Postcard from the 2013 Bank Chairman/CEO Peer Exchange

It was cold and rainy in Chicago in early April when a group of bank chairmen, directors and CEOs gathered to compare strategies, share problems and swap stories—fitting weather for an industry that is feeling the deep chill of margin compression and rising capital requirements.

This was the fifth year Bank Director has held the Bank Chairman/CEO Peer Exchange, which is built around a small number of presentations and three peer exchange sessions where the participants (representing 43 institutions) were able to share their thoughts in a private, off-the-record setting. And if I came away with one overriding impression, it’s that the attendees are determined to run successful organizations regardless of the challenging business climate they must operate in.

Plotkin.pngAnd the operating environment for banks is very challenging, to be sure. In a comprehensive review of the state of the industry, Stifel Vice Chairman Ben Plotkin laid out a good-news bad-news scenario. The good news: Improved profitability (due to under-provisioning for loan loss reserves, so this might be bad news for the future), a strong revenue flow from home mortgage lending, capital levels that are at a 70-year high and a significant improvement in bank valuations. The bad news: Slow economic growth and slow loan growth (which typically go hand-in-hand), increased regulation and net interest margin compression.

While the sessions were confidential, I think I can share a couple of things that came out of the three peer exchange sessions that I sat in on.

  • The directors and CEOs embraced the concept of enterprise risk management (ERM) as a risk mitigation tool rather than because regulators are forcing them to adopt it (although the bank regulatory agencies are big ERM proponents). Many of the attendees have also hired chief risk officers and set up risk committees. One CEO described ERM as a profit enhancement tool since every dollar saved through risk mitigation falls pretty much to the bottom line.
  • Many of the banks have responded to the margin pressure by expanding their lending activities into (for them) new areas. Examples include municipalities, mortgage warehouse funding, auto loans (including something that sounded very much like subprime), hotels (so-called non-destination hotels rather than resorts) and franchise companies. The point is that they are experimenting with new loan categories in an effort to protect their net interest margins, particularly since C&I lending has become extremely competitive. One participant commented that C&I loan pricing has become so irrational (both in terms of loan rates and duration) that he wondered if some bankers learned anything from the financial crisis.
  • Most of the participants seemed to have adopted a stoic attitude toward regulation. Many of them feel that they are overregulated, but they don’t waste a lot of time complaining about it because compliance is not optional. It is better to focus on something that can have a positive impact on, like margin compression.

Nash__Wolohan.pngThe most poignant session was unquestionably a joint presentation by Citizens Republic Bancorp CEO Cathy Nash and Chairman Jim Wolohan. Citizens was acquired by FirstMerit Corp. last fall—in fact, the deal closed on April 12—after a long, tough fight by Nash, Wolohan and Citizens’ executive management team and board to recover from wounds inflicted by the recession. The bank had regained profitability and was making good progress on its long-range strategic plan, but the FirstMerit deal gave Citizens’ shareholders a quicker payoff than the board and management would have been able to deliver. That’s a difficult position for any board of any target company. Whose interests do you put first, those of your shareholders, or management and the board?

“You do what’s best for the shareholders,” said Nash.

While Nash and Wolohan are not staying on with FirstMerit, I think they are two very talented and highly principled individuals who will resurface in major roles very soon. Cream always rises to the top, as the old saying goes.

Small Banks Chafe Under New Mortgage Rules

3-1-13_CFPB.pngThe Consumer Financial Protection Bureau (CFPB) is trying to crack down on some of the biggest contributors to the financial crisis: mortgage loans with balloon payments, high-interest loans, no-doc loans and loans that exceed 43 percent of a borrower’s income. 

The agency’s newly finalized rule that goes into effect in January 2014 creates a qualified mortgage standard and ability-to-repay rule that forbids those kinds of loans, that is, unless the lender wants to get sued for making them.

The trouble for small community banks and rural lenders is they often make some of those loans and they’re not trying to fleece customers.

Community banks sometimes make balloon payment loans of about five or seven years to hedge against interest rate risk. It sounds like a bad deal for the consumers, but these loans are kept in the bank’s portfolio and then simply refinanced without fees when the term is up–so no balloon payment is ever made and the borrower isn’t socked with a hefty reappraisal fee and other fees normally associated with a refinance.

People who don’t qualify for a loan under Fannie Mae and Freddie Mac underwriting standards–they work for themselves and don’t have a steady paycheck, or they own property that doesn’t qualify for a Fannie or Freddie loan for example—might be interested in getting such a loan from a community bank.

The banks don’t sell these loans in the secondary market or to a governmental authority. The bank keeps these loans, and their inherent risk, on their books. The logic is the bankers know their customers (in fact, their families have probably known each other for upward of 50 years).

One such banker is Jeff Boudreaux, the president and CEO of The Bank, in Jennings, Louisiana, a community of about 12,000 people about 36 miles from Lake Charles. 

“We can’t make 20- to 30-year fixed-rate loans because we don’t know what will happen with CD rates,’’ he says. “We cannot box ourselves in and have that interest rate risk.”

The CFPB recognized that some small banks and lenders serve rural areas and other parts of the country that don’t have good access to credit. The agency said it wants to mitigate the risk that the new qualified mortgage rules would cut access to credit for people in those areas.  The agency is carving out some exceptions for rural and small lenders. Yet, some community banks may still fall through the cracks.

For instance, rural lenders can make qualified mortgages with a balloon payment as long as they stay on the bank’s portfolio and the lender makes more than 50 percent of their mortgages in a designated rural or underserved area. The definition of rural will come from the U.S. Office of Management and Budget, but lenders such as The Bank won’t qualify. Despite its rural nature, Jennings falls in the metro area of Lake Charles. Only about 9 percent of the U.S. population lives in a designated rural area, says Matt Lambert, senior manager and policy counsel for the Conference of State Bank Supervisors (CSBS). 

In a separate proposed rule available on the CFPB’s web site, the agency proposes creating a fourth category of qualified mortgages for borrowers who don’t meet the required 43 percent debt to income ratio or will be getting an interest rate that exceeds 150 basis points of the prime lending rate. The only entities that qualify to make such loans would be certain non-profit or designated housing organizations, or small lenders with less than $2 billion in assets that made fewer than 500 first-lien covered loans the previous year. Those lenders will be able to charge as much as 350 basis points above the prime rate.  They must keep those loans in their portfolios, however.

But those lenders still can’t do interest only, negative amortization or balloon payment loans, or charge more than 3 percent in total fees and points (a higher fee is allowed for loans below $75,000), otherwise the mortgage is no longer a qualified mortgage. The rule has not been finalized.

Michael Stevens, senior executive vice president at the CSBS, points out that non-qualified mortgages are still allowed. They just don’t carry the newly created legal protection for lenders against lawsuits. 

The question is whether a lot or very little lending will take place outside the definition of a qualified mortgage.  Stevens thinks that if a lot of good borrowers are left out of the mix, the market will find a way to serve those people. 

Richard Cordray, the director of the CFPB, this week encouraged the audience at a Credit Union National Association meeting to make loans outside the qualified mortgage rule.

“Of course, we understand that some of you–or your boards or lending committees–may be initially inclined to lend only within the qualified mortgage space, maybe out of caution about how the regulators would react,’’ he said in written remarks. “But you should have confidence in your strong underwriting standards, and you should not be holding back.” 

Chris Williston, the president and chief executive officer of the Independent Bankers Association of Texas, is not satisfied. He wants a two-tiered system of regulation: one for small banks and one for larger banks that have the resources for complying with a deluge of government regulations.

The new qualified mortgage rule alone has more than 800 pages in it, and a concurrent proposal has more than 180 pages.

“All of our bankers are just weary and frustrated,’’ Williston says. “We have a lot of banks that are ready to throw in the towel.”

Phone Survey: Fiscal Cliff Will Impact Banks and Their Customers

fiscal-cliff.jpgAfter endless amounts of media coverage on the fiscal cliff, I felt it was time to hear from community bank chief executive officers.  Unlike the pundits on TV, community bankers work with small and medium-sized businesses that are driving economic growth and I thought it would be interesting to get a quick take on the fiscal cliff from the point of a view of community bankers. For instance, which will hurt bank customers the most: cuts in spending or tax increases? What are the chances that Congress and the president will reach a deal to avert the fiscal cliff before Jan. 1? How will the drastic cuts in spending and tax increases impact lending? What are the prospects for economic growth if a deal is reached?

The fiscal cliff refers to the series of automatic spending cuts and tax increases that will reduce the federal deficit by $503 billion in fiscal year 2012 to 2013, unless Congress comes up with a compromise to avoid the automatic cuts and tax increases, according to Council on Foreign Relations, a Washington, D.C.-based think tank. Half of the scheduled cuts would come from the defense budget. Some of the automatic tax increases include a reversal of the George W. Bush tax cuts, which would mean an increase in the top tax rate and higher capital gains and dividend taxes. Payroll taxes would also go back to prior year levels. The Congressional Budget Office has projected the automatic “cliff” could reduce the nation’s gross domestic product by 2.9 percent in the first six months, meaning unemployment would rise and the economy would likely fall into a double-dip recession, according to the nonpartisan Economic Policy Institute.

We conducted a phone poll Dec. 7 to Dec. 13 and got responses from 58 bank CEOs.

In our phone poll, CEOs expressed pessimism on the prospect of reaching a compromise before the deadline for automatic tax increases and spending cuts. Fifty-five percent of CEOs said they did not believe that Congress and the president would get a deal in place before the deadline.

Unsurprisingly, 66 percent of all CEOs thought the tax increases would be more detrimental to their customers than the spending cuts. Eighteen percent thought cuts would affect their customers more than tax increases.

On a happier note, if the fiscal cliff is averted and a compromise deal is reached with some tax increases and spending cuts, 57 percent of bank CEOs expected to see some economic growth while only 29 percent thought the economy would be stagnant with little growth.

While 67 percent of all bankers surveyed said they did not believe that “going off” the fiscal cliff would affect their lending activity, 31 percent said they thought the failure to reach a compromise would cause their bank to be less likely to lend.

Hopefully before the ball drops in Times Square, the folks in Washington won’t let the ball drop on the economy. 

Seven Things to Think About When Considering Loan Participations

partner.jpgFaced with heightened competition, a slow economic recovery, and tepid loan demand, community banks are looking to enhance profitability through prudent lending with attractive yields, often outside of the real estate sector where they have significant concentrations. Commercial and industrial loan participation arrangements may offer one answer, but it’s important to choose a participation partner carefully. Here is a list—by no means exhaustive—of what you might look for in potential partners.

1.  Consider your bank’s business objectives.

Your bank’s core mission is to serve your community. Before joining a participation organization, ensure that you understand how a relationship with that group will align with that mission. Look for an organization that will help you meet your bank’s strategic goals and benefit you in terms of enhanced profitability and asset diversification. Of course, you should consult with your own advisors to ensure that all of your questions are satisfactorily answered.

2. Look beyond size.

Loan participation arrangements offer community banks more than just the opportunity to serve clients with credit needs that are otherwise too large for the bank. Participations also offer the potential for geographic and industry diversification, which can be especially beneficial to community banks facing protracted regional recoveries. Participations can offer a buffer against fluctuating local economic conditions without increasing banks’ existing overhead costs.

3. Communicate with your regulators, and look for a partner who does the same.

Community bank examiners may review closely any loan participation arrangements. Open and early communication with examiners may help avert potential concerns and improve their understanding of the business line. An ideal loan participation partner regularly communicates with all applicable banking regulators and provides support to banks looking to satisfy applicable guidance and regulations.

4. Remember that loan participations may involve a relationship with a third-party service provider and involve certain risks.

Banks should examine the risks of third-party arrangements just as they would examine the risks of their own activities. Third-party arrangements require thorough risk management to carefully evaluate and continuously monitor potential partners. Therefore, if you are seeking out a loan participation partner, look for one who offers comprehensive disclosure materials and historical credit performance data. Ask for and review all documentation that explains the risks involved. Remember that not all partners are the same. Some are Registered Investment Advisers with fiduciary duties to their clients and are paid for providing advice. Others generate income predominately by reselling assets.   

5. Strong communication is essential in any relationship.

Loan participation organizations should put their clients’ needs first. Bankers should be attentive to potential sources of conflicting interests and what, if anything, the organization does to align its interests with its clients’ interests. Ideally, bankers participating in the loans should help govern the organization’s direction, operations and credit policies. If participants would like an increased focus on a particular loan type, they can work together to achieve that objective.  They should be able to regularly communicate with each other, and all bankers aligned with such an organization should have the opportunity to learn from each other and to express opinions on relevant matters.

6. Be selective, and expect the same from your partner.

Not every loan is right for every bank. Loan participation organizations should thoroughly evaluate potential loans on a variety of criteria and only recommend those loans that meet every criterion. They should also have some type of risk retention procedure. Banks should always have the option, whatever the reason, not to participate in a particular loan. No bank should be compelled to make a loan that doesn’t align with its business objectives.

7. Establish lending policies and procedures and ensure that an independent credit decision is made on each loan.

Expect your loan participation partner to maintain lending policies, and be sure to also have your own. Such policies should define limits around participation loans and identify the bank employees responsible for managing the business and reporting the results to senior management. The credit information necessary to both underwrite and conduct ongoing monitoring of borrowers should be easily available through a secure document delivery system. Banks should use this information to make their own, independent decisions about which loans they fund.

Loan Notes: Big Banks Lose Ground

The largest banks trailed the rest of the industry in terms of loan growth in the third quarter compared to the same period a year ago, according to SNL Financial.

Loan growth among the top 25 bank holding companies was just 3.27 percent during the quarter, compared to 4.2 percent for all bank holding companies above $1 billion in assets in the United States.

SNL called it a sign of how competitive the industry has been. The most active lending segments are commercial and industrial, as well as mortgage and housing-related lending. Credit card and auto lending also has been strong.

Among big banks, the leader in loan growth was TD Bank US Holding Co., the U.S. subsidiary of The Toronto-Dominion Bank of Toronto, Canada, which had 16 percent growth. Tied for second place was BB&T Corp. in Winston-Salem, North Carolina, and Discover Financial Services of Riverwoods, Illinois.

Among banks that saw declining loan portfolios were JPMorgan Chase & Co. in New York, Capital One Financial Corp. in McLean, Virginia, and Regions Financial Corp. in Birmingham, Ala.

Bank Assets Loan Growth Y/Y 3Q (%)

JPMorgan Chase & Co.

$2.3 trillion


Bank of America Corp.

$2.2 trillion



$1.9 trillion


Wells Fargo & Co.

$1.4 trillion


U.S. Bancorp

$352 billion


Source: SNL Financial

European Crisis: Should US Banks Be Concerned?

As Europe continues to experience a financial breakdown, there is no doubt that U.S. banks are and should be worried. All banks will be affected, although some more than others, depending on their relationship abroad. Business will be impacted in a number of ways, but according to the attorneys we polled, it’s not all bad.

Should boards at U.S. banks be concerned about the ongoing problems in Europe?

Sara-Lenet.jpgThe boards of U.S. banks that may be affected the most (such as banks that hold a significant amount of European debt, deal in Euros or otherwise engage in business in Europe or with European banks) should be particularly mindful of the situation. On the flipside, in some cases, the problems in Europe may actually open up new opportunities for U.S. banks, which are opportunities that boards of U.S. banks may want to consider. For instance, European banks may begin to lend less in the U.S. and focus on preserving capital and lending in their home countries, which would present increased lending opportunities to U.S. banks (including through loan syndications).

– Doug McClintock & Sara Lenet, Alston & Bird

dwight-smith.pngYes. On an immediate basis, the problems with the calculation of LIBOR will result in a different rate, although how that may be calculated is unclear. Since the rates on many commercial and consumer loans are based on LIBOR, any replacement will at a minimum complicate the lives of both borrowers and lenders. For lending going forward, a bank probably should not use a LIBOR-based rate and may want to consider whether to base lending on any standard rate. More broadly, on a macro basis, problems in Europe inevitably spill over into the United States.

Even though the spill-over seems unlikely to cause a second recession here, any resulting slow down necessarily will have an adverse effect on the U.S. banking industry—a phenomenon we are already experiencing. The macro consequences of the European problems are beyond the control of any bank, but on an individual basis, a U.S. bank should have a deep understanding of its European exposure. This would include not only any direct exposures, for example in the form of bonds, but also exposures to commercial borrowers that may depend to a material extent on their European businesses. A bank should re-visit the use of any foreign instruments that it may use for hedging purposes. The use of foreign exchange also may require more careful monitoring.

– Dwight Smith, Morrison Foerster

Chip-MacDonald.jpgOngoing problems in Europe affect U.S. monetary and fiscal policies, especially in a presidential election year. Concerns over Europe have led to an influx in foreign investment in U.S. Treasury securities as a safe haven investment. This has reduced yields upon Treasury instruments, and TIPs (Treasury Inflation Protected Securities) have even sold at negative rates. Lower Treasury rates adversely affect the yields on bank investment portfolios and compress margins on loans and other credit assets. This makes it more difficult for banks to generate returns on equity and funds available for dividends and repurchases of common stock. Current low interest policies may have created new systemic risks by encouraging investors to “reach” for higher yields in longer maturity securities with riskier credit quality.  

All directors should be concerned about current levels of interest rates, potential future inflation, and interest rate risks resulting from these policies driven by European and domestic U.S. concerns. The regulators are especially concerned about interest rate risks and their future effects on bank balance sheets and earnings.

– Chip MacDonald, Jones Day

john-bowman.pngYes. Boards of banks, regardless of asset size, must understand generally the business of their bank and the environment in which their bank operates. For example, it was not long ago that many bank directors had never heard of or made a subprime real estate loan. They quickly came to appreciate the many challenges to their banks that that loan product presented. The European Union is the largest trading partner of the U.S. Threats and the challenges presented by the second largest economy in the world (the combined economies of the euro zone) cannot and should not be ignored. Problems in Europe could have very real consequences for financial stability in the U.S. in areas such as employment and credit availability.

– John Bowman, Venable

Peter-Weinstock.jpgFortunately or unfortunately, the world in which we live is interconnected. What once appeared to be vast oceans now seem like small ponds (unless one is flying internationally in coach). With the current global economy, it is hard to avoid thinking of the Woody Allen quote, “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness; the other, to total extinction. Let us pray we have the wisdom to choose correctly.” Unfortunately, there are not many ways to inoculate our economy, and thus, the life blood of community banks from the contagion taking hold in Europe. Only if we as a country can get our own financial house in order will we be in a position not only to withstand, but to help the European economy to grow out of its problems.

– Peter Weinstock, Hunton & Williams

Nonaka_Michael.jpgObviously, boards at U.S. banks with European operations should pay close attention to country developments. However, boards at U.S. banks without European operations also should monitor Europe’s problems, because they have the potential for a major ripple effect if country initiatives are unsuccessful. A board should consider whether its bank has particular exposure to Europe and determine whether special contingency planning is necessary.

 —Jean Veta and Michael Nonaka, Covington & Burling

How Will Basel III Impact Banks?

With Basel III looming, financial institutions are yet again bracing themselves for the changes to come from new regulation. In simple terms, Basel III will require banks of all sizes to maintain higher capital ratios and greater liquidity as a safety measurement, but what will this really mean for a bank? Several bank attorneys think lending will suffer, as many banks will have to focus on increasing capital and taking on less risky loans.

How will the new Basel III capital requirements impact the banking industry in the U.S.?

Luigi-DeGhenghi.jpgBasel III will generally require all U.S. banks, large or small, to hold more capital than under existing rules, especially in the form of common equity. The effect will be to incentivize banks to reduce their risk-weighted assets by reducing their exposures or their level of risk in order to maintain a sufficient return on equity to attract investors. The impact on bank mergers and acquisition activity is unclear. Increased capital requirements will drive banks as sellers, but will temper banks as buyers. But there will likely be a contraction in the supply of credit from banks, which may drive lending into less regulated parts of the financial sector. This seems at odds with the prevailing political push for more lending from banks and more financial regulation.

—Luigi L. De Ghenghi, Partner, Davis Polk

Gregory-Lyons.jpgIf adopted as proposed, the Basel III requirements will have a significant impact on U.S. banks of all sizes.  Community banks were surprised that they were subject to Basel III at all, and the higher substantive and procedural burdens on both residential and commercial lending can reasonably be expected to force many of them to exit the industry.  For the larger banks, much of what is in the U.S. proposals is consistent with what they have been tracking from the Basel Committee since late 2010.  Nonetheless, the higher capital charges likely will continue to force the shrinking of business lines in the short term, and severely inhibit large bank mergers over the longer term.  

—Greg Lyons, Debevoise & Plimpton

Mark-Nuccio.jpgThe impact will be positive in the long term.  Basel III’s higher capital requirements will be phased in over a number of years.  While many are eager for banks to become more generous lenders, Basel III’s capital demands encourage banks to husband their resources.  The new capital regime will be a drag on economic recovery, but it ought to produce greater long-term financial stability. 

—Mark Nuccio, Ropes & Gray

Jonathan-Hightower.jpgThe real impact will be the change on Main Street.  The proposed risk-weighting rules will require banks to tie up more capital with certain asset classes, which will cause banks to increase their pricing of those assets in order to achieve the same return on equity. Therefore, we can expect higher pricing for junior lien mortgage loans, highly leveraged first mortgage loans, and highly leveraged acquisition and development real estate loans.

This change in pricing will affect the demand for these loans, which will in turn limit the number of developers and homebuyers in the market. That contraction will impact both the supply and demand sides of the economic equation. At the end of the day, these changes will lead to a slower recovery of the facets of the economy related to housing and development.

—Jonathan Hightower, Bryan Cave

rob_fleetwood.jpgThe implementation of the Basel III regime will highlight the need for banks to be creative in their capital planning. We have already been assisting numerous community banks in capital raising initiatives to provide support for the development and implementation of lending and other income-producing programs, as well as strategic acquisitions or expansions. We are encouraging our clients, to the extent they have not done so already, to implement comprehensive capital plans that focus on careful management of existing capital resources and proactive research of available sources of future capital.

We have also been discussing with clients the ability to implement new lending programs, other non-interest income sources and deposit products in anticipation of the new requirements. If done correctly, these initiatives may provide additional resources for banks to grow, despite the new requirements. However, as with all new programs, they need to be carefully studied and managed to ensure compliance with all regulatory requirements, not just the new capital rules.

—Rob Fleetwood, Barack Ferrazzano

Peter-Weinstock.jpgBasel III and the changes to risk-based capital regulations provide substantial penalties, in the form of increased capital allocations, for risk taking.  Former chairman of the Federal Deposit Insurance Corp. Bill Isaac, in his book, “Senseless Panic: How Washington Failed America” demonstrated the pro-cyclical nature of mark-to-market accounting.  Yet, the Basel accord now mandates it for the securities portfolio.  The risk-based capital ratios dramatically increase the risk-weighting of several asset classes, including mortgages that are not “plain vanilla” and problem loans.  Because such penalties have a potentially severe impact on capital, prudent bankers will reduce their risk of a capital shortfall either by rejecting loans at the margin or maintaining higher capital cushions.  Either way, the credit crunch for all but the clearly creditworthy is likely to be exacerbated.

—Peter Weinstock, Hunton & Williams

Opportunities in a Neglected Field

solar.jpgThe large financial institutions that were heavily involved in equipment financing have reduced the size of their portfolios from pre-crisis days. Does that mean there is an opportunity for smaller banks, even with soft growth in the U.S. economy? BancAlliance thinks so. The Washington, D.C.-based network of member banks pool their resources to access national commercial and industrial loans, gaining access to larger loans than they might otherwise be able to finance. It recently added a new equipment finance team lead by Jay Squiers, who talks about trends in the sector.

Why did BancAlliance get into equipment financing?

Our members have told us that they would like to see a variety of C&I loan opportunities, including equipment finance. We are focusing on larger equipment loans to larger companies—these loans just would not fit on the balance sheet of a community bank. We have a lot of experience with the underwriting and collateral associated with these loans, and many community banks don’t have the resources to access this asset class on their own. It is a solid asset class that community banks will appreciate—with tangible collateral—but still very different from commercial real estate loans.

Why is it a good asset class?

It is a market in which many of the larger players have exited. A few years ago, a number of large financial companies were active in this space, building significant portfolios. As a result of the financial crisis, the capacity of these financial players has diminished, and capital costs have increased. We believe that we will be able to go into the market and access good loans that are well structured and acquire them on behalf of our member banks, and we can be a significant player in this market.

Are you essentially buying loans from these big lenders?

As we get this asset class up and running, we are working with agents who already have loans in the pipeline. As we continue to grow, we will have the capacity to originate our own loans. We will base our strategy on member preferences.

What does the market look like, economically speaking?

We’re in a replacement cycle—not a growth cycle. Companies have tightened their belts for the last few years. The equipment that needs financing right now is absolutely an essential part of a company’s ongoing business. As a lender, you want to finance essential equipment for a business because you know they’ll take care of their equipment and stay current on the loan. When you’re talking about real estate, that’s all about location and the local economy. When you’re talking about equipment, it runs on a different economic cycle than local real estate.

What are the special challenges for doing these loans?

You have to be comfortable with collateral valuations, including a sense for projected valuations. If depreciation dramatically exceeds amortization, you’re going to end up with an underwater loan that is not covered by your collateral. The valuation is affected by a lot of factors: Can this equipment be redeployed? Is it going to maintain its value? How comfortable am I that the market is going to be there in three to five years? To answer these questions, we use an independent evaluator, with strong credentials, who performs detailed analysis. It is analogous to the appraisal process on real estate loans. The appraisers are independent, experienced and knowledgeable about the type of equipment we’re asking them to value.

You underwrite both the collateral and the borrower?

Yes. You want someone who is a good operator and is generating sufficient cash flow to repay you. We look at the downside scenario as part of the underwriting. We need to be comfortable that we are lending to an experienced operator who is not prone to mistakes. Equipment loans are typically structured on a full recourse basis. In addition, a secured claim with priority in bankruptcy exists against particular pieces of equipment if that scenario ever occurs.

What types of equipment are we talking about?

We will cover a broad range of sectors, including manufacturing, oil and gas, trucks and railcars, cargo carriers, tankers or barges, and equipment used to process and haul commodities. Medical equipment is a really competitive space right now, but we will do it if we find the right opportunities. I think we’ll very much focus initially on the U.S. middle market and larger loans, $5 million to $100 million.

Debate: How Will the CFPB Impact Banks?

As the Consumer Financial Protection Bureau gets underway, compiling data and taking complaints, there is still a large amount of uncertainty about the impact on banks. Although technically only supervising banks with more than $10 billion in assets, the ripple effect in this industry is what worries smaller banks. We asked legal experts in the field what they thought the most immediate effect would be for banks. Many lawyers believe the CFPB will impact banks in a big way, and may reduce lending and the availability of credit across the board. 

What is the most immediate effect that the Consumer Financial Protection Bureau will have on banks?

geiringer.jpgThe most immediate effect that the CFPB will have for banks over the $10 billion threshold is that their compliance examinations will now be conducted by an agency whose mission is based solely on consumer protection.  For banks under the $10-billion asset threshold, the primary potential impact is that the CFPB will promulgate consumer protection regulations for these smaller banks, even though it will not generally examine them.  This may create a disconnect in the CFPB’s understanding of smaller institutions and exacerbate the current one-size-fits-all compliance approach about which community banks have expressed concern.  In addition, all banks should be prepared to respond to postings on the CFPB’s website, which prominently invites the public to “submit a complaint” about their financial institutions.

—John Geiringer, Barack Ferrazzano Kirschbaum & Nagelberg LLP

charles_washburn.jpgBanks and other insured depository institutions with total assets of more than $10 billion and their affiliates are serving as guinea pigs as the CFPB develops its examination staff, standards and procedures. Banks that have gone or are currently going through CFPB compliance examinations have reported that the experience is very challenging. Accordingly, large banks need to double check the effectiveness of their compliance function before the CFPB comes calling.

—Chuck Washburn, Manatt, Phelps & Phillips, LLP

John-Gorman.jpgThe cost and compliance burden [of the new CFPB] will put a damper on consumer lending, but it will be more pronounced with respect to banks with assets in excess of $10 billion.  It is already happening.  Almost by necessity, the CFPB is taking or will take a one-size-fits-all approach to regulation, such that the problems associated with the worst and least regulated entities are presumed to be the industry norm, and all participants’ conduct will have to comport with a regulatory reaction that is based on the lowest common denominator.  When the CFPB issues rulemaking, the bank regulators, who will police the conduct of the under-$10-billion banks, will not want to be viewed as lax enforcers.  The cost and risk of lending will increase for all banks.  That will result is less lending.

– John Gorman, Luse Gorman Pomerenk & Schick, PC 

Mark-Chorazak.jpgWith uncertainty over how the Bureau’s approach to supervision and enforcement and its priorities will evolve during the next several years, an important task for banks, regardless of asset size, has been to establish good working relationships with Bureau staff. For larger banks with assets over $10 billion, such relationship building is critical in light of the Bureau’s exclusive examination authority and primary enforcement authority for compliance with federal consumer financial laws. However, smaller banks with assets of less than $10 billion also have an incentive to build a solid reputation with Bureau staff. Although it has no examination and enforcement authority over smaller banks, the Bureau may participate in examinations conducted by the prudential banking regulators (“on a sampling basis”), refer enforcement actions and require reports from these institutions.

—Mark Chorazak, Simpson Thacher & Bartlett LLP

Peter-Weinstock.jpgRegardless of whether the Consumer Financial Protection Bureau (“CFPB”) has supervisory authority over a financial institution or not, its presence, seemingly atop the regulatory pantheon, will mean increased costs on financial institutions and reduced availability of credit.  It is too early to say how the CFPB will maintain a balance between regulation and cost of compliance, on one hand, and availability of reasonably priced credit, on the other hand.  Recent indications do not look good for financial institutions or credit availability.  A classic example is the CFPB’s statements regarding unfair, deceptive, abusive acts and practices (UDAAP).  The CFPB has indicated that a financial institution needs to evaluate whether a proposed customer, such as an elderly customer, understands all of a product’s terms.  The consequences for financial institutions that are out of compliance with issues such as UDAAP are quite severe.  Financial institutions will err on the side of not making certain loans, rather than expose themselves to losses.

– Peter Weinstock, Hunton & Williams, LLP

John-ReVeal.jpgBanks with more than $10 billion in assets also are already undergoing CFPB compliance examinations.  Even those banks that believed they were fully prepared have been surprised by the scope and duration of these examinations.  The pre-examination information requests alone often exceed in scope what bankers would face in an entire examination cycle that included all aspects of compliance and safety and soundness. Banks with less than $10 billion [in assets] are not subject to the direct compliance examination authority of the CFPB, but will still incur significant costs.  First, the CFPB has the primary responsibility for developing and implementing new consumer protection regulations.  These costs will come in the future, but banks of all sizes will need to contend with these new regulations. 

—John ReVeal, Bryan Cave

Confusion Reigns on Mortgage Compensation

lost.jpgYou probably thought the Consumer Financial Protection Bureau (CFPB) was just focused on, well, consumer protection, but the new agency has an important voice on certain compensation matters as well. And the beleaguered home mortgage industry, which really doesn’t need any more challenges right now, is waiting on the bureau to clarify whether mortgage loan origination compensation rules—first adopted by the Federal Reserve Board in September 2010 under Regulation Z—prevents the payment of performance bonuses to mortgage loan originators (or, to lapse into industry jargon, MLOs) as part of a non-qualified incentive compensation plan.

Rulemaking authority for Regulation Z, otherwise known as the Truth in Lending Act, was transferred to the CFPB by the Dodd-Frank Act, and in December 2011 the bureau issued interim final rules that recodified the Fed’s earlier restrictions on mortgage loan origination compensation. On the face of it, those restrictions were fairly straightforward. “Subject to certain narrow restrictions, the Compensation Rules provide that no loan originator may receive (and no person may pay to a loan originator), directly or indirectly, compensation that is based on any terms or conditions of a mortgage transaction,” according to CFPB Bulletin 2012-02, released on April 2 of this year.

In an official staff commentary issued by the Fed shortly after the rule was adopted, compensation was defined to include salaries, commissions and annual or periodic bonuses. Terms and conditions were deemed to include a loan’s interest rate, loan-to-value ratio or prepayment penalty.

I suppose it makes sense in our hyper-regulated world that the CFPB’s consumer protection authority would extend to MLO compensation because one of the more pernicious industry practices is steering, where borrowers—often low income people with poor credit histories—are unknowingly directed toward a more expensive mortgage that provides higher compensation to the originator than a cheaper loan.

Rod Alba, vice president and senior regulatory counsel at the American Bankers Association in Washington, says that up to this point the Fed’s commentary—including its amplification of “compensation” and “terms and conditions”­­—was easy enough to understand. But the commentary also stated that MLO compensation may not be based on a “proxy” for a term and condition. The CFPB bulletin explained it thusly: “[C]ompensation may not be based on a factor that is a proxy for a term and condition, such as a credit score, when the factor is based on a term and condition such as the interest rate on a loan.”

For Alba and others, that statement leaves too much to the imagination. “What the hell is a proxy?” he asks. “Well, a proxy is anything that would stand in the place of a term and condition. The problem with that is no one knows what it means. It was brought up in the commentary to the rule, not in the rule itself.”

More specifically, it’s unclear how banks can structure an incentive compensation program for their MLOs that won’t end up violating the rule. Alba worries that that any plan based on a profitability metric—whether it’s the profitability of a mortgage operation or even the bank itself—could run afoul of the rule if profitability is later judged to be an impermissible proxy. The regulatory rationale, I suppose, is that MLOs might still be tempted to engage in abusive practices like steering if they stand to gain under a performance-driven bonus plan that benefits the entire bank.

“Performance-based bonuses do fall into [the] proxy [definition] because the bonuses are derived from the loans,” Alba says. “That means [performance-based] bonuses are gone.”

“When they inherited this [from the Fed], the bureau didn’t clarify it,” adds Alba. “This rule is a mess!”

The CFPB has tried to provide some clarity about the compensation rule. In Bulletin 2012-02, the bureau states that banks “may make contributions to qualified plans like for loan originators out of a pool of profits derived from loans originated by employees under the Compensation Rules.” This would include 401(k) plans, which are the primary retirement programs for most employees today.

However, the bulletin did not provide guidance about how the rules apply to non-qualified plans like the ones that Alba is worried about.

Another confusing issue is the definition of an MLO. Is it someone who underwrites home loans? Or would the MLO designation also apply to, say, a branch manager who referred the borrower to an underwriter and might have played some role in negotiating the loan? If the latter turns out to be the case, then they would also fall under the rules and might not be eligible for a bonus paid out by a non-qualified plan.

Susan O’Donnell, a managing director at New York-based Pearl Meyer & Associates, relates the case of a client bank whose CEO might not be eligible to receive a bonus based on the bank’s performance because he has a license to originate loans and thus could be considered an MLO.

“If you fall into that category, then you can’t participate in any program that is tied to the profitability of the bank,” O’Donnell says.

How soon this mess gets cleaned up is anyone’s guess. In Bulletin 2012-02, the bureau points out that Dodd-Frank contains a provision that also deals with mortgage origination compensation and it must adopt a final rule to satisfy that requirement by Jan. 21, 2013. The bureau anticipates providing “greater clarity on these arrangements” in connection with that effort. But does that mean banks will be operating in the dark in terms of their MLO incentive compensation plans until next January? We don’t know.

The CFPB did not respond to an interview request on the matter. Neither did the Office of the Comptroller of the Currency, which along with the Federal Deposit Insurance Corp. (FDIC), has enforcement authority for Regulation Z at banks under $10 billion in assets. A spokesman for the FDIC declined to make an agency official available for an interview, but he did send along a Financial Institution Letter—FIL-20-2012—that was sent out to FDIC-supervised banks on April 17, 2012.

The FDIC’s letter framed the issue in pretty much the same fashion as the CFPB bulletin, and acknowledged that the CFPB has yet to provide any guidance about non-qualified incentive compensation plans for MLOs.

The letter concluded with this vague statement, which was probably meant to clarify the FDIC’s own enforcement perspective on MLO bonus plans, but probably didn’t clarify anything: “FDIC Compliance Examiners will review institution compensation programs in light of the Compensation Rules, and consider the specific facts of the institution’s compensation program, the totality of the circumstances at each financial institution, and the institution’s efforts to comply with the Compensation Rules.”

Hmmm… Good luck bankers!