September 22-23, 2009
Strategic Risk Associates was asked to be a presenter at the 2009 RBC Capital Markets Financial Institutions conference. SRA Partner Don Hooper was on a panel discussion regarding Distressed Loans. This was an informative conference, and below are some of Don’s notes from the different panel discussions that you should find interesting.
Bank Credit: When Will Nonperforming Assets Peak
- California residential real estate is now stable and maybe improving.
- Commercial Real Estate is still declining and not sure where or when will hit bottom.
- Commercial CMBS delinquencies have not increased significantly, but can be expected to rise as maturities and resets occur.
- Underwriting standards are so tight they could choke off the recovery. Regulatory requirements contribute to stringent UW standards.
- The industry is experiencing a high decline rate. It was felt that many customers are trying to replace what should be equity with debt, and it will not work in this environment. One banker acknowledged declining approximately 65% of all current requests.
- Community Bank problems are primarily centered in real estate construction loans where interest reserves have expired, and have little guarantor support.
- Customer loyalty is surprisingly strong, even for banks operating under a Cease and Desist Order. The community Bank’s hold on their customers is very strong.
- Most everyone on this panel saw nonperforming loans going up. A banker from Californiafelt his NPA’s would stay about the same but with the composition moving from mostly residential to commercial.
- Allowance for loan losses will come down slowly as the economy improves, and will probably be in the 1.5% to 2% range. Expect regulatory requirement for increased allowances to continue for some time.
What Lies Beneath: Positioning the Franchise for the Next Phase of Growth
- Residential is stabilizing but at a very distressed level.
- 40% of all US foreclosures are located in Florida, California, and Nevada and tends to skew numbers of problem residential loans.
- Commercial line usage is at the lowest point any of the panel members could remember.
- Stupid competition is gone.
- There is significant deposit growth from consumers and their behaviors have changed. Consumers are saving more and paying down debt.
- If a bank’s cost of funds is low, which it is for most banks today, you don’t have to take big risks to be profitable.
- Regulatory risks are some of the biggest risks facing banks today.
- Regulators may redefine the definition of a well capitalized bank. Tangible common equity will be the main capital component going forward.
- One presenter made an interesting observation – – Too big to fail means too big to manage. Some large banks have divisions that are capable of bringing down the bank, and their CEO’s don’t even know they exist.
- There is a real possibility that FDIC special assessments will continue.
- Based on recent past dealings, there was some general agreement that people should NOT be surprised if the FDIC reneges on some of their loss share agreements.
- Expect loan growth to come from Specialty Finance, but overall expectation is that balance sheets will shrink.
West Coast Banks Panel – Enough Already! Is There Any Relief In The Year Ahead?
- Phoenix is starting to recover, especially since residential prices are down to 2000 levels.
- We’ve not seen buying opportunities like today since 1993.
- Nevada is still challenged. Undeveloped land has been hit hard and is still declining in value.
- Las Vegas residential transactions are up 75%, but prices are still low. At least inventory is moving and should eventually result in prices turning upward.
- An area’s Affordability Index is something that everyone should start paying attention to. So many areas are now affordable and can be expected to turn around faster than ones not so affordable.
- If the West residential markets have not hit bottom, it is very close.
- The future headwind in CRE will be CMBS, and expect it to impact everyone.
Address By Nancy Wentzler, OCC Chief Economist-Deputy Comptroller for Global Banking and Financial Analysis
A good portion of her talk regarded Stress Testing and how important that will become in the future.
- Make probability of default better tied to what actually causes losses.
- Do not use historical averages because history has no resemblance to what we are seeing today.
- Banks need to change the way they characterize concentration risk and should look at concentrations by economic drivers. For example, if unemployment rates get to 10%, how would this affect our portfolio and ultimately our capital?
- Liquidity also needs to be stress tested.
- Need to stress test remote events – something with low probability of happening but with potential huge consequences. She referred to these as “FatTail Events”. Banks should have meaningful conversations on what could happen and what would you do. What impact would they have on the bank? You cannot wait until it happens to have these discussions.
- Expect Regulators to do another round of stress tests on the large banks, and will probably expand the scope of banks tested.
She identified several challenges facing banks as follows:
- Defaults will continue to increase. The economy will struggle for many years to come.
- Credit card portfolio problems will increase
- There will be a continued reach for yields as the NIM for small banks is getting crushed.
- The industry needs to determine how to get rid of Government support as they cannot continue to prop up the industry forever.
- Economic cycle is not really a cycle – so many events are coming together at the same time, such as globalization, technological changes and their elimination of jobs, etc.
- Cash flow struggles will continue.
- Unemployment will go higher and will remain high for some time.
- There are certain regions of the country that are suffering more than most. Expect Florida to be one of the last states to come out of this recession.
- A lot of corporate and bank debt is coming due in 2011 and 2012. C&I should shake out beginning next year.
- Regulators will do stress testing for Regional Banks and will be as stringent as that for the top 19 banks done earlier. She hopes it will be more rational though.
- Expect required capital levels to go up. Regulatory focus going forward will be on Tangible Common Equity.
Focused Small Cap Banks: Maintaining the Course in a Troubling Environment
- There are a lot of bottom feeders now looking to buy assets, but prices are low. You can get rid of problem assets and properties, but most likely will have to take a big capital hit to do it.
- One panel member thought that the FDIC will have strong, well managed banks take over and run banks for the FDIC instead of having a closure. This hopefully will be cheaper on the FDIC than closing down a bank.
Equity REITs: Are The Clouds Clearing?
- Underwriting is still very stringent but Life Insurance companies are beginning to get back to lending.
- Life insurance companies prefer to lend to public companies instead of private as they know public companies have better access to debt.
- Many banks are operating under “extend and pretend” philosophy as they do not want to face the harsh realities of the current economy.
- The hotel REIT, Sunstone Hotel Investors is giving properties back to lenders when they don’t work, and readily acknowledges it is a business decision that benefits their shareholders.
- Bank deals that are occurring are almost always recourse.
- CMBS will present great opportunities for buyers, but not yet.
- The shopping center REIT, Regency Realty mentioned that they will probably never use CMBS again. Said they have $1 Billion in loans coming due in next two years and are expecting to pay down the loans by 40% when they come due even though all loans are current.
- All panelists predicted there will be a significant amount of distressed assets, but not sure exactly when the bulk will hit the market. For office properties, expect sooner than later as many properties will not cash flow today.
- As office building leases expire, tenants are looking for quality and are looking to improve their space at today’s good rents. Office rents have gone down 25% or so but appear to be stabilizing.
- Consumers are not spending and retail shopping center owners are having to cut rents to keep tenants in place. More pressure on rents and occupancies is expected.
Commercial Real Estate: The Next Shoe Is Dropping. Is It A Ballet Slipper Or Combat Boot?
- Expect to see significant stress through 2010 especially in retail and office properties.
- We are in the worst CRE climate since the depression.
- There is $1.4 trillion in CRE debt coming due in the next four years, of which 70% will NOT underwrite to today’s standards.
- We are in the worst CRE climate since the depression.
- In 1945, we prospered after the war because so many other countries were devastated and the US had to staff up to supply goods to these countries. The situation is directly opposite today, and as a result, US labor growth is expected to be slow.
- CMBS past dues more than tripled in the past year.
- Current loss estimates upon default for hotels is 60% and for multifamily properties 30%.
- Bank’s information systems are generally poor and getting a handle on all their CRE problems is almost impossible.
- As can be seen from the above notes, this panel actually talked more about distressed debt vs. CRE. That clearly suggests more problems in this sector can be expected.
Distressed Loan Panel
- Since I was a part of this panel, I did not have the opportunity to take notes. But I can summarize some of the more interesting discussion items.
- There are a lot of buyers ready to buy distress debt, but few sellers. Main reason is banks do not have the capital to write down assets to their current value.
- One panelist was from Debt-X, and their growth has been staggering over the past couple of years, and expected to grow more as FDIC takes over more banks.
- Everyone saw future profit potential in residential lots because of the significant discount given to these properties in today’s market and the disconnect between current lot prices and overall sales prices of homes.
- A question was asked about the impact if banks had to mark their loans to market, and we all agreed there would be a lot more bank failures.
- A question was asked if we had seen a lot of fraud as the cause of this situation, and I stated that that had not been my experience. When the market is down for so long as it has been in residential properties, even good loans are going bad as borrowers and guarantors simply run out of funds to support projects.
M&A Panel: Distressed Acquisition Opportunities
- Why won’t the FDIC allow PE firms to bid on failed banks?
- There is a concern that all a PE firm wants is profits, and they do not care about what happens to the bank, its people, or its communities.
- Most PE firms do not have an established and trusted management team in place as the FDIC requires.
- >The FDIC and Fed have a clear distrust for PE firms.
- The FDIC should allow more PE transactions and should allow them to go public faster than the required 3 year holding period.
- The FDIC will not release bids on failed banks mainly because they have not always accepted the highest bids. In other words, the FDIC has awarded bids to banks over PE firms even if the PE bid was higher.
- There are 6,000 banks controlled by one or a very few people. Why are the rules so different for PE firms?
- Are there opportunities for a healthy bank acquisition?
- Yes but only if the price is right and most healthy bank owners are not realistic on their pricing.
- With so many FDIC loss sharing arrangements available today, banks are not looking at healthy banks for acquisitions.
- John Kanas from Bank United mentioned that his group had looked at over 100 banks and could not find one he felt was a good deal until they were able to purchase Bank United from the FDIC.
- The Bank United deal contained warrants payable to the government in the event profits exceed certain levels over a 10 year period. They were able to win the bid on Bank United mainly because the management team was already known and trusted to regulators.
- There was some concern expressed that the FDIC could change the rules on loss share agreements, but this panel did not think that would be the case. They did think that the FDIC will require acquiring banks to hold properties longer and to attempt more workout solutions rather than just dumping properties. This would have the effect of reducing a purchaser’s expected yield on a loss share transaction. One of the main reasons given for the FDIC delaying disposition is to extend the life of available money in the FDIC reserve fund.
- Expect 1,000 banks to fail in the next three years, bringing the number of US banks to around 5,000.
- Getting a new bank charter will be very difficult if not impossible.
- Most M&A action will be in the smaller banks.