Bob's Blog

Muni Bond Price Discovery: Don’t Get Picked Off!

12/05/2012 00:43:00

It’s the worst kept secret in the brokerage business: community bank CFOs and investment managers rarely seek pre-purchase validation on prices paid for investment securities. If the yield and the structural characteristics look good, most are apt to pull the trigger. That is a painful, expensive mistake—especially in today’s muni market.

Municipal bond price levels have skyrocketed in 2012---particularly since the November elections. Bond traders are on the prowl in search of inventory. Most have integrity. Some do not. Here is a scenario to watch out for: a bond salesman phones about a particular CUSIP that he sold you a few years ago. It’s a 5% coupon AA- credit that you bought in 2010 for 101.5. He’s got an interested buyer and he’s willing to buy it back from you for 112—a handsome gain. You think about year-end; you’d love to book a nice gain…and perhaps trade out that bond for a security a little further out on the curve. You agree to the price and moments later a confirm arrives via e-mail. What the salesman didn’t tell you was that you could have easily sold that bond for 115.

Most of the big commissions in muni trades are being made right now on the bid side—not so much on the ask side. Bond reps are bringing in inventory at spreads that in some cases exceed 3 and even 4 points as result of the recent run-up in prices. Once in house, the bonds are re-sold either by the same rep---or by another salesman in the firm. If sold by a different rep, the bulk of the commission is kept by the salesman who brought the bond in (of course). With as much demand as there is these days for securities, good inventory doesn't last long.

Where can you investigate muni prices? Save this site in your favorites: it’s the Municipal Securities Rulemaking Board. Type in any muni CUSIP and you can view the trading history---both the buy and the sell side. Not only can you use this site for price validation…you can also use it to back-test transactions as a measure of how you’re being treated by your favorite bond salesmen. The MSRB is also a great go-to site for research, financial updates and issuer releases.

Here’s a recent heist that involved me: In late November I was quoted a price of 115.916 for 270 New Lenox, IL GOs. They fit my parameters and I bought them. Later that week I went to MSRB and saw that my trade was done at a spread of 241 bps. That’s a difference of 1.70% vs. 2.04% on a bond with a 2026 final! I was not pleased. I phoned my rep (a salesman I’ve known and trusted for years). He walked me through the transaction…and contended that he’d only made about 7 bps the trade. It was the “other guy” who’d made the killing. Hmmmm….

Most firms have maximum allowable commissions…but they are egregiously wide. We all know that bond reps work for a living…but we’d also like to believe they’re taking good care of us, too. See my trade here.

Here’s another transaction that happened to a bank in my town around the same time: 500 Minnesota Highway GOs were bought in at a brokerage firm at 116.40 on 11/20/2012. On 11/26 those same bonds were sold at 118.685. The total commission in this case was 2.28%--or $11,425 for a few minutes work. Ouch! Upon calling this trader, the CFO was given a long, convoluted explanation…but rep wouldn't reveal how much he had made on the trade. Here’s the spec on that one.

The moral of this Christmas story: do your homework, be careful on the sell side—as well as the buy side---and keep the “jingle” on your balance sheet! These days we bankers need every basis point we can get.

Happy Holidays from BankForward Consulting

Enablement vs. Entitlement

06/28/2012 22:05:00

First a divisive, partisan tale--and then a personal reflection

6-28-12

A woman in a hot air balloon realized she was lost. She lowered her altitude and spotted a man in a boat below. She shouted to him,

"Excuse me, can you help me? I promised a friend I would meet him an hour ago, but I don't know where I am."

The man consulted his portable GPS and replied, "You're in a hot air balloon, approximately 30 feet above ground elevation of 2,346 feet above sea level. You are at 31 degrees, 14.97 minutes north latitude and 100 degrees, 49.09 minutes west longitude."

She rolled her eyes and said, "You must be a Republican.
"I am," replied the man. "How did you know?"
"Well," answered the balloonist, " I can believe that everything you've told me is technically correct. But I have no idea what to do with your information, and I'm still lost. Frankly, you've not been much help to me."

The man smiled and responded, "You must be a Democrat."

"I am," replied the balloonist. "How did you know?"

"Well," said the man, "you don't know where you are -- or where you are going. You've risen to where you are due to a large quantity of hot air.

You made a promise you have no idea how to keep, and you're hoping that I will solve your problem. You're in exactly the same position you were in before we met, but now you're now disappointed with me and feel that I've somehow failed you."

Personal reflection: I can appreciate why millions of individual citizens are celebrating today. For those without health insurance, those for whom insurance would consume an overwhelming share of income, and for those who stay in office by entitling them, this is a day that has "entitled" them to something substantial. For the millions who are unwilling or unable to afford health care coverage---their lives have been measurably improved this day by way of entitlement. That is a genuine reason to celebrate. I know many folks who will be grateful for years to come as result of today's supreme court decision.

Alternately, today was a kick in the head to a nation that is living beyond its means. Our leaders have opted to live for today...because in the short term people vote. Our leaders have been continually choosing "entitlement" over "enablement"...and so our nation becomes less "able". The welfare of our citizens was improved today by way of entitlement. The welfare of our nation was (further) imperiled today...because the entitlement will prove unsustainable. RDK

A Surprise (to me, anyway) in Comparing Judicial vs. Non-Judicial State NPA's

06/23/2012 13:55:00

I've had opportunity to speak with senior management from several thrift charters over the past couple of weeks. During two conversations in particular--one each with an Illinois and an Indiana thrift--executives complained that the judicial foreclosure process in their states was extending the time necessary to resolve residential mortgage NPA's, foreclose and turn around rehabilitated properties for sale. By comparison, they said, non-judicial states had more streamlined processes to take control of properties and get them off their balance sheets. This got me to wondering. So with the help of Rick Boals, a fellow Senior Bank Strategist at Bank Intelligence Solutions, I pulled comparative stats for judicial vs. non-judicial states for 1Q12. Specifically, we compared non-performing residential real estate mortgages and total ORE to average outstanding total loans for the quarter. In pulling the data, we only queried those institutions where res mortgage NPA's and total ORE was >0, so the query didn't pull all institutions, but only those that had data to measure.

The outcome was a surprise to me, especially given the expressed concerns of the two judicial state execs. For both stats---res mortgage NPA's to total average loans and total ORE to average loans---judicial states show lower NPAs on their balance sheets than do their non-judicial counterparts. Full analysis detail is available for download on the "Resources" tab of my website for those interested to view the state-by-state stats.

Why do I find it a surprise? I thought that judicially-imposed procedures would surely have slowed the workout time--and therefore increased the pipeline---of both NPA's and ORE on the balance sheets of judicial states.

Now, I do realize that judicial processes are not uniform across states that require judicial execution...and neither are non-judicial state processes. I also realize that one quarter's results may not present a perfect reality. But certainly residential mortgage NPA levels and total ORE levels in 1Q12 are not unrepresentitive of recent trends, and I can think of no reason why 1Q12 would represent an ill-timed quarter to measure these stats. So please consider this a request for input, both from judicial as well as non-judicial states: are these comparative results what you expected to see? If so, why? If not, why? Are there other questions that need to be considered when viewing these stats...or some other way to frame the question?

I would appreciate your considered thoughts and feedback.

Oh, and click here to view a Mortgage Bankers Association white paper on the subject of judicial vs. non-judicial procedures.

RDK

Torture Numbers and They'll Confess To Anything

04/15/2012 11:51:00

On the front page, above the fold in the April 4th edition of American Banker, a graph is prominantly displayed that shows compelling growth in C&I lending from September 2010 through the first quarter of this year. The accompanying story on page 10 includes related graphic details, but you'll need your AB credentials to read the full article.

While the trend looks comforting, it probably left most bankers wrinkling their brows, wondering why they haven't seen anything like that in their own board reports. Here's why:

Loan growth in 2011---especially C&I---occurred almost exclusively at banks with greater than $10B in assets...which accounts for about 140 institutions. Banks with asset levels between $100MM and $1B saw overall growth only in ag lending, while banks with assets between $1B and $10B experienced some moderate growth in C&I. Those $100MM to $1B institutions fortunate enough to be located in the farming belt saw minor growth in ag...but nowhere else.

A tip of the hat to Rick Boals, senior strategist at Bank Intelligence for this illuminating research, gleaned from the Fed's Beige Book.

2011 ended with roughly 7,200 chartered financial institutions insured by the FDIC. The majority of those institutions saw their loan portfolios decline throughout the year--either intentionally through deleveraging, or unintentionally through pay-offs and amortization. Loan growth remains a challenge for community banks, despite what 'overall' trends may present.

Does Strategy Matter?

02/17/2012 00:53:00

There are eight distinct lending strategies and least five intentional funding strategies a banker can pursue in building a balance sheet. Think that strategy doesn't matter? Check out the interactive graph using the interactive graph on the Bank Intelligence website. It's a thought-provoking tool.

Brilliant But Flawed

12/04/2011 15:06:00

Peter Wallison, a respected fellow at the American Enterprise Institute, published an insightful op ed piece in the December 3-4 weekend WSJ that appears to be getting wide circulation across the web. The article makes several important points about regulatory shortcomings leading up to the financial crisis of 2007...but I differ materially with one of his prime contentions. Read his article first...then consider my response below (I also posted this response with the article on WSJ.com). I would appreciate your thoughts and feedback in this regard. You can Wallison's piece in the on-line WSJ by clicking here. For those without an on-line WSJ subscription, the article is pasted at the bottom of this blog post.

All the best,

Bob

BRILLIANT BUT FLAWED

Mr. Wallison offers several valuable insights into the contemporary complications of banking---but his article is flawed in a way that undermines his central point: it is not accurate to contend that mortgage-backed securities (MBS) require only 1.6% capital backing.

Risk-weighted capital is a fundamental ratio in measuringthe soundness of a bank. Agency-backed MBS---those issues backed by Freddie Mac and Fannie Mae, require a 20% risk-weighting. For example, a $1MM MBS security requires risk-weighted capital support amounting to $200K on a bank's balance sheet. That's because Fannie and Freddie are (unfortunately) absorbing all the losses on their bad issues. Ginnie Mae (GNMA) MBS is fully government backed (as opposed to gov't agency backed) and requires 0% risk-weighted capital. In other words, GNMA securities are considered "riskless" to a bank's balance sheet, because the "full faith and credit" of the U.S. supports those issues (yeah, I know...but that's a different argument). Put another way, a bank could hold 20% more of a GNMA issue for the same capital commitment of a Freddie Mac issue. Most importantly,so-called "private label" MBS---all that stuff issued by Goldman Sachs, Merrill Lynch and the like, require a 100% risk-weighted capital support--the same as that of a corporate loan. A bank could hold $5MM of a Fannie Mae MBS CUSIP for the same risk-based capital required to hold $1MM of a Goldman MBS CUSIP---or a customer loan. The higher the risk, the more capital required to support the asset.

Banks holding portfolios of GNMA and agency-backed securities did quite well for themselves between 2008 and 2010, as the prices of those securities began to soar in late 2008. Huge gains were booked for those banks that held those securities through 2009 and up through today. Those holding private label MBS got hammered.

While it is fair to criticize bank regulators for not seeing the apocalypse coming, it is not fair to offer a one-size-fits-all critique: banks that dealt in huge portfolios of non-supported MBS took on a very different risk profile than those that bought or traded in government andagency-backed paper. As such, those 1988 ratios to which Mr. Wallison refers warrant a better explanation.

All the best,

Bob Koncerak

Bankforward Consulting, LLC

WSJ Online OPINION December 3rd, 2011

How Regulators Herded Banks Into Trouble

Blame the Basel capital standards for over-investment in mortgage-backed securities and now government debt.

For many in the U.S., the worrisome events occurring in Europe recall the 2008 financial crisis. If Greece or some other country should fail to meet its debt obligations, the result could be much like the 2007 mortgage meltdown in the United States. Many banks and other financial institutions in Europe, and some in the U.S., may be weakened by the loss in value of the sovereign debt they hold. Why is all this happening again?

The important factor in both the American and European cases is what is known to scholars as a common shock—a sharp decline in the financial condition and regulatory capital of a large number of financial institutions because a widely held asset has suddenly lost its value.

In the U.S., this shock came when the 10-year housing bubble deflated and U.S. financial institutions were weakened by a sudden loss in value of the mortgage-backed securities (MBS) they were holding, especially those based on subprime mortgages. Mark-to-market accounting did the rest, requiring banks to write down the value of their MBS assets until they appeared unstable or insolvent.

In Europe, the problem is similar and so is its source. Europe's banks, like those in the U.S. and other developed countries, function under a global regulatory regime known as the Basel bank capital standards. Basel is the Swiss city where the world's bank supervisors regularly meet to consider and establish these rules. Among other things, the rules define how capital should be calculated and how much capital internationally active banks are required to hold.

First decreed in 1988 and refined several times since then, the Basel rules require commercial banks to hold a specified amount of capital against certain kinds of assets. Under a voluntary agreement with the Securities and Exchange Commission, the largest U.S investment banks were also subject to the form of Basel capital rules that existed in 2008. Under these rules, banks and investment banks were required to hold 8% capital against corporate loans, 4% against mortgages and 1.6% against mortgage-backed securities. Capital is primarily equity, like common shares.

Although these rules are intended to match capital requirements with the risk associated with each of these asset types, the match is very rough. Thus, financial institutions subject to the rules had substantially lower capital requirements for holding mortgage-backed securities than for holding corporate debt, even though we now know that the risks of MBS were greater, in some cases, than loans to companies. In other words, the U.S. financial crisis was made substantially worse because banks and other financial institutions were encouraged by the Basel rules to hold the very assets—mortgage-backed securities—that collapsed in value when the U.S. housing bubble deflated in 2007.

Today's European crisis illustrates the problem even more dramatically. Under the Basel rules, sovereign debt—even the debt of countries with weak economies such as Greece and Italy—is accorded a zero risk-weight. Holding sovereign debt provides banks with interest-earning investments that do not require them to raise any additional capital.

Accordingly, when banks in Europe and elsewhere were pressured by supervisors to raise their capital positions, many chose to sell other assets and increase their commitments to sovereign debt, especially the debt of weak governments offering high yields. If one of those countries should now default, a common shock like what happened in the U.S. in 2008 could well follow. But this time the European banks will be the ones most affected.

In the U.S. and Europe, governments and bank supervisors are reluctant to acknowledge that their political decisions—such as mandating a zero risk-weight for all sovereign debt, or favoring mortgages and mortgage-backed securities over corporate debt—have created the conditions for common shocks.

But that is not all that can be laid at the door of regulators. Examiners and supervisors operating "by the book" tend to disregard the judgments of bank managements in favor of regulator-approved methods of assessing credits and carrying reserves. As banks begin to conform to regulator preferences, natural diversification declines and all banks start to look pretty much alike. Then, like genetically altered plants, they are vulnerable to a pathogen—like MBS backed by subprime mortgages—that sweeps through the population.

This does not mean that all regulation is counterproductive. Yet the way it is currently pursued under the Basel rules will—through encouraging future common shocks—make the financial system more, rather than less, vulnerable to systemic breakdowns. To create a stable financial system, regulators should encourage asset diversification and do away with the Basel risk-weighted capital system.

Congress then should repeal Dodd-Frank, which authorizes the Federal Reserve to supervise all "systemically significant" nonbank financial firms, thus spreading dangerous conformity to insurance and finance companies, hedge funds and others. Stability can come only when we stop rewarding herding behavior, and penalize it instead.

Mr. Wallison is a senior fellow at the American Enterprise Institute.

Documenting Assumptions Along The Boulevard of Broken Dreams

10/04/2011 13:26:00

“Borrowing short-term at a near risk-free rate and lending at a longer and riskier yield has been the basis of modern-day finance. The further out the Fed moves the zero bound towards a system-wide average maturity of seven to eight years, the more credit destruction occurs.”

- Bill Gross quoted in the Financial Times, 9-6-2011

October is a beautiful month: temperatures are cooler here in Georgia, harvest festivals are under way, and we finance types turn our attentions to fanciful thoughts of….budgeting. With the best of intentions, we enter this season with a host of “fanciful” assumptions. But as the steely skies of November approach, treasurers and CFO’s across the financial services industry will begin to wrestle, grapple and squeeze their input models in an effort to structure assumptions that will inspire confidence for 2012 and beyond. This is going to be one tough assignment. It’s not that modeling payment speeds and reinvestment rates is anymore difficult than it’s ever been…but the level to which 2012 assumptions will need to be stretched is bound to bend minds in many a boardroom. Here in the south we refer to such contortions as “putting lipstick on the pig." And some of these pigs are going to need a lot of lipstick.

The process of documenting assumptions is the modeler’s effort to quantify risk. If you’re looking for confirmation that the banking industry is pre-occupied with risk modeling, try typing “documenting ALCO assumptions” into your Google search engine. I got 986,000+ entries in .26 seconds. And for good reason—management teams and regulators alike are straining for validation of stable earnings in what has become a morbidly fascinating rate environment. Yields continue to float downward, and if Big Ben is to be Believed (BBB), rates will fall farther out on the curve as "covert" quantitative easing takes hold through the spring of 2012. Nobody would fault a bank board secretary these days for removing sharp objects from the room before distributing the monthly financial reports.

Of course it’s important to develop a summary of critical assumptions and to share them with your board. Those assumptions should, at this point, be the same for both your 2012-13 budgets and your forecasting ALCO model.

Of course it’s important to gather validating data for each assumption and to keep the info on file for the regulators…as well as for benchmarking updates. Today’s regulatory examinations are nothing if not a testimony to documenting "why you believe what you believe". And of course it makes sense to compare your in-house assumptions to FIDICIA 305 standards (9,290 Google hits in .25 seconds). Fundamental steps like these allow the modeler to stand—if ever so precariously--on a foundation of relevant information.

Dallas Wells, VP with The Asset Management Group in Kansas City recently wrote a useful paper (with summarized bullet points) on this subject that's well-worth the read. You can access it by clicking this link.

Here is the cold, frosty reality of it all: bankers make a living from balance sheet spread---not from yield. Cash flows from a loan yielding 8.5% less ALLL and a cost of funds is a breeze to model in comparison to the likelihood that a 6% floor will hold at renewal in a zero-rate lending environment. That’s essentially Bill Gross’s point in the opening quote to this post: bankers are going to have a difficult time justifying credit creation with no margin to validate the mission. Credit creation is fostered by the opportunity to take on reasonable risk for reasonable return. The rate markets in the latter half of 2011 are making it very difficult to structure reasonable assumptions that will lead to market growth. The Boulevard is wide...but the traffic is very, very light.

So what’s a CFO to do? Here are a couple of “Fall-back” recommendations (sorry ‘bout that one):

Evaluate decay rates on non-maturity deposits in your model. Don’t gloss over consensus decay rates loaded by your ALCO model vendor--even if the default input is the FIDICIA 305 average. Why? Because EVE volatility (aka risk) is driven by average maturities. Decay rates derive an average maturity. So test what happens to EVE in your bank model by shortening and extending NMD maturities. FDICIA decay standards for MMDA are 50% less than 1 year and 50% 1-3 years for an average of 1.2 years. Try extending those averages out to two years---or at least as long as BBB implies. DDA, NOW, and Savings account standards are 60% 1-3years, 20% 3-5 years and 20% 5-15 years, or an average of 4 years. The exercise of modeling decay rates will give you a feel for the volatility of balance sheet equity. It's no good as a dinner party trick, but hey, you can at least impress your ALCO.

Decay should be the highest when rates are rising fast…and that’s not what the Fed is projecting

Discipline on the lending side will mean controlling pay-offs through good relationship management and by instituting pre-payment penalties at renewal.

One-off interest rate swaps can allow a bank to offer surprisingly low fixed rate structures out to 15 years or more. If you haven’t talked to one of the growing number of customized swap providers in this arena, take the opportunity to do so. I can recommend firms upon request who will gladly walk you through helpful examples. Loans above $500,000 can be swapped at surprisingly competitive rates.

Discipline on the deposit side will mean charging for services like remote deposit capture and pro-actively managing liabilities for a rock-bottom cost of funds. Liquidity sources are plentiful, and now is the time to consider extending some borrowings. QuickRate, brokered deposits and FHLB advances offer astonishingly low rates out to 4, 5 and even 7 years. Three-year brokered money can be had for as little as 95 bps. Five year FHLB hybrids can be booked this week at 1.51%. As in all areas, moderation in wholesale funding is warranted---but a good A/L manager always builds a cost of funds model from the bottom up and maximizes sources of liquidity.

Bonds should play an important role as investible liquidity builds on the balance sheet. The Feds upcoming “twist” action is targeting the spread between MBS, corporates and treasuries. While you may not want to venture much beyond 15 year maturities, spreads have widened in recent weeks, and will almost certainly contract if BBB holds sway. Stay cognizant of structure: CMO’s provide more stability than pass-throughs, but the yields should be moving in your favor over the coming months. They’ll surely beat 25 bps at the Fed...for as long as that lasts. Part of the "twist" initiative is a proposal to eliminate the current 25 bp yield on Fed-held liquidity.

The financial services business---and community banking in particular, has felt like a long stroll down the Boulevard of Broken Dreams for the past couple of years. The assumptions on which we model our success—and our futures, have shifted markedly. This new environment is telling us that our assumptions and our projections need to enable us, equip us and help our banks survive on the streets of this volatile industry. The health of our financial institutions depend on realistic, well-grounded assumptions. Take your frustrations out on that jack-o-lantern this Hallowe'en---and also take some time to enjoy the beauty of this changing season. Give me a call or send me an e-mail at RDK@BankForwardConsulting.com if I can be of service.

Happy fall---and happy modeling!

What's A Portfolio Manager To Do?

08/06/2011 13:07:00

Those who follow my occasional thoughts on the direction of the economy, investments and interest rates know that “morbidly fascinating” is a phrase I’ve come to use in framing our American predicament. Looking back on this past week, I do wish that my choice of words was less appropriate.

The Saturday, August 6 edition of the Wall Street Journal is a keeper. If you haven’t seen it, get one and read it. I’ve placed mine atop the stack I keep that heralds above-the-fold headliners like Bear Stearns, Lehman Brothers and Fannie Mae.

I’ve written this piece in response to requests from community bank executives looking for balance sheet strategies and interest rate insights in light of this past week’s events.

I offer three thoughts:

Regarding debt: all credit ratings are both comparative and relative. If S&P thinks U.S. Treasury debt has moved from AAA to AA+, inevitable attention will be drawn in the coming weeks to comparative ratings across sovereign, corporate and municipal markets. Regardless of how the downgrade will be spun by pundits, it makes no difference whether this was an 'economic' or a 'political' downgrade. The damage is the same. Spreads are going to widen across lower credit grades as the law of relativity takes hold. Downgrades will occur across state and municipal issues, because AAA just got better defined. If you haven’t scrutinized the financials behind the securities that you hold, don’t panic—but get to work. Don’t be placated by gains you’ve enjoyed as the tide has come in and lifted all boats. Most bond portfolios have benefitted mightily from the declining rates we’ve experienced since January. Critically examine your holdings and think about the months to come. And by the way, MBS is in a different harbor: mortgage rates won’t rise and MBS yields won’t fall until there is demand either for houses…or for mortgage-backed paper. Private label is going to have some trouble, but agency MBS should fare just fine in the months ahead..unless you’re shopping for yield. Another thought: if you've never considered corporate bonds for your bank portfolio, they represent another opportunity for diversification. Tread carefully--revaluation will occur across corporates as well. We suddenly live in a world where a few American corporations have higher debt ratings...than the American govenment.

My vote for best paragraph in Saturday’s WSJ (8/6/11):

“The full faith and credit of the U.S. was established by Alexander Hamilton’s 1790 push to have the fledgling federal government assume and pay back debts states incurred during the Revolutionary War. It has gone largely unquestioned since, with just the occasional hiccup, including a 1979 debt-ceiling argument that delayed a few payments.”

Lo, those many years ago.

Regarding equities: Back to “relative value”: at the end of July, the P/E of the S&P 500 stood at 22.9. At this past week’s intraday low, the adjusted P/E fell to 20.2--meaning the market got about 10% cheaper in 5 days. The historic average for the adjusted S&P P/E over the past 50 years is 19.5 Does that mean stocks are now “fairly valued?” Really? Fear drives valuations: Jason Zweig noted recently that the S&P’s P/E hit 13.3 in March 2009, 6.6 in August 1982, 8.3 in December 1974 and 5.6 in June 1932. Note to self: it’s not a “stock market”. It’s a “market of stocks”. Look for value in individual issues. Index funds can be killers in the coming weeks.

Regarding the direction of rates: Again, from Saturday’s WSJ:

“The 10-year accomplished its biggest weekly gain since August 2009. Market participants are piling into treasuries on heightened fears about the global economic outlook.” “The yield on the two year note hit a record low Thursday, and the benchmark 10-year note’s yield dropped early in the global day Friday to its lowest level since October, a month before the Federal Reserve launched its $600 billion Treasury bond buying program to stimulate the economy.”

A week ago Friday (7/28/11), the 10-year stood at 2.80%. It’s been at high as 3.72% in the past year. On Thursday (8/4/11) it ended at 2.46%. At one point on Friday (8/5/11) it fell to 2.33%. By late Friday afternoon the 10-year was down 27/32’s, pushing its yield back up to 2.55%. Why, folks are asking, are treasury yields plummeting if our debt rating is in trouble? The answer is simple: where else is all that money supposed to go? For better or worse, the U.S. economy is the best looking horse in the glue factory. Our debt won’t be replaced as a safe haven until there’s something with the breadth and depth to replace it. And what’s that going to be? China?....fat chance. The Euro? Give me a break. I believe that the 10-year treasury can hit 2.00% in the coming weeks. I would prefer to be proven wrong on that forecast. And don’t look for China to help. They’re still working through the $622 billion stimulus they spewed out after Lehman fell in 2008. Takeaway: If you’re going to be a problem—be a BIG problem with no alternative resolution. Right now, that’s America’s saving grace. Secure your tray tables and return your seat backs to an upright and locked position. We’re in for a bumpy, exhilarating ride.

One final thought: many portfolio managers will feel the need to trade..or just sell in this environment. Before you do, explore the swap markets and consider hedging. If you don’t understand these markets, learn them. The 3-year LIBOR swap closed yesterday at 76 bps bid. That means a portfolio manager could have protected $10MM for the next 3 years at a one-time cost of $76,000. And the premium is amortized over the life of the contract. I’m just sayin’…..

The only thing worse than spending money to protect yourself is to leave your balance sheet vulnerable. If you don’t understand hedging, you're not alone. Many community bank CFO's managing < $1B in assets have never executed a portfolio hedge. Reach out to a trusted souce for advice and modeling. Both you and your board will be glad you did.

RDK 8-6-11

Salvage Efforts In The Skittish Landscape of Community Banking

07/20/2011 22:04:00

Early this year I began a search for metro Atlanta community banks with good market demographics, a strong deposit base and non-performing assets (NPA’s) that have been written down to a level such that the bank’s remaining capital plus ½ of the loan loss allowance would serve as sufficient cushion against any "burn" on newly invested capital. My investment premise has been that new capital can be injected into qualified targets at a fraction of book value, and that cost efficiencies in combination with a focused business plan could yield compelling returns for a targeted set of community banks over the coming 3-5 years (investment premise available in a separate document). The parameters that I employed revealed several “de novo” institutions and several banks with moderately distressed loan portfolios—or “on the bubble” banks that fit my criteria. “Bubble” banks in my definition are those which can be recapitalized---but first need to submit to a diligence review to validate tangible net worth and then demonstrate marginal profitability to justify investment. I also began to model banks that would fit well into a north metro ATL franchise---some by acquisition at failure...others by rehab/capital injection.

I reached out to institutional investors that I know...but the general response was that my project was “too small” to warrant consideration: the effort necessary to underwrite a $10-$20MM equity deal in order to “start the ball rolling” was not worth the risk/return when much larger projects in other industries are available with potentially large-scale results. I continued to plug away through my networking contacts, and was eventually introduced to two investors that had interest and appetite for my initiative. Encouraged by their interest--and capacity--I approached two open banks on my target list. I explained my approach and requested the opportunity to undertake a summary diligence review in order to attest to each bank’s intrinsic value.

Bankers are cautious, incredulous people—especially in this market, and so both institutions were skeptical. “How can we ask our boards to spend money” they responded, “without first meeting the investors and validating their capacity and interest to invest?” I discussed this concern with the investors: both expressed a willingness to front diligence costs for failed bank acquisitions, but both expected open banks to demonstrate their viability on their own nickel. One of the two investors, however, offered an introductory meeting in order to “break the ice”.

I returned to the banks in early May and requested execution of a one-page, non-circumvention agreement that would protect my interests in the event that a deal might eventually be consummated. If my investors are willing to reach out solely on the basis of my recommendation—without prior diligence, I wanted the banks to commit that they wouldn’t shut me out from any ultimate deal. Curiously, one of the banks refused. The other committed to a negotiated document after several rounds of minor edits.

By now it was summer. The investor who offered a meeting encountered a serious health crisis in early June that required extended hospitalization. As of mid-July he has still not returned to work. The other investor remained intrigued with my ongoing efforts, but was not willing to meet on anything less than a validated opportunity. After taking time to refine what I feel is a compelling investment case, I approached the (healthy) investor in early July with a plan that includes both failed and open bank acquisitions. The investor controls a Florida charter with significant excess capital. After considering my plan, the investor became interested to bid on a targeted failing GA bank in order to establish a base of operations in Georgia. Unfortunately, legal counsel for the Florida institution convinced the owner to delay submission of a bid because their OTC charter is in process of converting to OCC as of July. The investor asked me to hold tight for 60 days. We will resume discussions in late August. It seems apparent that this investor will want to start with a failed bank target because of the likely up-front gains.

In the meantime, I was offered a meeting with the stricken investor’s portfolio strategist (this investor does not control a charter and is interested in open bank acquisitions). Without the benefit of a qualified diligence review, the portfolio manager contacted Renova Partners (an Atlanta based loss-share/financial advisory firm) and solicited a valuation opinion (using the 3-31-2011 Call report) on the bank that signed the non-circ agreement. Renova’s valuation: Negative $15MM. Needless to say, the portfolio manager was unimpressed. At least he offered to pay for lunch.

I puzzled over Renova’s valuation—and hope soon to have opportunity to speak with the analyst that constructed the valuation. But here is what I think I know:

Institutional investors are applying huge discounts when valuing open banks—especially those with any measurable level of asset challenges. Large investors are not equipped to give these institutions the benefit of the doubt---and the underwriting size is often below their minimum. Further, the lucrative gains available for failed bank acquisitions are effectively accomplished with a “post-bankruptcy” cleansing that is unavailable with an open bank acquisition. There is no warranty period when acquiring an open bank. Unless an open bank in search of capital is willing to undertake a no-holds-barred approach toward convincing an interested investor of its merits, the likelihood of attracting capital seems to be small indeed. Short of a strong, independently verified diligence review by a reputable firm, my experience shows that the bank’s chances are seemingly slim.

I believe the bank in question (the one that signed the non-circ agreement) is realistically worth somewhere between $1MM and $-4MM. At 3/31/11, the bank reported Tier 1 capital of $4.1MM and a loan loss allowance of $1.6MM. The bank holds $9MM of ORE and contends that it has stabilized its remaining troubled loans. Past dues reportedly declined during the second quarter. The bank was profitable Q1 and will reportedly be profitable Q2. Internal controls are seemingly strong, and an active director has told me he is convinced that the bank has favorable momentum in its markets.

Here’s my point: in conjunction with a new capital injection, this bank can write down its ORE from $9MM to $5MM. If currently priced at market, selling the ORE at $5MM upon recap will yield a $4MM recovery gain to the acquirer. Even if the NPAs require another $2MM write-down, there is still a $2MM disposition gain available to be captured. These gains are independent of accretive returns accomplished by acquiring shares at a fraction of book value. Institutional investors might possibly be tracking such deals on their radar---but the size of most individual deals doesn’t merit the risk of underwriting and execution, because after all, they don’t know the institution up close. As a further admission of reality, there aren’t many “scratch-and-dent” banks in Georgia where this math actually works.

There will come a day soon when FDIC-enriched failures will slow…and then stop. As this happens, the value of these precious few “bubble banks” will become apparent. I can only hope that I find a way to capture some of the opportunity before it becomes obvious.

A Response To The Question: Can Community Banks Survive?

02/24/2011 00:24:00

One of my all-time favorite cartoon comic strips is Frank & Ernest. The strip features two bums spouting earthy one-liners of wit and wisdom. A particular favorite that I recall from way back during the Carter administration featured Ernest in a supermarket check-out line, purchasing a package of ground round. The caption reads: "Isn't $1,645,469.83 a little steep for a pound of hamburger?!?!" (I searched Google to try and post the cartoon, but alas...). Here's the point: during the late 1970's, people began to believe that 13% inflation was going to be with us forever, and society began to think and extrapolate accordingly. If prices were rising, they would continue to rise. So long as wages rose accordingly (though never by enough!), society grumbled, adapted and got on with it. Human nature tends to make us perceive that a market cycle is linear reality. But it’s not.

I have great respect for alternate views, but I contend that the population of community banks will fall...until it starts rising again. Indeed, weary directors, worn-out CEOs, over-zealous regulators and the splendid brutality of our free market will winnow down the population of mono-line, non-distinguished, non-strategic banks---until the next generation of ingenuous, hungry capitalists enters the scene.
Look at the mortgage business: the whole industry is one glorious mess. No one knows how to pay brokers, nobody wants to hold the paper, administration is mind-numbing….it’s enough to make you want to pound your head against the sidewalk and move into Hospice care. The 30-year fixed rate residential structure may well change…the insurance behind the note may privatize…securitization has all but vaporized…but people will still buy houses and close mortgages. The business will evolve—and remarkably so, but it will remain a robust business.

Consider the supermarket business: gone are the mom-and -pop grocery stores. Walmart and Target have huge, huge stores and low, low prices...but have you noticed the number of convenience food store/gasoline stations in your neighborhood? Have you noticed how many of them sell milk, bread and cheese? I can assure you that all of those gas-and-shops don't stock white bread and velveeta just to look "homey".
FiServ, Fidelity, Jack Henry, Harland, Diebold and a host of other huge community bank service providers are all watching the banking evolution with keen interest. So are the auditors, law firms, IT service companies, compliance gurus, pre-paid card moguls and printers. They all know that right now, their banking client base is only getting smaller. Wanna bet that FiServ will soon spin out a value-priced service platform that caters to the <$500MM bank? Do you think that maybe Jack Henry might respond? Will they enjoy doing it? Heck no!—but they’ll do it to support their considerable presence in the industry. How about Diebold….'think they’ll eventually respond to new trends in the market place that will supplant those ridiculous $55,000 cash dispensing dinosaurs that community banks never could afford in the first place? Will they want to? Certainly not! But do you think that Diebold would rather shut down that big plant in Canton, Ohio and send all those workers home? I don’t.
I contend that what’s happening right now in community banking is “morbidly fascinating”. I think it’s about time that basic concepts like Cost Accounting flush out the less productive shops in over-banked markets and provide opportunities for new models of sustainable, profitable franchises. I think that all those community bank “organizers” who intended to be “investors”--- but never envisioned themselves as “directors” will cast around at ways to resolve their “investment” for better or worse. The great majority of community bank directors and executive officers are solid, well-intended business people, and they'll work things out as best they can.

My second point is this: Industries evolve only because they have to. The community banking industry got really, really good at one thing: asset-based lending. The industry feasted on a 15-year binge of rising commercial and residential real estate markets--especially here in the southeast (I live in metro Atlanta...we know a thing or two about asset based lending). Asset-based lending worked fantastically well as a lending platform…until it didn’t work any more. "Revenue diversification" is the new mantra in the marketplace not just because it’s a “salvation”--it's the new mantra because it's a healthy alternative to a single-source diet. Rather than the analogy of a bubble popping, I see this moment as more of an enormous pendulum swing. There will be a “next” 15-year binge. It might be treasury services, it might be mobile banking. It could be financial planning; it could be the trust business. But people still need to earn a living, so the marketplace will evolve. I, for one, am fascinated with the urgency of getting on with the evolution, because all of us know that we never commit to "change" until we have to…..and oh, brother---do we ever have to now!

My consultancy is based on the evolving model of sustainable community banking. Please check it out at www.bankforwardconsulting.com and let me know what you think. If I can help foster an improved model for your bank, I’d be happy for the opportunity—and grateful for the business.

Oh---and the price of hamburger? I checked at Publix this afternoon…it’s $3.69 a pound.

All the best,

RDK