It’s not over ’til it’s over

FDIC contractor says more bank failures on the way

closed-sign.jpgMichael Sher has a first-hand view on the nation’s bank failures. He is managing director of RSM McGladrey, which has various contracts with the Federal Deposit Insurance Corp., including assisting the FDIC in shutting down banks, and assisting them with managing and selling the assets. He discusses where FDIC-assisted deals go from here, and what mistakes bankers make when buying failed banks.

What do you do for the FDIC?
To date, we and our strategic partner The Corvus Group, Inc. have assisted the FDIC in shutting down 59 failed financial institutions. Additionally, we are a contractor to the FDIC providing due diligence services to assist them in disposing of the assets that have been retained from the failed financial institutions. The first large deal was a $1.7 billion structured sale involving substantially non-performing acquisition and development loans. With a structured sale, the FDIC enters into a partnership with the buyer of the assets and typically, the FDIC retains a 60 percent ownership interest. The other transaction that we were involved with was a securitization backed by approximately $394 million of performing commercial and multi-family mortgages from 13 failed banks.

Do you think the FDIC will do more securitized asset sales in the future?
As we move ahead, I think that the FDIC will focus more on securitizations. The cost of due diligence for buyers on a structured sale is substantial and the size of the loans pools historically have exceeded a billion dollars in unpaid principal balance. It is apparent that the interest in such large transactions has waned.  The pricing received from the securitization sales is potentially higher than the other methods that the FDIC uses in disposing of assets from failed financial institutions. In addition, with a securitization, the FDIC does not retain an ownership interest that requires on-going monitoring. With structured sales, there is speculation that the size of the transactions will get smaller to encourage more participation.

Where do you think we’re headed in terms of bank closures?
I don’t believe it’s over. If you look at the number of banks on the watch list, it’s roughly 10 percent of the banks in the country. How can this crisis be over when we have not seen an overall increase in real estate values? That being said, in my opinion, the number of banks going into receivership will decrease as I think that the FDIC will encourage banks to merge prior to a failure. A benefit to this is that the directors and officers may avoid being investigated by the FDIC subsequent to failure, and may avoid possible legal ramifications.

What’s really the demand for banks in hard-hit areas such as Georgia and Florida and Illinois?
This is no different than the savings and loan crisis in the late ’80s and early ’90s. A lot of individuals and organizations made plenty of money buying distressed assets when others thought it was ludicrous to do so. I think that those who are not taking advantage of the distressed times now will be kicking themselves in the coming years because they missed the opportunity. Yes, you have to be cautious about what you buy, but those who get involved have the potential to make a lot of money.

How does the FDIC view the community banks who want to buy these failed banks, versus the big institutional investors?
In my opinion, the FDIC views this banking crisis as the banking industry’s problem and is looking to the healthy banks to resolve it. Most of the institutional investors don’t have the experience or the know-how that the FDIC is looking for. I think the FDIC is somewhat reluctant to get these money players involved. The key is to have the right team in place to manage and dispose of the assets.

What sort of mistakes do buyers make in buying failed banks?
I think one of the biggest mistakes made is buyers not having a full understanding of their rights and obligations under the loss share agreements that they have entered into with the FDIC. The acquiring banks have a short time-frame to truly understand what they have acquired and their reporting responsibilities under the loss share agreement. This results in the acquirers not fully understanding how to manage and/or dispose of the assets that they acquired.

Opportunity knocks, but there are drawbacks

The mess in banking isn’t over yet.That means hundreds of banks, most of them small, community organizations, likely will fail in the years to come. The flip side of all that carnage is an opportunity for bankers to buy troubled institutions, grow balance sheets during tough economic times and let the Federal Deposit Insurance Corp. take most of the bad assets of the failed bank.
The investment bankers and attorneys who attended Bank Director’s May 2nd conference in Chicago agreed on one theme: There are still plenty of deals to be had for banks looking to buy failed institutions from the FDIC, as long as they work hard, fast and smart to do the deals right. 
“There is ample opportunity,’’ said Jeffrey Brand, managing director at investment bank Keefe, Bruyette & Woods. “The FDIC will allow you to bid as many times as you like and they will let you be as creative as you like.”
There were more than 523 banks with $318.3 billion in assets at the end of last year that had Texas ratios topping 100 percent, said Brand, using SNL Financial data. The Texas ratio is commonly used to predict bank failure, and is the amount of non-performing assets and loans, plus loans delinquent for more than 90 days, divided by tangible equity capital and loan loss reserves. If it’s more than 100 percent, that’s trouble.
The number of troubled banks also appears to be increasing. The number of banks with Texas ratios above 100 percent increased 4.5 percent from the third quarter.
The FDIC’s “problem” bank list also appears to be growing. It reached a record high for this cycle of 884 banks at the end of last year, more than 10 percent of the total banking system. That number was up from 860 the quarter before.

Louis Dubin, president of Resolution Asset Management Co., said the states with the most number of troubled banks are Georgia, Florida, Illinois and Minnesota.

Troubled Bank Map: 2010 Q4


CRITERIA: Texas ratio > 100%, Leverage ratio <9%

Picking up failed banks from the FDIC offers some benefits: the FDIC can take on as much as 80 percent of the failed bank’s losses, using a tranche system based on the size of the losses. Plus, the acquiring bank can cherry pick the assets, locations and employees it wants. The failed bank’s pre-existing contracts are automatically voided on the sale.

And bankers can get creative in terms of how they structure deals. Brand recommended making several bids, including one that follows traditional FDIC deals and one that doesn’t. For instance, banks can price bids to take into account future risk, instead of using a loss share agreement, avoiding the hassles of regular audits from the FDIC to make sure they comply with the loss-share agreement.

“The FDIC is discovering the costs of auditing all these banks to see what their losses are,’’ Brand said. “Now they’re doing deals without loss share (agreements). You don’t need that expensive accounting system. But they are taking away that safety net, too. If losses are worse than estimated, that’s 100 percent coming out of your pocket.”  

One of the drawbacks of FDIC deals is the possibility that the government could change the rules at any time. The loss share agreement lasts a decade for single-family housing assets; five years for commercial properties.

Buyers also don’t have much time to do due diligence. The entire process, from expressing an interest in acquiring a bank, to closing, can take about 90 days, less if the failed bank’s situation is dire.

“They don’t let you wander around the bank talking to all the lending officers,’’ said James McAlpin, an attorney and partner at Bryan Cave in Atlanta.

Bank employees will have to work quickly to make a bid and conduct due diligence. Plus, they must be able to reopen the bank on the Monday after the bank’s Friday closure, and follow timelines to transition the acquired bank and dispose of its assets.

“It is a tremendous strain on your organization,’’ Brand said.

Regulators to bankers: Just talk to us

Communication is key to every successful relationship. It’s also key in dealing with your bank regulator. During the last session at Bank Director’s annual Bank Chairman/CEO Peer Exchange in Chicago, the message from the panel of regulators was resounding: Please talk to us. Moderated by Paul Aguggia, partner at Kilpatrick Townsend & Stockton LLP, the session’s panelists included Bert Otto, deputy comptroller, central district at the Office of the Comptroller of the Currency, and Anthony Lowe, representing the Federal Deposit Insurance Corp. as regional director, division of supervision and consumer protection.

Aguggia set the stage for the discussion by painting a scenario of tension among the regulators and the banking industry. After a day and a half of in-depth discussions, bankers had reiterated that feeling of being in a constant state of fighting–fighting to reinstate good relations with regulators, fighting to get applications approved where there was no issue before, and fighting for the freedom to fix their own problems. Meanwhile, regulators are feeling the pressure from the public to protect the system and punish those who corrupted it.


Let’s Talk About It

In the eyes of both the OCC’s and the FDIC’s representatives, maintaining open and ongoing communication is the solution for ending the underlying tension between the two groups. Otto admitted that the regulators had not done a good job communicating with the industry before the economic fallout, but shared the government’s plans for reaching out more and listening to the bank’s concerns. It’s all about relationship building, if anyone expects the system to get fixed. Lowe echoed that sentiment by requesting that bankers maintain that dialogue throughout the year, rather than just before their examination. By keeping the lines of communication open, banks have more credibility in the eyes of the regulators and thus help to further cement the relationship.

During the session, a few attendees took the opportunity to test the communication theory and vented to the panelists about some challenges they were having with their examiners. Both Otto and Lowe suggested they take their concerns to the top, and not just let renegade examiners off the hook. They also warned that the regulators were going to be tougher during their exams, and that they were going to look long and hard at an institution’s high risk areas.


Handling the New Normal

Although examiners are taking closer looks at several areas, a few stood out: Interest rate risk and bank management. Does the bank have people with the right skills to handle environment changes? Will this institution be able to deal with the new normal?

Risk management processes are also high on their radar, as regulators look for good systems that allow banks to identify risks. After hearing some banks had no idea what examiners are looking for in terms of good risk management output, Otto explained that it’s about representing a level of commitment. What do the staffing levels look like for the audit and loan review teams? What is the long term strategic plan?

Signs of Improvement

However, a bit of good news from the regulators: There is a decline in the number of banks failing, the capital markets are loosening up, and there is stabilization in the real estate market. The FDIC has been releasing some institutions from formal threat and there are signs of overall improvements. Both Otto and Lowe acknowledged that the community banks are stressed by all the new regulations, but said that community banks are still important to this country, and there will be a market in which to successfully compete. The session ended on an optimistic note. And at least some communication had opened up between the regulators and the regulated.

What To Do About Risk Management When There Are No Clear Answers

For American Community Bank & Trust, a $590 million-asset institution located about 70 miles north of Chicago in McHenry County, Illinois, enterprise risk management (ERM) has steadily become a part of the culture and dialogue throughout the organization. Chief Executive Officer Charie Zanck admits that it will still require continual improvement over time, but knew she had to start somewhere.
A common theme throughout this year’s Bank Chairman/CEO Peer Exchange event was the topic of enterprise risk management and what exactly that means to today’s financial institutions. While many bank leaders are finding the term difficult to define, it is clear that the Federal Deposit Insurance Corp. will be focusing heavily on risk management processes and not just for the publicly traded and/or larger banks.


After much research and calls to the regulators, Zanck had come up empty in her quest to define what ERM was and what the industry standard best practices were for her to build upon at her institution. What she discovered was that it wasn’t easy, or simple, and there was no hallmark case or standard process. Now what?

Although it was hard to get started, Zanck knew that the old siloed or isolated approach to managing risk wasn’t going to work anymore. So she began to build out her own processes for assessing the risks in her organization, identifying the bank’s risk appetite in conjunction with the board, putting controls in place and determining how to best measure those risks.
American Community Bank & Trust ended up changing the way it looks at risk and has begun to apply those processes to not only specific areas such as IT or vendors, but also to their strategic and growth decisions. For example, when the management team wants to introduce a new product into the marketplace, it must first get the approval of the ERM committee, which looks at it from all different perspectives and asks the tough questions. That is the essence of enterprise risk management, and no one person can do it all, Zanck said. It requires a team of people from compliance, operations and senior management to fully assess the risk to the entire organization. Zanck then reports the findings to the board and audit committee.

Unfortunately, the regulators weren’t much help to Zanck despite their new mandate to monitor her organization’s risk. She sympathized with her fellow bankers, noting that this was why it was such a difficult process for her and her team. If the banks don’t figure ERM out for themselves, then it will surely get decided for them. The question is by whom?

Taking the Long View on Regulatory Relations

two-man-facing.jpgWhen FDIC Chairman Sheila Bair gave a speech last month at the American Bankers Association’s Government Relations Summit in Washington, D.C., she got into what the American Banker newspaper characterized as some “testy” exchanges with the audience while taking questions after her prepared remarks, particularly on topics like the Dodd-Frank Act and a proposed reduction in interchange fees.

Given the tone of the Q&A session, one could reasonably conclude that the state of “government relations” between bankers and the federales smells like sour milk right now. Certainly, banking regulators have been playing hardball over the last two years with institutions that are dangerously undercapitalized or have been slow to address their deteriorating asset quality. If the regulators were asleep at the switch during the real estate bubble in the mid-2000s, they probably overcorrected once the bubble burst.

To paraphrase Claude Rains in “Casablanca,” regulators were shocked – shocked! – to discover that highly leveraged banks were piling up concentrations in commercial real estate loans that turned out to be extremely dangerous.

But this is not the first time in my memory that federal banking regulators have cracked down hard on financial institutions after a period of, shall we say, benign supervision. Back in the late 1980s, after the so-called thrift crisis, Congress passed the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) that among things abolished the old Federal Home Loan Bank Board – the thrift industry’s prudential regulator – and replaced it with the Office of Thrift Supervision. FIRREA was detested nearly as much as the Dodd-Frank Act is today, and the OTS used the law’s higher capital requirements to put a lot of highly-leveraged thrifts out of business. It struck many people back then as an example of frontier justice with the OTS playing the roles of sheriff, judge and hangman.

The point is, what’s happening today isn’t new. If you watch the banking industry long enough, you’ll see everything at least twice, including things that everyone swore the first time would never happen again.

Like it or not, the regulators have a job to do. Many banks became too reliant on real estate lending during the bubble, and once it popped they needed to raise capital so they could afford to charge off their worst loans. Based on what I have heard from bankers, lawyers and investment bankers, the regulators haven’t been willing to allow marginal institutions to earn their way out of their asset quality and capitalization problems, but have been forcing the issue in many instances. As much as they dislike Dodd-Frank or the proposed limits on interchange fees, I believe that much of the tension between banks and their regulators derives from regulatory activism at the grass roots level.

It won’t always be this way. The industry’s asset quality will gradually improve as the economy strengthens, most undercapitalized banks will either figure out a way to raise capital or will sell out to a stronger competitor, and the regulators will ease up. CEOs and directors may not like this oscillation between supervision sometimes being too soft and sometimes being too tough, but it seems to be a normal phenomenon in banking.

After living through one of the worst financial crises since the Great Depression, I am sure that all of federal banking regulatory agencies have felt pressure to tighten up their supervision. And while privately they might chafe against the heightened scrutiny, smart CEOs and their boards don’t go to war with their institution’s regulators. Instead, they consult with them frequently, communicate regularly and take a proactive approach to problem solving.

Smart bankers take the long view of regulatory relations. And that certainly doesn’t include picking a public fight with the chairman of the FDIC.

A Turnaround Year?

For the third time this week, I found myself on the FDIC’s website to start my day. A glutton for regulatory punishment? More a curiosity to see the agency’s latest report card. On the bright side, it shows that the banking industry checked in with an $87.5 billion profit in 2010 (up from a net loss of $10.6 billion a year earlier). Less rosy, four points worth noting as a follow up to my post on Monday about FDIC-assisted transactions:

  • Last year, the number of failed banks reached 157, an 18-year high.
  • The number of institutions on the FDIC’s “Problem List” rose from 860 to 884.
  • Total assets of “problem” institutions increased to $390 billion from $379 billion in the prior quarter, but are below the $403 billion reported at year-end 2009.
  • While the problem banks has grown for the fifth year in the row, it expects the number of failures to be fewer than last year.

Additionally, the report shows that lending remains weak: total loans and leases fell again during the fourth quarter. Not surprisingly, the agency’s chairwoman, Sheila Bair went on record with her expectation that “industry to take the next step, and begin to build their loan portfolios. The long-term health of both the industry and our economy will depend on a responsible expansion of bank lending.”  While not a surprising position, some might be reminded that the banking industry remains under considerable pressure from financial regulations that impact lending activity.

The fall continues for WaMu

Full disclosure: I’ve long thought of Washington Mutual’s leadership team in high regard. During my “first tour of duty” with Bank Director, I had a chance to hear WaMu’s than-CEO Kerry Killinger speak at one of our Acquire or Be Acquired conferences and came away impressed with his enthusiasm and vision for the bank. We covered WaMu in the pages of Bank Director throughout the 00’s, so I’m well versed in their fall from grace. Yes, we’d seen their highs; sadly, history hasn’t been kind to this once-darling of Wall Street. As many know, JPMorgan Chase bought the functional assets of Washington Mutual in the fall of ’08. Once the nation’s largest savings and loan, the price tag was a mere $1.9 billion after the federal government shut down the bank and held a quick auction. But until last night’s news about the FDIC potentially suing former execs from the bank, I’d filed away their demise as product of the black hole many banks were sucked into. Now?

In preparing for yesterday’s post on the coming wave of M&A, I went on to the FDIC’s website to get a sense of where our industry is and where it might be heading. While I didn’t cite any of their press releases, these three are all up and featured:

  • First California Bank Assumes All of the Deposits of San Luis Trust Bank;
  • Bank of Marin Assumes All of the Deposits of Charter Oak Bank; and
  • HeritageBank of the South Assumes All of the Deposits of Citizens Bank.

If you read yesterday’s post, you’ll notice a common thread between what I wrote and what the FDIC has promoted: assisted transactions for healthy banks. Still, the third release gave me temporary pause — not by the size of the deal; rather, the name of the acquirer. If you’re on the board of any financial institution, I’ll bet $20 you know the name Heritage (Community) Bank.  No, not the one from above; rather, the failed bank whose executives and outside directors are under siege from the FDIC.

Our editor wrote about this type of government action last month in our publication. And many service providers (namely, attorneys) have sent clients executive briefings about what this might mean to them.  Still, if you recall the S&L crisis of the late 80’s and early 90’s, the FDIC sued or settled claims against bank officers and/or directors on nearly a quarter of the institutions that failed during that time. And if the past is any indication of the future, then there is a significant risk that directors of failed banks from the recent financial crisis may see some type of action taken against them by the FDIC.

So who might be next? Well, it just came to light that the FDIC sent letters to former executives of the failed Washington Mutual Bank warning of possible legal action. According to a Wall Street Journal report I read last night, the regulator has already discussed damages of $1 billion in relation to the potential Washington Mutual lawsuit. So I have to wonder when and/or where this will all end… and who will be next.

Where My Deals At?

Last summer, Keefe Bruyette & Wood’s released an interesting bank takeover list. It had the usual suspects — potential buyers and potential sellers — and a “surprising” third: potential buyers who could become sellers. I thought back to this report while watching a handful of videos from our annual Acquire or Be Acquired conference over the weekend. With so much discussion at AOBA centering on FDIC-assisted transactions (which we will explore in greater detail in Chicago this May), this survey came back to me as it focused on so-called open-bank consolidation, comprising potential deals that wouldn’t involve a shutdown by the FDIC first.

Quite a few presented their views on non-distressed bank mergers at our 17th annual M&A conference —  forecasting a huge wave of bank M&A driven by aging management, the need to cut expenses and boost earnings, heightened regulatory costs and more. Of course, FDIC-assisted bank transactions continue to attract strategic acquirers, and the bidding process remains competitive. So “escaping” this particular discussion at our event proved nearly impossible. Indeed, for any healthy bank, considering this type of deal as a growth strategy bears real consideration.  

Case-in-point, this short video of Ben Plotkin, Vice Chairman of Stifel Nicolaus & Co.and long-time Bank Director supporter. We asked Ben to provide his thoughts on the impact of FDIC-assisted deals on M&A activity when we were together at AOBA; take a look:

A random fact that might interest only me…

As we celebrate President’s Day today, February 22, did you know today’s federal holiday celebrates George Washington’s birthday? In fact, this is the first federal holiday to honor an American citizen — celebrated on Washington’s actual birthday in 1796 (the last full year of his presidency).

D&O insurance: hope for the best, prepare for the worst

red-umbrella.jpgOn day three of our annual Acquire or Be Acquired event, a major snowstorm was hitting the mid-west and shutting down many airports leaving attendees either stranded or dashing off to catch a flight. The possibility of being stuck in Arizona didn’t concern the many remaining bankers who joined the breakout session on D&O insurance, led by Dennis Gustafson, SVP & Financial Institutions Practice Leader of AH&T Insurance, as he explored how changes at an institution can impact its risk profile as perceived by the underwriters.

While there are a variety of activities that will impact the underwriters’ risk assessment process, by understanding what they look for, directors and officers can better communicate their story to the insurance carrier. Gustafson shared the following key factors that today’s underwriter considers when identifying a financial institution’s risk profile:

Regulatory Exposures
Given the condition of the financial services industry, regulatory exposure is still the single largest risk to bank boards. With the increase in bank failures reflective of the increased number of lawsuits authorized by the FDIC, it’s become the government’s standard practice to contact the insurance carriers of a failed bank to recoup their losses and therefore gain access to the policy whether the board did their job or not.

However, as Gustafson pointed out to the audience, when a bank is considered a regulatory risk, the D&O carrier can file a regulatory exclusion which allows the insurance agency to deny claims filed by FDIC based on asset quality and capital. 

Mergers & Acquisitions
Any director and/or officer of an institution in an acquisition is considered an increased risk as they are more likely to be sued. The insurance policy might need a mid-term acquisition’s threshold for acquirers, discovery provisions for sellers, change of control provisions, cancellation and M&A exclusion. Directors should conduct an in-depth conversation about the specific M&A goals of the institution with the carrier before renewing the policy.

Loan & Asset Quality
For many reasons, loan and asset quality directly affects the risk profile of any director or officer. AH&T utilizes an underwriting risk spreadsheet that includes benchmark figures and calculates the risk associated with each policy. For instance, a loan portfolio with 1-4 family mortgages carries less risk than an institution with a higher commercial real estate profile. Deposits, positive ROA and ROE, along with capital, give the underwriter a good sense of the overall risk profile.

Peer Benchmarking
By reviewing what a bank’s peers are doing, insurance carriers can help measure what type of policy a board member should be getting and how much they can expect to spend. As an industry, financial services saw the highest premium rate for $5 million in coverage during their last renewals

Securities Litigation filings by Industry
Another method carriers will use as consideration is the number of securities class action lawsuits filed in the financial industry as compared to the rest of the universe. In 2009, the financial industry had 38.2 percentage of market capitalization subject to new filings which made for a riskier profile.

Gustafson strongly recommends that before your next D&O renewal, you set up a meeting with all the bidding underwriters to accurately present the financial institution’s goals and objectives over the term of the policy. With a face-to-face conversation, the underwriters are able to ask and answer questions in order to get a better sense of the bank’s risks. By engaging in these conversations, insurance carriers can prepare the most appropriate language for a policy, therefore better protecting a director’s personal assets.

Want to buy a bank? Look for that fatigued banker near you.

Bank directors are fatigued, many aren’t having much fun anymore, and that’s creating an environment where bank acquisitions are going to increase as some bankers just give up, according to investment bank Stifel, Nicolaus & Co.’s managing director Collyn Gilbert and executive vice president Ben Plotkin.

The two spoke today, on the first morning of Bank Director’s Acquire or Be Acquired Conference, which lasts through Tuesday in Scottsdale, Arizona. Close to 700 people have signed up to attend.

“One thing I see diminished is passion for what you are doing,’’ said Gilbert, an analyst for Stifel, speaking to a crowd of about 350 bankers, consultants and bank directors. “If you’re not passionate about what you’re doing, your vision for the business gets crowded.”

But it’s not just a general sense of malaise that’s going to lead to more acquisitions. Loan growth also is slow and banks have lots of capital they aren’t using all that effectively, Gilbert said. Buying other banks is one way to put that money to work.

Plotkin said that prices banks have to pay to buy other banks will go up in the future as the economy gets past its post-traumatic stress. Opportunities to buy at a good price are diminishing.

“I think it’s really that moment of truth in banking,” he said.  

Small banks under $1 billion are the most likely to sell to other banks because it will be so challenging for them to make a profit.

But the string of FDIC-assisted deals is slowing and becoming less attractive for acquiring banks, Plotkin said.  Private equity is competing heavily for those deals and it is taking a long time to close, leading to even further deterioration in the acquired bank’s value, he said.

Commercial real estate may have hobbled many a community bank’s bottom line, but that doesn’t mean the community bank business model is broken, Plotkin said.

Community banks can provide banking services, loans and fee-based products to small businesses, continuing to serve their local communities.

Improving execution of the bank’s strategy will be the key to success, he said.