boards will have little choice but to cut costs, making hard choices about which projects can be forestalled, which branches can be mothballed, and which jobs can be cut. Through June, the financial services industry had reduced payrolls by 83,000, according to executive recruiting firm Gerson Group, and could shed another 175,000 in the coming year.

The crisis has exposed other general governance weaknesses. Shareholders could look harder at the relationship between boards and management. Isaac says a defining characteristic of many troubled banks is a dominant CEO who “rules with an iron fist and doesn’t tolerate dissension on the board.” The boss might be a major shareholder, but that does not diminish the duty of directors to challenge management and ensure that proper strategies and procedures are followed.

Succession planning will be more in the spotlight. The search that led to Steel, for instance, made the Wachovia board’s planning efforts looked makeshift and harried, and it wasn’t the only one: Boards at companies such as Citigroup, Merrill Lynch & Co., and E-Trade Financial Corp. appear to have been caught flatfooted when it came time to find new CEOs.

Board composition is likely to come under the microscope, too. The Sarbanes-Oxley Act came with a mandate to boost board financial expertise. It was a good first step, but also clearly wasn’t enough. Many boards simply didn’t understand the various collateralized debt obligations and other complicated financial instruments held by their banks well enough to set appropriate risk tolerances, and to ensure those tolerances were followed through tough questioning of growth-hungry managements.

“Boards don’t need to understand all of the complexities of these financial instruments,” Petrou says. “But they need to ensure that a sufficient number of directors are sophisticated enough in their understanding of modern finance to be able to ask intelligent questions.”

As they catch their collective breath, boards also will need to strike a better balance between short- and long-term growth and profits in their pay practices. Many banks continue to reward top executives for quarterly growth, not long-term stability. In one sense, that’s understandable, because banks that don’t deliver growth can be vulnerable to lower multiples and, perhaps, a takeover. But the crisis has shown that greater weight must be given to safety and soundness. Umpqua’s board, for instance, has recently tied more of CEO Ray Davis’s pay to the bank’s CAMELS ratings.

“Bank boards fear that if they don’t grow, their valuations will get punished so much that someone else will swoop in and buy the company. The flip side is that many of the problems we’ve seen were attached to the pursuit of short-term growth,” Isaac says. His advice: “Tune out the noise and be most concerned about having a bank that can make it through good times and bad-one with a strong balance sheet and good risk diversification. … A bank like that winds up buying other banks at a time like this.”

Glancz predicts that once the crisis is over, many directors will conclude the risks and time are too much, and step down. That will mean finding new board members-something that could be a challenge, given what appears to be in store for the present ones.

Umpqua’s board has five directors over the age of 60, and has been working on a “hit list” of prospective replacements, but Lansing says one question keeps bothering him: “Financial institutions have been painted with such a dark brush recently, why would someone put his or her name in the hat to become a director?”

As this industry-changing crisis plays out, many other board members are doubtless asking the same thing.