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Raising Capital

 

            In early May two years ago, we co-hosted a three day program in Denver for bank clients.  One of our featured speakers was an OCC executive who had just attended the agency’s spring planning conference.  Six weeks earlier JP Morgan had gobbled Bear Stearns and the subprime mess was upon us; but the crisis appeared to be easing as no other failures followed and bank financial performance metrics ticked higher in Q1 2008 when compared to the last two quarters of 2007.

            The OCC exec began his presentation, “You all ask me, are the events of March the end, or just the beginning?  They are just the beginning.  Three hundred banks will fail.  Many of the home loan banks exhibit stress.  Capital problems will be surpassed by liquidity problems.  You need to prepare for the worst.”  During the accompanying slide show that proved these points, a community banker from Tennessee asked, “Aren’t the problems confined to the big institutions?”  In an instant, the OCC speaker shot back, “No.  And remember, they have sovereign wealth funds coming to their rescue.  Who is going to rescue you?”  Silence.  When questions and answers resumed after a coffee break, the OCC executive quipped, “I went to the men’s room at the break and it was filled to capacity.  I guess I scared the p-s out of you.”  He did.

            Two years later, the FDIC’s official tally of bank failures stands at 251 since 2007.  Insolvencies exceed 300 when “merge or fail” bank acquisitions are included.  Losses to the Deposit Insurance Fund now total $70 billion.   Another approximately 800 banks received temporary capital under the Emergency Economic Stabilization Act of 2008.  Without the lifeline thrown by the U.S. Treasury, many of them would have been in “troubled condition” and legally required to raise additional capital at a time when the capital markets were closed to banks.  More forced mergers and outright failures were thus avoided.

            As Congress hurries to complete its overhaul of the federal regulatory scheme governing banks and other financial services companies before the July 4 recess, the storm appears to have passed.  FDIC data for the first quarter show banks’ average return on assets reached 0.54% (0.78% pre-tax), a level not attained since Q3 2007 (with the exception of Q1 2008).  Average return on equity has also rebounded, hitting 4.36% in Q1 2010 compared to -0.36% in Q4 2009.  This ratio too is at its highest level since Q3 of 2007 (again excepting Q1 2008).  The percentage of institutions reporting year over year earnings growth (52.2%) is greater than at any time since Q3 2006 (53.9%).  Average net interest margin (3.83%) is at a level last seen in Q4 2002, when the previous recession was at its end. 

            Even with this good news, the fragility of the nascent recovery is evident in the ratio of accounting reserves taken for potential future loan losses to net operating income.  At 30.3% in Q1 2010, this measure is down from 51.7% in Q4 2008 (an historic high), but remains at a level experienced only once in the last 25 years, in 1989-90 at the height of the financial crisis that followed the 1980’s leveraged buyout boom and the insolvency of the thrift industry.  Similarly, net loan charge-offs as a percentage of loans and leases were 2.84% in Q1 2010, down from 2.93% in Q4 2009, but still a 25 year high.  The previous record was 1.89% in Q4 1989. 

            If there is a silver lining in the statistical measures of the recent banking crisis, it is most banks’ relatively strong capital positions.  The crisis 20 years ago prompted Congress to enact a “prompt corrective action” regime, which set required capital levels significantly higher than they had been and required regulators to compel banks to raise more capital or close their doors if their capital fell below minimum capital requirements and stayed there.  This legislative reform has worked, even if not always as well as its authors intended.  Thus, while the ratio of noncurrent loans and leases to Tier 1 capital plus loan loss reserves reached a recessionary high of 29.6% in Q1 2010, the ratio remains well below the ratio for the entire period 1984-1991.  As the financial crisis of the late 1980’s unfolded, the ratio reached 47.8% in 1987 among all institutions and 61.2% among banks having more than $10 billion in assets. 

            The benefits in the recent crisis of the higher capital requirements mandated in 1989 have not been lost on legislators or regulators.  Most observers expect still higher minimum levels of capital to be prescribed, first under international capital standards applicable to the largest banks and later under federal standards that apply to all banks.  Also expected to be phased in over the next few years is a rule that eliminates trust preferred securities from being included in Tier 1 capital.

            For community bankers especially, it is tempting to view higher capital requirements as somebody else’s problem, since their banks have historically maintained higher levels of capital than large banks.  For example, in Q1, the average Tier 1 capital ratio among the smallest community banks was 17.57% vs. 11.62% for >$10 billion banks, and the average small community bank total risk based capital ratio was 18.67% vs. 14.66% for >$10 billion banks.  National averages, however, mask wide disparities in regional and local experience.  The average total capital ratio among 15 Jacksonville, Florida community banks was only 7.25% at March 31.  “The regulators are going to require damn near every bank in the state of Florida to raise capital,” said a Jacksonville banking analyst.  [1]  Closer to home, of the 32 banks located in Ohio, Michigan, Indiana and Illinois that received more than $25 million in preferred stock investments by the U.S. Treasury, only four have redeemed the government’s investment.  Bank stocks being out of favor on Wall Street is certainly part of the reason.  Another factor is the long-overdue restructuring of the automotive industry on which those states’ economy is so dependent.

            The easing of the recent crisis is opportunity for action.  Raising additional equity capital should be high on the agenda for most community and regional banks.  Conversations with directors and executives yield a dozen excuses why “our bank is different” and “we have plenty of capital.”  None of them hold water, however.  As a veteran of capital raising transactions, I well understand the discomfort that accompanies going to market for capital.  The prospect of being rejected is daunting.  But a thoughtfully constructed strategy and a realistic plan to implement it can improve the odds of success dramatically.  The end of the crisis is an inflection point no less than the crisis itself was.  The strong will prosper by recognizing and embracing the opportunity.  The rest will continue their slow march to oblivion. 

            [1]        http://jacksonville.com/business/2010-05-20/story/bad-loans-mean-banks-need-raise-more-capital.

Posted in Uncategorized.

By admin
June 21, 2010

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The Untouchables

The richness of the English language is such that we have dozens of words that have two opposite meanings. Some auto-antonyms, as these words are called, are the result of slang usage, like “cool” and “bad”. Others are common words whose meanings depend on the context in which they are used. Thus “grade” can mean “level” or “inclined”.

Two other auto-antonymns came to mind as we reviewed evidence submitted to the U.S. Senate Permanent Subcommittee on Investigations (”PSI”) as part of its hearings last week and this week titled “Wall Street and the Financial Crisis: The Role of Bank Regulators.” In colonial India, “untouchables” were people whose social standing was so low that they did not warrant being assigned a caste in the social hierarchy of that country. An American newspaper reporter during the 1930’s applied the word “untouchables” to FBI Special Agent Eliot Ness and his team of agents, whom Al Capone’s legendary Chicago Outfit tried but failed to bribe. Ness and others appropriated the Untouchables sobriequet as the title for book and movie versions of his crew’s exploits. “Oversight” is the other word of opposite meanings that came to mind, since it can mean either “to have charge over,” or “error” and “lapse in proper management.”

The PSI investigation focuses on the Office of Thrift Supervision’s (”OTS”) oversight (in both senses of the word) of Washington Mutual Bank (”WAMU”). The 509 pages of exhibits document OTS examiners’ increasing unease concerning the bank’s shoddy business practices and growing portfolio of dodgy residential real estate loans. The OTS examiner in charge at WAMU summed up the situation in an e-mail to a colleague after WAMU failed.

I think that once we (pretty much all the regulators) acquiesced that stated income lending was a reasonable thing, and then compounded that with the sheer insanity of stated income subprime 100% [Combined Loan-to-Value] lending, we were on the figurative bridge to nowhere. Even those of us that were early opponents let ourselves be swayed somewhat by those that accused us of being ‘chicken little’ because the losses were slow in coming, and let[']s not forget the mantra that ‘our shops have to make these loans in order to be competitive’. I will never be talked out of something I know to be fundamentally wrong ever again!!

Five years in a row from 2003 to 2007, the OTS examiners on the WAMU account detailed weaknesses in WAMU’s lending practices, particularly its loan underwriting. When called to task, WAMU executives each year said they would “take all action required to correct the problem,” but did very little. In 2005, the year that WAMU ramped up its subprime lending and securitization business, an OTS examiner wrote, “[Securitizations] prior to 2003 have horrible performance. . . . [WAMU subprime origination and syndication subsidiary] finished in the top 12 worst annualized [Net Credit Losses] in 1997 and 1999 through 2003. . . . At 2/05, [the company] was #1 with a 12% delinquency rate. Industry was around 8.25%.”

WAMU hired and lost nine chief compliance officers between 2000 and 2007. In a memorandum to the last of these officers, OTS Compliance Examiner Susie Clark lamented, “The Board of Directors should commission an evaluation of why smart, successful, effective managers can’t succeed in this position. If you would like my opinion, just ask. (HINT: It has to do with top management not buying into the importance of compliance and turf warfare and Kerry [Killinger, WAMU CEO] not liking bad news. . . . Regulatory Relations [the department charged with OTS liaison] is a joke. The purpose of this group seems to be how can we give the regulators the bare minimum without them raising a fuss[?] And let’s give them a Findings Memo that is so hard to manage that they will spend half the exam time messing with it.”

Particularly disturbing is evidence of a running conflict between the OTS and the FDIC that escalated as WAMU’s financial condition worsened. OTS executives systematically blocked FDIC personnel from obtaining direct access to WAMU loan files and other examination data. The FDIC objected, but did not force the issue until the damage to WAMU was done. The interagency conflict climaxed on August 6, 2008. FDIC Chairwoman Sheila Bair e-mailed OTS Executive Director John Reich about the need for a contingency plan.

Art [Murton, Bair's subordinate] talked with Scott [Polikoff, Reich's subordinate] about making some discrete inquiries to determine whether there are institutions which would be willing to acquire [WAMU] on a whole bank basis if we had to do an emergency closing, and on what terms. I understand you have strong objections to our doing so, so I’d like to talk this through. My interest is in assuring that IF we have to market it on an emergency basis, there is multiple bidder interest.
In any event, both the FDIC and the FRB agree that there needs to be a contingency plan in place, so let’s talk this through on Friday. I’d really like to develop a plan everyone is comfortable with.

Sheila

Six hours later, Reich responded angrily.

You really know how to stir up a colleague’s vacation.

I do not under any circumstances want to discuss this on Friday’s conference call, in which I may or may not be able to participate, depending on cell phone service availability on the cruise ship location.

Instead, I want to have a one on one meeting with Ben Bernanke prior to any such discussion - as early next week as possible following my return to the office. Also, I may or may not choose to have a similar meeting with Secretary Paulson.

I should not have to remind you the FDIC has no role until the [Primary Federal Regulator] (i.e. the OTS) rules on solvency and the PFR utilizes [Prompt Corrective Action authority to declare the institution in Troubled Condition].

You personally, and the FDIC as an agency, would likely create added instability if you pursue what I strongly believe would be a precipitous and unprecedented action. And if it occurs without my consent, I will not sit quietly by and observe - there would be a public reaction. Put yourself in the PFR’s shoes in this situation.
                                                                                                                     * * *
This is an OTS regulated institution, not an FDIC regulated institution. We make any decision on solvency, not the FDIC, and I have staff equally as competent as staff at the FDIC, whom I know well.
The FDIC can do whatever internal contingency planning it wishes, but should in no way go outside the FDIC. This is a 3-rated institution. Are you also trying to find buyers for Citi, Wachovia, Nat City and others [whose primary federal regulator was not the OTS]?

The answer to the last question, as we now know, was “Yes.”

The Memorandum submitted to the PSI by its Chairman and the Ranking Member makes surprisingly little effort to answer the question why, in the face of all the evidence, the OTS and the FDIC failed to act until WAMU’s failure was inevitable. The U.S. Government Accountability Office reported in March 2009 that regulators said they did not take forceful actions to address bank weaknesses, such as changing banks’ CAMELS ratings, until the crisis occurred because the institutions had strong financial positions and senior management had presented the regulators with plans for change. In the case of WAMU at least, this is simply contrary to fact, as the documentary evidence gathered by the PSI amply demonstrates.

Inter-agency and intra-agency politics are partly to blame. The 509 page exhibit record yields a number of instances in which Western Region OTS officials made adjustments to examiners’ findings favorable to WAMU. The PSI cover memo cites “demoralized” examiners, one of whom wrote, “I’m not up for the fight or the blood pressure problems. . . . It doesn’t matter that we are right . . . . They [WAMU] aren’t interested in our ‘opinions’ of the [lending] program. They want black and white, violations or not.” Questioned why it did not use its independent enforcement authority, the FDIC said doing so would be “an act of war” that would impair its working relationship with OTS and the OCC. One memorandum from an FDIC official suggests that agency should allow OTS to fall on its face rather than intervene to save the situation.

Undeniably, OTS officials recognized WAMU as their most important charge. WAMU-paid exam fees represented 12-15% of the OTS revenue budget during the last decade. Senior OTS executives’ correspondence shows them to be especially solicitous toward WAMU CEO Kerry Killinger. Executive Director Reich at one point refers to WAMU as his largest “constituency.”
The final answer, in our view, is one word-securitization. Had WAMU’s business model been to hold to maturity the mortgage loans it originated over the last decade, OTS would have placed the bank under prompt corrective action much sooner (or at least one must hope that would have been the case). But because everybody involved, including the regulators, believed that the dodgy mortgages would only briefly belong to WAMU before being sold to unsuspecting investors to whom they believed they owed no duty, they allowed the reckless behavior to continue.

As Congress exercises its oversight role by legislating adjustments to the regulatory landscape for banks and other financial services providers, this is the lesson that should be internalized and made into law. We need bank regulators who have the spirit of Eliot Ness and Sheila Bair, not John Reich. We need them to be fair in the exercise of their authority. And we need them to be willing to be held accountable by Congress and the public when they are wrong. If Congress rises to the occasion by passing a reform package that makes order out of the current mess of too many regulatory agencies all protecting their turf and their hind end at the expense of the public interest, then Congress too may number themselves among the Untouchables. If Congress instead succumbs to pressures from Wall Street, the regulatory agencies, or both, to take it easy on them, then members of Congress will prove themselves to be merely untouchable.

Posted in Banking, Uncategorized.

By admin
April 19, 2010

1 comment

Impact

“You arrogant ass! You’ve killed us!” The submariner’s words to his commander an instant before the Soviet submarine Konovalov is destroyed by its own torpedo in the 1990 movie The Hunt for Red October equally describes behavior during, and in the years leading up to, the Panic of 2008. Two new tell-all books provide the play-by-play, On the Brink, by former Treasury Secretary Henry Paulson, and Too Big to Fail, by A.R. Sorkin of the New York Times.

Paulson’s narrative is a tone poem of the crisis–measured, by turns anxious yet confident, always reflecting a seasoned deal-maker’s instincts for adapting as circumstances change. Patterned on Barbarians at the Gate, Sorkin’s account is, by design, an epic tale. It portrays Wall Street’s New Age barons as vain, preternaturally competitive, narrow minded, and consumed with honoring Wall Street’s pecking order and social protocols even as their firms crumble around them. Thus we have Jamie Dimon in mid-September 2008,

“They want Wall Street to pay,” he told the room of bankers relaxing after their late dinners, hoping to get them to appreciate the political pressure Paulson was feeling. “They think we’re overpaid assholes. There’s no politician, no president, who is going to sign off on a bailout.” . . . “We just hit the iceberg,” Dimon bellowed to his men as if he were standing upon the deck of the Titanic. “The boat is filling with water, and the music is still playing. There aren’t enough lifeboats,” he said with a wry smile. Someone is going to die. “So you might as well enjoy the champagne and caviar!” [Sorkin, pp. 335-36]

Hyperbole aside, both books are devoted to telling their story rather than prescribing fixes for the “system” whose upheaval gripped the nation. Paulson does offer four recommendations. Address structural economic imbalances among the world’s major economies. Update the U.S. financial regulatory regime. Limit use of financial leverage. And come to terms with the implications of industry consolidation such that the largest financial firms are indeed too big to be allowed to fail. While these suggestions are salutary, the challenge of the present moment is how to put them into practice. Just last week, U.S. Senators resumed efforts to “reform” the financial regulatory system, including conducting hearings in which Fed Chairman Bernanke argued for preserving the bank supervisory powers of the twelve Federal Reserve Banks and the Fed’s Board of Governors. Our own view of the crisis is that a broad, principles-based effort is needed, but that it must be underpinned by a military-sized investment in technical infrastructure.

Tupolev’s Rule vs. the Golden Rule.

The great irony of the crisis is that the predatory behavior that Wall Streeters elevated to an art form beginning in the 1980’s came back to destroy them, just like submarine commander Tupolev’s torpedo in Red October. Merrill Lynch’s pre-crisis CEO, Stanley O’Neal, tells his subordinates, “Ruthless isn’t always that bad.” [Sorkin, p. 144]

In 1984, a banker client of ours attended a two day retreat in New York City for all of the officers of his London based bank. The topic was how to make money on the growing boom in hostile takeovers. The organizers of the event began by saying, “Let’s take a city, suppose Pittsburgh, Pennsylvania. Now let’s look at the 28 Fortune 500 companies headquartered there. Let’s dissect their financial statements. There’s a lot of sleepy capital there. Let’s figure out how we can put these companies in play, buy them, break them up, and sell off the pieces for more money than the price we paid for the companies as a whole.” And, during the next 15 years, that is exactly what Wall Street did, all across America’s industrial heartland. Never content to leave well enough alone, the Street also enabled sound companies like Westinghouse and Allegheny International to gorge themselves on debt, acquisitions, or both, with the result that the companies failed as spectacularly as Lehman did in 2008. Or as Commander Tupolev said, with no visible affect, as he announced the command to locate and destroy the Red October submarine, “We’re going to kill a friend, Yevgeni. We’re going to kill Ramius.”

For Wall Street’s commanders, death personified was short sellers. The hedge funds and other unregulated pools of private capital–the banks’ best customers in good times–relentlessly questioned the financial stability of Bear Stearns, meanwhile selling the stock short. They then turned, in order, on Lehman, Merrill, Morgan Stanley and Goldman Sachs. None of these companies’ CEOs objected until his company was the target, by which time the objection was too little, too late. Sorkin describes the conflicted Richard Fuld, Lehman’s CEO and the crisis’ brooding public face.

“Fuld also knew that his firm’s own arbitrage desk had hedge fund clients who were selling short, and they made the firm a great deal of money. He certainly didn’t want to alienate them, and at the same time, he recognized that there was a legitimate debate about the issue [the SEC's uptick rule, which it abolished in 2007, making short raids easier to accomplish]. And however protective the restrictions may have been intended to be, Fuld knew perfectly well that investors could get around them by using options and derivatives. [Sorkin, p. 98]

Paulson quotes Goldman CEO Lloyd Blankfein the day after Lehman filed Chapter 11,
” ‘Hank, it is worse than any of us imagined.’ If hedge funds could not count on the safety of their funds, ‘no one will want to do business with us.’ ” [Paulson, p. 231] And so it was that the Wall Street boats still afloat put into the bay called bank holding company status, which meant the Federal Reserve System guaranteed the investment banks’ liquidity, thus stopping the bank run that had brought financial markets to a standstill.

The notable exception was GE Capital. Paulson observes that the magnitude of the crisis was such that, in late September 2008, GE could not roll over its commercial paper as it matured. If GE was functionally insolvent, then everybody else was too. Again, the irony is rich. Earlier in the decade, the parent company had publicly scoffed at the idea of GE Capital becoming a bank or bank holding company. GE was simply too big, too profitable, too important and too smart was the implication. Yet in the heat of the crisis, after Goldman and Morgan Stanley became bank holding companies, GE CEO Jeff Immelt called Paulson to complain that GE was being “left behind.” [Paulson, p. 367]

Driving Blind.

More arresting than the drama itself is the realization how little good information the government had about the true financial condition of the firms at risk. Paulson learned of AIG’s troubled condition, and the risk it presented to major banks, not from his regulator peers, but from fellow former Goldman partner Chris Flowers. He fed Paulson information about AIG’s increasing desperation in an effort to cause the government to force AIG to sell its most valuable assets in a fire sale. Flowers (surprise) hoped to be the buyer.

While Congress has called to task financial institutions regulators, especially the SEC, our view is that the real fault lies with Congress itself, specifically the 106th Congress, which passed the Gramm Leach Bliley Act in 1999. Members of Congress and commentators today frame the issue as one of regulation vs. deregulation, debating whether repeal of the Glass Steagall Act was wise. In our view, the error was that Congress removed the barriers that separated different types of financial activity and enabled the creation of super holding companies, called financial holding companies, without adjusting the roles and powers of the five principal federal regulatory agencies (Fed, Treasury, FDIC, SEC and CFTC) to reflect the new industry alignment that GLB was designed to foster. The major impediment to restructuring was the fierce infighting among the agencies in the months before GLB passed. Congress’ solution was not to spend political capital needed to resolve these conflicts, but to declare the Federal Reserve to be the first among equals with each agency otherwise retaining the same role it historically discharged. “Functional regulation” it was called.

Lacking guidelines by which to consolidate their functions as well any legal or financial incentive to do so, the agencies kept doing what they always did. Congress did not mandate, so the agencies did not create, shared infrastructure to monitor market participants across legal categories or to manage a crisis. Nor was any money appropriated to build financial models or command and control capabilities that could be used to warn of, and manage, potential systemic disruptions. So when the crisis hit, governmental officials had to improvise, bend the rules, or disregard them altogether, such as when the government coached Lehman’s directors to approve that firm’s filing for bankruptcy protection. It is therefore all the more remarkable that, while many crisis participants orally challenged the legal positions the government took, none defied the government or took it to court. Likely this is due to everyone understanding the gravity of the situation. Do we dare count on that in the future?

What Next?

Two years, six months and three weeks since the crisis began, we wait to see what Congress will write. A systemic risk regulator is a sure thing. So are higher capital requirements and stress testing of all components of the balance sheet. Forever conditioned by Tupolev’s Rule, Wall Street will work to undermine or circumvent the new regime while publicly championing it.

It would be an epic mistake in response to an epic crisis for Congress to legislate a return to the compartmentalized approach of Glass Steagall. Too much has changed to make that worthwhile. The emphasis instead should be on funding and creating the financial industry equivalent of the air traffic control system or the equivalent technology that tracks submarines at sea. No system will be perfect. Accidents will happen, and sometimes they will be big. Yet if we put the effort into building a safety and soundness regime that alerts us when we are on a collision course with an object we do not yet see, then we all will be better served.

Posted in Banking, Uncategorized.

By admin
March 2, 2010

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Banking on the Super Bowl

Last year, 98.7 million people watched the Pittsburgh Steelers claim the franchise’s sixth Lombardi trophy. Remarkably, no member of Congress complained that the National Football League oligopoly of 32 teams needs a systemic risk regulator. Neither players nor owners suffered public rebuke over their indisputably large compensation packages. After the event, every sporting goods store within a 100 mile radius of Pittsburgh sold Steelers championship jerseys and t-shirts at a 6:1 price premium compared to unadorned apparel. And the championship-labeled merchandise sold as fast as the stores stocked it.

In the year that followed, the Obama Administration unveiled in April a serious bid to recast the nation’s regulatory framework for financial institutions. The industry worked night and day to undermine the effort while publicly praising it. By December, the debate had degenerated into finger pointing, with the President saying on CBS’s 60 Minutes telecast, “America went through the worst economic year it’s gone through in decades and you guys [bankers] caused the problem.” After Republicans won the late Ted Kennedy’s Senate seat, the Administration rolled out 82 year old Paul Volcker to propose mega taxes for large banks and a ban on proprietary trading, except for customers. Industry executives scoffed. Said one to the New York Times, “I can find a way to say that virtually any trade we make is somehow related to serving one of our clients. They can go ahead and impose the rule on Friday, and I can assure you that by Monday, we’ll find a way around it.”*As our friend the Rev. Harold Lewis says, “What is wrong with this picture?”

The difference between professional football and banking is not one of sport vs. business, weekend pleasure vs. weekday work, or even success vs. failure. It is the difference between effective, controlled competition and ruinous competition. It is also a difference between a system where the actors largely regulate themselves and one another, and a system whose main actors seem to prefer chaos to regulation. Sadly, the public conversation over reforming bank regulation has devolved into a contest of sound bites built around the symptoms of the crisis rather than its causes and potential cures.
Whether and how to regulate competition among banks is as old as the Republic.

A history of Philadelphia banking reports,

The Bank of North America was able to delay the opening of a second bank in Philadelphia by co-opting its organizers with a new stock issue to share in the first bank’s profits. The Pennsylvania Bank, in its turn, offered the [Commonwealth of Pennsylvania] a “gift” of $200,000 in 1803 provided the Philadelphia Bank’s charter application was not approved. The legislature rejected the Pennsylvania Bank’s “gratuity” in favor of a smaller one of $135,000 from the Philadelphia Bank’s charterers and the prospect of a steady stream of high dividends from yet another quarter. **

The oligopoly structure of American business and banking spawned by New Deal legislation and World War II conferred an advantage on large commercial banks that lasted 50 years. Ironically, it was the securities firms that banks divested as a result of the Glass Steagall Act that usurped banks’ leadership position beginning in the 1980’s. An earlier installment of this publication describes that sea change in greater detail. Banks and securities firms that embraced deregulation did so in the belief that they could prosper at the expense of weaker competitors in a deregulated environment. Industry consolidation followed. At the peak of the quest for “shareholder value” the Federal Reserve Board of Governors in September 2000 reversed decades of precedent and approved the hostile takeover of Dime Bancorp by North Fork Bancorporation. In its order, the Fed wrote:

Additionally, there are public benefits to be derived from permitting capital markets to operate so that bank holding companies may make potentially profitable investments in nonbanking companies and from permitting banking organizations to allocate their resources in the manner they believe is most efficient when, as in this case, those investments are consistent with the relevant considerations under the Bank Holding Company Act.

Following the failure of so many large banks and investment banks in the last two years, the question is not whether to retrade the regulatory regime, but how. Here, in our view, the National Football League offers a useful reference point. The rules of the game are established by the ownership group on recommendation of the Competition Committee. The Committee’s members are coaches-those closest to the game on the field of play excepting only the players. As fans know, rules on controversial subjects like instant replay are often revised on multiple occasions, based on input from constituencies. Game officials who apply and enforce the rules are graded weekly on their performance. Rules infractions outside the field of play are adjudicated by the league office including ultimately the Commissioner. Equal sharing among teams of television contract revenue enables smaller market teams like the Steelers to compete against larger market rivals. The annual player draft is structured to promote parity of human capital among competing teams. Like any system of rules governing human behavior, the NFL regime is not perfect. What is remarkable, however, is how well the system functions, especially compared to the feudal fief that is Major League Baseball. Equally important, NFL players, coaches, owners and fans alike accept the football system as being fair.

There are differences between football and banking to be sure. Most fundamentally, banking is an essential feature of modern life; football is not, even for the most ardent fan. In this way, banking is a public utility, whose availability, cost, safety and soundness are essential to the “general welfare,” whose promotion is one of the three purposes of the U.S. Constitution according to its preambles. And that is where our public officials, both elected and employees of regulatory agencies, come in.

“Cops and robbers” is how one senior Securities and Exchange Commission official privately describes her work. This is one aspect of the role, not its sum and substance. To view the whole relationship to the market and its participants through a prism of “catch’em if you can” diminishes the regulatory enterprise one is sworn to uphold. Questioning is healthy, paranoia is not. The overly dark attitude that many regulators currently manifest deprives everyone engaged in the game of the opportunity for fair play. And it breeds anger and defiance among those who are regulated. As a result, competitors seek advantage any way they can find it, skirting the law or violating it outright, hoping to amass a sufficient fortune to exit the game before they are caught.

For our national financial system to function, industry participants and government officials, as the representatives of the electorate, need to collaborate to create a regulatory structure that works. Everybody needs to be equally, and fully, invested in the system and its outcomes. And nobody alone can occupy the high ground-economic, legal or operational. If the actors involved allow one another that much, and the system can be recast to promote hard but fair play, then we can all concentrate on the game and the challenges and fun of playing it opposite worthy adversaries.

*New York Times, February 1, 2010, “Bankers in Davos Seek a Unified Message on Volcker Rule.”
**C. Greenberg, The Role of Commercial Banking in Regional Economic Development: Philadelphia 1945-1970, unpublished 1975 doctoral dissertation in the library of the University of Pennsylvania.

Posted in Banking, Uncategorized.

By admin
February 4, 2010

2 comments

High Water Mark

          Financial panic is to banks as flood is to human habitation-disruptive at best, fatal at worst.  The primal human response is to build and occupy an ark to ride out the storm.  Like Noah, we release the raven and the dove when we believe the danger has passed.  The dove’s return to the ark with an olive leaf prompts us to disembark and begin building again in the flood plain.

            Thus it was that the top story on page B6 of the weekend Wall Street Journal heralded “CLO Sales Offer Hint of Recovery: Battered Corner of Structured Finance Perks Up After Being Laid Low by Crisis.”  Below the fold, a much smaller item noted that the FDIC closed three banks Friday, bringing the total for 2009 to 133, the highest number for any year since the Thrift Crisis. 

            Twice this year we have examined state-by-state data published by the FDIC as a measure of the severity and duration of the current recession in the states where many of our readers work and live, New York, New Jersey, Pennsylvania, Ohio, Michigan and Indiana.  In this installment, we review just-released third quarter 2009 information to determine whether the sale of two collateralized loan obligations trumpeted in the Journal is a bona fide olive leaf for the credit markets.

            The FDIC data indicate that although panic in the equity markets abated in the first quarter, the flood of distressed loans continued to swell into the third quarter.  Meanwhile, other negative credit trends evident in the first quarter continued.  These include particularly severe credit contraction in manufacturing-dependent Midwestern states and the sand states of the Deep South and West Coast. 

            In our six state region, non-farm job growth turned negative during the fourth quarter of 2008, averaging -0.9% in New York, New Jersey and Pennsylvania vs. -2.7% in Ohio, Michigan and Indiana.  Ohio’s rate of job losses reached 4.9% in the second quarter of 2009, but eased to 4.7% in the third quarter.  New York, New Jersey, and Indiana experienced similarly slight drops in the rate of job losses from Q2 to Q3 this year.  Michigan, however, held steady at a job loss rate of 7.3%.  Only Pennsylvania ticked up a tenth, from a 3.10% rate of job losses in Q2 to 3.2% in Q3, a shift small enough not to be statistically significant.

            Manufacturing employment fared worse during the same period, but the rate of manufacturing job losses slowed in every state but New York and Pennsylvania in the third quarter.  These states along with New Jersey were less hard hit in the first place than their Midwestern counterparts.  The deceleration in the rate of job losses is significant.

            In our June review of first quarter statistics, we noted, “the ratio of past due and nonaccrual loans to total loans in the near Midwest states ranges from 50% to 100% greater than for banks in New York, New Jersey and Pennsylvania.  Interestingly, however, the rate of increase in this ratio from 2007 is greater in the Eastern states than the near Midwest.  Michigan in fact shows the slowest rate of increase from Q4 2008 to Q1 2009 and the second slowest (after Ohio) from 2007 to Q1 2009.  This may simply reflect that the Midwest states began the recession in a worse position.  Or it may indicate that, having dwelled longer in the darkness, Midwest banks have adjusted for current conditions and are holding their own as we reach the bottom of the credit cycle.”

            Second and third quarter data suggest the answer is, “both of the above.”  In New York, New Jersey and Pennsylvania, past-due and nonaccrual loans as a percentage of total loans rose 40%, 51% and 35%, respectively, from Q4 2008 through Q3 2009.  Ohio and Indiana experienced less than half this rate of increase, 18% in Ohio and 12% in Indiana.  Michigan’s ratio hardly budged, rising a mere 1.7% to 4.67%.  Yet it remained nearly double the average among New York, Pennsylvania and New Jersey.  In fact, those states Q3 2009 average ratio is only 75% of the level experienced in Michigan in 2007, demonstrating that Michigan’s economic slump has been both severe and especially lengthy.

            Second and third quarter 2009 data show banks needing the full benefit of the loan loss allowances they have set aside.  The table below presents the ratio of institutions’ allowance for loan and lease losses (ALLL) to past-due and nonaccrual loans.  Q1 2009 was the first quarter in which this ratio was less than 1:1 in all six states.  By September 30, Pennsylvania was the only state where this ratio was >.67%.  Consistent with the rapid rise in nonperformers in New Jersey this year, its banks showed the lowest rate of reserve coverage of nonperformers. 

    Q3 09 Q2 09 Q1 09 Q4 08 Q1 08 2008 2007
ALLL/Noncurrent Loans (median multiple)
Penna   0.72 0.82 0.94 1.06 1.27 1.06 1.37
NY   0.65 0.76 0.93 1.07 1.37 1.07 1.45
NJ   0.54 0.66 0.75 0.8 1.32 0.8 1.34
Ohio   0.60 0.61 0.67 0.72 0.64 0.72 0.82
Mich   0.57 0.60 0.59 0.65 0.63 0.65 0.67
Ind   0.63 0.66 0.67 0.7 0.88 0.7 0.97

                    Despite these conditions, banks in all six states continue to demonstrate their ability to contain net loan losses as a percentage of total loans.  New Jersey retains the distinction of having the lowest median ratio in this category (.07% in Q3 vs. .01% in Q1), while the Michigan bank median tops the list at .64% (compared to .4% in Q1).  The average of all six states’ median ratios is .25%, compared to .14% in Q1.  This still compares favorably to Georgia (0.83% in Q3 vs. .37% in Q1), Florida (1.06% in Q3 vs. .38% in Q1), California (1.08% in Q3 vs. .37% in Q1) and Washington (1.27% in Q3 vs. .58% in Q1).  It remains the case that this ratio, perhaps more than any other datum in the FDIC release, shows the continued depressive effect of real estate lending in Southeast and Pacific coast states.  General economic conditions, particularly employment, may be worse in the Midwest, but loan losses are deeper in Georgia, Florida, California and Washington.

            Taken as a whole, the FDIC data suggest that the flood tide of the current recession has indeed peaked and begun receding.  In June we ended our review of first quarter FDIC data with the opening words of a Kipling poem, “If you can keep your head when all about you are losing theirs . . . .” To that one can add that the best olive leaves and olives will go to those who get to the newly rejuvenated grove of olive trees first.

Posted in Banking, Uncategorized.

By admin
December 14, 2009

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Acorns Aplenty

“The current recession is the worst in living memory.”  Claims like this appear daily in the popular media, sounding like Chicken Little’s declaration that the sky was falling after she was hit on the head by a falling acorn.  Writers and television journalists vilify bankers and public officials, whom they blame for the market events of the last two years.  Public tut-tutting abounds.  “We all could have done a better job,” said FDIC Chairwoman Sheila Bair, according to the New York Times on November 19.  Concluded the Times reporter who interviewed Bair, “financial overseers failed to act quickly and forcefully to rein in runaway banks.”

 

If a few years ago these banks made loans too liberally, today the problem is the reverse–many banks have run away from making loans at all.  Recently, Midwest bankers have told me:

·         “We slammed both feet on the brake last fall (i.e., 2008) and haven’t let up since.”

·         “Right now, I intend to sit on our capital and make no loans to anyone for anything.”

·         “We will make no loans until, maybe, 2010.”

And these guys (yes, they are all guys) are not even in the hardest-hit states of Florida, Georgia, Michigan, California and Nevada.  American Banker recently published data on the 75 largest commercial loan portfolios of American banks.  Virtually every portfolio shrank from 2008 to 2009, evidence of the breadth, if not the depth, of the economic contraction.

 

Bank regulators have aided and abetted this trend by supplying ample quantities of negative reinforcement: harsher than usual examinations, increased deposit insurance assessments and a steady stream of enforcement actions.  The bad karma flowing from regulators led former FDIC Chairman Bill Isaac to remark, “Right now, bankers don’t need to be told it is a dangerous world,  . . . they need to be told there will be a tomorrow.”

 

Can anything useful be gained by swimming against the tide of darkness?  In our Renaissance Partners business over the last six months, we have seen bankers courageously but cautiously make loans that defy present-day conventional wisdom that the best loan is the one not made.  The deals we have closed have involved large national banks, regional institutions and community banks.  Industries include financial services, primary metals, business services, real estate and consumer goods manufacturing.  The borrowers are uniformly veteran operators who, despite recession-induced volatility in their businesses, know how to make their businesses work in both good and bad economies.

 

If Bill Isaac is right (and he is), then we bankers, regulators and advisers ought to cut out the Chicken Little routine.  We should act like squirrels not chickens.  If we collect the acorns, i.e., new loans, and put them in our store house, they will yield earnings that will sustain us through this winter and for years to come.  More than self-deprecation about past errors or creating new capital requirements or legislating regulatory reform, hewing to the fundamentals of good banking business is the means to create a safe and sound future in banking.

Posted in Banking, Uncategorized.

By admin
December 1, 2009

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Savings

          A New England fable that we have mentioned before in this space tells of an elderly man who died peacefully at home.  When his family divided his possessions, they discovered two huge identical trunks in the attic.  The lid to the first trunk was labeled, “String.”  Inside the trunk the family found a lifetime of balls of string, carefully tied end to end, then wound and put away for safekeeping.  When they opened the second trunk, they found the same thing.   Marveling at their ancestor’s thrift, they lowered the lid of the second trunk and smiled knowingly when they saw the label: “String Too Short to Save.”

 

            Since the 30 year financial flood of the last autumn, banks have been swamped with depositors seeking the safety of FDIC insurance.  Bankers have been perplexed to understand whether the large deposit inflows are temporary or permanent.  Many in the industry hope the liquidity strains experienced by money market mutual funds and bond funds will lead to a permanent shift toward bank deposits.  Yet concern abounds that when financial market conditions become less volatile, depositors will withdraw their funds and return them to higher-yielding non-bank accounts.

 

            In our work with bank clients, we encourage them to campaign actively to retain the deposits that have come their way.  The present moment is, we believe, an extraordinary opportunity to return insured bank deposits to the place where they belong in the firmament of financial products.  Why, you ask?  And why now?

 

            Three generations of Americans, born since WW II ended, have rejected saving in favor of consumption.  Buy a bigger house than you need or can afford—the interest you pay on the mortgage loan will reduce your federal income taxes.  Lease the car you drive—“pay only for what you use” say the advertisements.  Ignore the fact that owning a car for its useful life of 10 years or 150,000 miles would save you a minimum of 35% compared to the cost of leasing.  Use your credit cards to “earn rewards” for every dollar you spend.  Never mind the usurious rates of interest that credit card companies charge on carried balances.  Like trillion dollar federal budget deficits, however, these behaviors continue only at the sufferance of the creditors who make the loans.  In time, the bill will come due.  For many debtors, that time is now.

 

            To be sure, many if not all members of the banking industry have promoted unhealthy borrower behavior like a medical doctor peddling cigarettes to patients.  Examples include “Loan Sale” banners across branch bank entrances, reckless origination and securitization of loans that have no prospect of repayment, and credit policies that invite deposit account overdrafts so long as customers pay $39 per-item overdraft fees.  Yet one need not be a weatherman to recognize that the winds are changing.  Smart banks and bankers will come about and fill their sails with the shifting winds.  Promoting healthy behavior, particularly saving money in insured bank accounts, is the best way both to defend recent deposit inflows against encroachments by competitors and to build durable and deep customer relationships.  For sake of discussion, consider the opportunities that exist within three distinct demographic groups: recent college graduates, middle-age wage earners and recent retirees. 

 

            Because recent college graduates are in a stage of life where they are net spenders rather than savers, promoting savings to this audience serves more to mitigate the risks associated with making mortgage and consumer installment loans to these customers.  To the extent that young customers can build up a savings cushion, they are less likely to default on their loans when they hit a rough patch of water.  If the average young customer household’s aggregate loan balance is $200,000 and a bank has 1,000 such customers, then its aggregate exposure is $200,000,000.  If the bank can cut the percentage of loans that default during the bottom of the credit cycle from 5% to 1%, the bank has avoided potential losses of $8 million.  What bank do you know that would not invest $250,000 to hire and train recent college graduates to provide credit counseling to young customers and prospects so they do not later become a statistic in the ALLL account?  The cost of the program can and should be priced into loans extended to this cohort of borrowers just as auto insurance companies apply surcharges when they insure young drivers.

 

            For middle-age wage earners the golden goose is college savings accounts for children of those wage earners.  College costs have risen faster than the rate of inflation for more than 30 years.  Ironically, when the education lobby suggested in 1978 that Congress implement a tuition tax credit, lawmakers said that would be too costly to the federal treasury.  So they opted to sponsor federal student loans, which became a fixture of higher education financing and allowed universities to raise tuition at unsustainable rates.  Recent market volatility has exposed the dangers of using 529 plans and other equity-market-based strategies in an effort to keep up with tuition hyperinflation.  The remedy to the situation is for the higher education industry to reprice its offerings to be more affordable and for parents and students to save more money in advance of enrollment.  So there is the opportunity for banks.  The age-old strategy of laddered maturities of certificates of deposit looks like a winner to anyone who has suffered the vagaries of the equity markets in the last several years.  For every family with children who have the aptitude for higher education, bankers should be knocking on the family front door to formulate an effective tuition funding strategy.

 

            For anyone age 55 or older, the equity market’s recent tumble is a reminder of the wisdom of not being greedy when it comes to asset allocation, especially during retirement.  Having a significant cash reserve is a necessary precondition to taking the risks of equity investing.  Through our work we constantly hear Baby Boomers say they wish they were not so exposed to the volatility of equities.  Here again is the opportunity for bankers.  With FDIC insurance at $250,000 for the foreseeable future, banks have a calling card that should enable them to retain and build deposits from this age group.

 

            The biggest impediment to banks’ retaining and building further the deposit flows that have recently come their way is inertia.  In the words of an entrepreneurial client of ours, “If it is going to be, it is up to me.”  To attract and retain the under-40 crowd, hire young bankers who can relate to their customer/contemporaries.  Sponsor savings and investment clinics the same way Mastercard and VISA hand out towels at college football games to get customers to sign up for their products.  For the middle-aged college-savings-obsessed earners, partner with service organizations to promote college savings in return for sponsorship of service organization events.  “We will sponsor your ‘Race for the Cure’ event if you allow us to speak with your members about college savings options.”  To attract and retain the over-60 crowd, hire retired or semi-retired persons the way Wal-Mart does.  They want and need something worthwhile to do with their days.  Promoting savings and self-sufficiency among their peers is as fine a cause as any.  And seniors will be some of the most effective ambassadors your bank can have.

 

            Sun Microsystems chief scientist Bill Joy said it is most difficult to see the future when you are in the vortex of change.  The last two years have felt that way.  The stars of consumer finance have recently realigned to present the opportunity to again attract and retain large numbers of savings depositors.  Bankers who act accordingly will fill the attics of their banks with deposits none of which is too short to save.

Posted in Banking, Uncategorized.

By admin
October 26, 2009

1 comment

Not with a Bang but a Whimper

                     The last line of T.S. Elliot’s poem, “The Hollow Men”, came to mind as we read Sunday’s New York Times.  A page 1 article titled, “Small Banks Fail At Growing Rate, Straining F.D.I.C.”, reported what we have observed.  Every Friday, the government closes several banks, usually community institutions.  The continuous wave of closures seems designed to spread the pain, not all of each week’s failures being located in any single region.  The three-failures-per-week litany also attracts less attention in the public eye than if the closures were bunched together at several points during the year.

 

                        Last year’s failures were bangs—big ones.  Wachovia, National City, Washington Mutual, Countrywide, and IndyMac all imploded in spectacular fashion.  This year’s 100 bank failures have garnered little notice outside the industry and the communities affected by the closures.  The Times attributes the recent bank closures to failed commercial real estate projects.   “These banks loaded their balance sheets with loans to home builders and other property developers to make up for lost business in credit card and mortgage lending that bigger competitors wrested away.  They eased their lending standards during the boom years and made big bets on new housing developments, strip malls and office projects.  Now, many of those deals are falling apart, and the lenders are scrambling to raise capital to cushion the losses.”  The article quotes unidentified regulators who posit that hundreds more small banks will fail over the next five years while the nation’s largest institutions return to health.  “The parade of failures” of small banks, the Times says, “underscores a growing divide between them and large institutions like Goldman Sachs, JP Morgan Chase and U.S. Bancorp, which are slowly growing stronger as the economy improves.”

 

                        This thesis has all the credibility of a press release from John Thain’s office at Merrill Lynch last fall.  On the contrary, recent studies demonstrate that the developments that have destabilized the U.S. banking system began 30 years ago and have been steadily building to a crescendo.  Consider, for instance, what the Federal Reserve Bank of New York reported recently in a study titled, “The Shadow Banking System: Implications for Regulation”, by Tobias Adrian and Hyun Song Shin, and available on the Fed’s website.

 

                        The nine-year business expansion that began in 1981 established the trend.  As the decade began, U.S. banks sat astride the capital markets the same way General Motors monopolized passenger vehicle sales.  They led; others followed.  U.S. banks intermediated 45% of private non-financial debt in 1981, compared to 28% handled by non-bank capital markets participants. The lines crossed, however, in 1989, when depository institutions and the securities markets each handled 39% of private non-financial debt.  By the beginning of the next business cycle, the roles had reversed.  The securities industry’s volume rose from 48% of the total in 1995 to 55% in 2007.  Banks’ share declined slowly but inexorably, from 32% in 1995 to 29% in 2007.

 

                        Exogenous factors reduced banks’ role too.  Important developments included the Federal Reserve System’s successful campaign in the 1980s to reign in economic inflation, the consequent return to favor of equity securities (at the expense of bonds other than high-yield varieties), heavy penetration of the U.S. market for durable goods by state-sponsored European and Asian industrial companies, and the consequent erosion of the U.S. manufacturing economy.  Securities firms capitalized mightily on these trends.  From 1954 to 1980, the total value of assets held by households, non-financial corporate firms, banks and securities firms grew steadily, but in lockstep with one another.  In 1981, securities firms broke from the pack, increasing their assets exponentially while banks, households and non-financial firms continued to grow in sync with one another.  The secret sauce of the securities firms was the admixture of financial leverage and securitization.  

 

As securities firms increased the levels of leverage they used in their businesses, banking regulators took the opposite tack.  They raised capital requirements for banks after the 1988-92 banking crisis.  Residential mortgage lending, meanwhile, became the petri dish in which Louis Ranieri and others cultured securitization.  Here especially, securities firms gained at the expense of depository institutions.  Market-based holdings of residential mortgages first exceeded bank holdings in 1990, when both channels represented approximately $1 trillion of assets.  By 2000, $1 trillion was the amount by which market-based holdings exceeded bank holdings.  By 2008, the gap had widened to $3 trillion, banks holding $3.3 trillion while market-based holdings equaled $6.8 trillion.  (Some of what is reported as market-based holdings must have been bank-owned mortgage backed securities, or the data in the table below would be in error.  Probably the more important consideration is that the securities firms and their accomplices, the rating agencies, defined what was credit-worthy for inclusion in MBS transactions rather than the banks that bought the securities.)

 

            In the view that prevailed pre-2008, even when mortgages defaulted, the defaults and losses would be widely distributed among a vastly larger universe of bondholders who held the defaulted debt.  Like a synthetic latex balloon whose greater elasticity than a natural rubber balloon allowed it to be filled with a greater volume of gas, securitization marked a genuine innovation that invited greater risk taking.  Wall Street responded not only by filling the balloons with more gas.  They changed the type of gas to one that would provide greater buoyancy, i.e., yield.  They substituted subprime mortgages for prime mortgages.  It was like filling a balloon with hydrogen rather than helium. 

 

                        If the securities firms like Bear and Lehman that led the mortgage securitization parade were the only fallen heroes, then one could say they got what they deserved.  Unfortunately, they sold many of the hydrogen-filled subprime mortgage balloons to banking system members just before the electrical storm. 

Consequently, the banking system a year ago resembled the German airship Hindenburg coming in for its fateful landing at Lyndhurst, New Jersey, 72 years ago.  The table below, courtesy of the New York Fed article, shows who took how much pain when the hydrogen ignited.

 

 

Total Reported Subprime Exposure ($USD billions)

Percentage of Total

Investment Banks

75

5

Commercial Banks

418

31

GSEs

112

8

Hedge Funds

291

21

Insurance Companies

319

23

Finance Companies

95

7

Mutual and Pension Funds

57

4

 

 

 

Leveraged Sector

896

66

Unleveraged Sector

472

34

Total

1,368

100

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Human minds, however, subordinate painful memories.  Sunday’s article in the Times is Exhibit A.  The message being peddled by some regulators (or is it lobbyists for Goldman Sachs?) is, “The new threat is the community banks’ exposure to commercial real estate.  Big institutions (‘systemically important institutions’ in the new buzz phrase) are strong and getting stronger.  We will suffer a lot longer with the pain from community banks.”  Huh?

 

Just a week ago, the Times reported on a Treasury Department assessment that said the nation came much closer to financial Armageddon late last year than anyone in the government has acknowledged.  Statements by then Secretary of the Treasury Henry Paulson and Fed Chairman Ben Bernanke that the nation’s nine largest banks accepted TARP funds “for the good of the U.S. economy” were false, according to the Treasury Department’s Special Inspector General for the Troubled Asset Relief Program.  He added, the economy suffered rather than benefited from the same officials’ implication that the largest institutions’ receipt of the first $125 billion of TARP funds would enable them to begin lending again.

 

The implications in our view are clear:

 

1.                                          Regional and community banks cannot depend on their traditional industry lobbyists to effectively represent their interests as Congress deliberates over regulatory reform.  As the New York Fed data show, the current lobbying team’s performance over the last thirty years has been an unmitigated disaster.  If they were football coaches, they would not just be fired; they would be run out of town on a rail.

 

2.                                          Banks that are not “systemically important institutions” must thoroughly reconsider every aspect of their business, both as it exists today and as it will be affected by regulatory reform when it arrives.  To this end, we will devote the next several installments of this newsletter to ideas intended to rebuild and strengthen the core business of banking.  Please remember as you read our work that we make our living putting your and our ideas into action for our bank clients, to make their businesses better.  So if you’re not a client yet, please become one.  If you are a client, consider putting us to work on the projects you never have time to complete.

 

            The Wall Street geniuses are not any smarter than you are (they only want you to believe that to blow you off the ball).  They do have more capital.  They can bring to market new ideas like securitization.  They may have more or better friends in Washington (but only if you are passive about advancing your agenda).  At the end of the day though, their job is the same as yours and ours—to take good care of the customer and make a reasonable profit doing so.  Which is what really matters.

Posted in Banking, Uncategorized.

By admin
October 12, 2009

1 comment

Shortcuts and Cold Cuts

            The current economic recession has focused public attention on an inordinate number of financial schemes to defraud investors, financial institutions and the general public.  All year long, national media outlets have picked over the carcasses of Bernie Madoff, Alan Stanford, Paul Greenwood and Stephen Walsh.  Closer to home, in Cleveland, the Cuyahoga County-owned and operated health system has been rocked by allegations that its executive in charge of physical facilities received more than $600,000 from a contractor in exchange for preferential treatment on supposedly competitively-bid construction jobs.  Meanwhile, Pittsburgh news accounts continue to illuminate the irregular business practices of Le-Nature’s, Inc., a Westmoreland County, PA, producer of bottled water and juices that collapsed into bankruptcy in 2006. 

 

            Because prosecutors inevitably “follow the money” in making their cases, banking institutions inevitably find themselves drawn into these scandals against their wishes.  Bankers universally understand that when they suspect a customer has engaged in illegal activity involving their bank, they must file a suspicious activity report (SAR, in trade parlance) with the U.S. Financial Crimes Enforcement Network (FINCEN, in governmentese).  The stigma attached to filing SARs concerning one’s customers makes bankers loath to do so.  Many delay until the situation has deteriorated well past the point of no return, increasing the risk that they and their employers will be viewed as complicit in the suspicious activity.

 

            Lawyers and accountants too can be ensnared in fraudulent schemes.  Once prominent Atlanta law firm Powell Goldstein (now merged into St. Louis’s Bryan Cave) has battled allegations that it committed malpractice by advising a client to proceed with a corporate acquisition in the face of evidence the target was a failing business.  According to the bankruptcy trustee for Powell Goldstein’s former client, the firm’s lawyers knew the deal would not produce the benefits the client’s management claimed (including positive cash flow for the combined entity), knew the client’s management had lied to the client’s bank (RBC Centura) about the impact of the acquisition on the client’s business, and helped prepare a misleading proxy statement that prompted the client’s shareholders to approve the acquisition.  In the Le-Nature’s case, the latest information reveals the company’s chief financial officer and two other financial staff members resigned in 2003 after CEO Gregory Podlucky refused to grant the CFO access to the company’s general ledger and other records.  The CFO did the right thing, bringing the irregularities he observed to the attention of the company’s independent certified public accountants, who, in turn, refused to continue to serve the company absent a complete legal investigation.

 

            Bankers, accountants and lawyers who get drawn into these cases are ensnared because they value in other people the same skills that make them successful as bankers, accountants or lawyers.  They respect someone who can create order, foster discipline, and exert control over a difficult situation.  They look for rational explanations of behavior.  And, as the judges say, they weigh the facts and sift the circumstances; if the facts and circumstances “add up,” they are satisfied.  What they fail to recognize is that fraud is a drama, and at its best, a drama of seduction.  To make it succeed, perpetrators create a story line that is plausible and act it out convincingly.  They mask their theft by deception, the cover story being 180° opposite of the truth.  Fraud artists appear as natural born leaders, perfectionists and pillars of the community, who are indefatigable in their commitment to the success of the enterprises they lead.  They do not tell their victims what to believe about them.  They show them; and the victims embrace the deception as their own version of the truth about the perpetrator.  Thus they are seduced.

 

            Detecting fraud requires that one examine the minor inconsistencies and contradictions for the clues they present to the larger scheme.  Consider the bank executive who declines his directors’ invitation to join them at an after-hours club on the grounds he is happily married, when the whole bank knows he seduces any woman employee he can.  Or the e-mail directive to a subordinate, as part of a collateral audit on mobile home loans, to visit “7/8 properties.”  When the employee responds that it would take two years to conduct site visits on that percentage of nearly 2,000 mobile home loans, the executive writes back, “No; visit 7 or 8.  If the homes are there, the others are too.”  Or the oral directive to another subordinate not to send the executive e-mail about legal bills for personal projects he has lawyers working on at bank expense.  Or emotional outbursts that are grossly disproportionate to the employee performance issues that prompt them.  Detecting fraud, in short, requires placing oneself inside the psyche of the perpetrator and imagining why he (seldom is it a she) would take the action taken other than for the reason given.  “Get rid of those files; we don’t need them.”  “Give me those files; I will keep them.”  “Send those files to [name of distant location where the examiners will not find them]; we need the space for [insert false purpose].”  And so forth.  It is always the little things that give fraud away. 

 

            In the Metro Health case in Cleveland, the corrupt executive e-mailed the contractor with whom he was in cahoots, asking the contractor to cater a lunch for the executive’s employees.  “No cold cuts,” he wrote.  “Ribs and chicken, with some corn on the cob will do.” All so the executive could appear to be Mr. Big in front of his employees.  Or as a blogger about the case wrote, “Gosh—I actually knew this guy.  Seemed like an upstanding straight shooter.”

 

            In the Le-Nature’s case in Pittsburgh, asked to produce evidence of large volume purchases of leaf tea, Mr. Podlucky said no documents of the transactions existed.  Weeks later, however, he produced 700 bills of lading bearing dates ranging over a six month period, but numbered in sequential order. 

 

            Twenty years ago, a bank that has since passed from the scene retained me to extricate it from a lending commitment they had made to Mr. Podlucky.  The more they checked out the business he proposed to buy, the less confidence they had that the deal was bona fide.  The bankers trusted their instincts, backed them up with diligent inquiry into the facts, and were dead right.  Sometimes when the prospective client is pushing the filet mignon, it pays to ask for the cold cuts.

Posted in Banking, Uncategorized.

By admin
September 14, 2009

2 comments

One of Us - Part 2

In the first installment of this column, we described the FDIC’s proposed policy statement, defining terms under which private equity firms may acquire distressed financial institutions, as an opportunity to diversify and strengthen our financial system. We pointed to 20th Century industry pillars like J.P. Morgan, Crocker and Mellon as examples of effective private equity ownership. We promised a second installment after the FDIC adopted its final rule, suggesting cautions that should accompany this evolution.

 

The FDIC itself took a cautious approach when it approved its final policy statement August 26. The agency generally turned a deaf ear to pleas from private equity firms that sought more favorable treatment than the draft statement allowed. For example, the draft statement included a requirement that acquired banks maintain a Tier 1 leverage ratio of 15% for the first three years following the acquisition. Private equity firms lobbied for a lower requirement, saying the 15% standard would place them at a competitive disadvantage in relation to non-distressed institutions, whose minimum ratio is typically 5%. In the final policy statement, the FDIC gave with one hand, cutting the ratio to 10%, but took with the other, making it a ratio of common equity to total assets. As a result, the numerator excludes many types of Tier 1 and Tier 2 capital like perpetual preferred stock and subordinated debt that can help banks satisfy the leverage ratio. Without saying so, the change is the FDIC’s statement to the private equity community, “We have no faith that you will not scheme to manipulate the balance sheet to make it look stronger than it is.” The agency added a specific statement that if an institution’s ratio of common equity to total assets drops below the required 10% level, the institution and its owners are subject to the Prompt Corrective Action regime applied to undercapitalized banks. Included here are civil money penalties that may be assessed against officers and directors should an undercapitalized institution fail to be restored to well-capitalized status.

 

The final policy statement made minor adjustments to a number of other features of the original proposal. Permitted are transfers of bank stock ownership to affiliates during the three year minimum holding period prescribed by the FDIC. Banks under 80% or greater levels of common ownership are subject to the “source of strength” doctrine (previously no percentage threshold was stated). All in all, the final FDIC policy statement reveals an agency that remains extraordinarily wary of private equity firms and their interest in joining the banking club. They simply are not “one of us” in the government’s view.

 


 

If the FDIC is cautious, then what cautions should industry participants observe?

 

First, like the Bush stimulus that preceded the Obama stimulus, the FDIC’s embrace of private equity may be too tentative. A private equity firm that desires to recapitalize a troubled institution must be prepared to capitalize it at higher levels for a longer period of time than a performing bank. Would a firm take the associated risks to its capital without the prospect of outsized returns? Of course not. Yet the banking industry is one where the 20-30% internal rates of return that private equity routinely seeks are all but impossible to attain. Rates in the high teens are as good as it gets usually, due to the commodity nature of banking and the effects of regulation. So as a matter of policy, the incentives have yet to be aligned with the risks.

 

Second, the imbalance of risk and return means that the FDIC will face greater pressure to offer compensating considerations to would be buyers in specific bank receiverships. Although the agency can thereby exercise greater flexibility to match needs and permissions, the accompanying risk is a public perception of ad hoc and even fickle government intervention. The need for ad hoc decision making (e.g., saving Bear Stearns but not Lehman Brothers) is something the Fed and the Treasury Department have both publicly said they want to move away from by means of comprehensive revision of financial regulation. Yet here we have an important public policy pronouncement from the FDIC where the stage is being set for more of the same.

 

 Third, perhaps the greatest risk that accompanies large private equity infusions into the banking system is that bad actors become the source of the equity. Recall the notorious Bank of Credit and Commerce International. Owned and operated by a multinational rogues gallery, the bank specialized in irregular banking practices performed for customers who lived in the shadows. The FDIC’s policy statement recognizes the risk at hand, prohibiting private equity ownership that flows from “bank secrecy jurisdictions.” The reality, of course, is that resources available for detection of criminal activity seldom can keep pace with the rate of innovation by criminals. So the FDIC and friends have much work ahead of them when it comes to policing the new regime of private equity investment in U.S. banks.

 

Overall, the development of greater private equity investment in the U.S. banking system will be a work in progress for years to come. For the strength and diversity it brings, especially to mid-sized banking institutions, private equity offers a unique benefit. The challenge for private equity funds and the government alike will be to frame the means of the investment so that it is attractive to those providing the funding without creating unreasonable risks for financial institutions, their investors or the public.

Posted in Banking, Uncategorized.

By admin
September 9, 2009

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