Thursday, June 24, 2010

Real Estate: Love it or hate it?

Economists and government officials continue to cite lack of lending activity as a key contributor to our economic malaise. At the same time, I keep hearing from bankers about the lack of credit-worthy borrowers and regulatory pressure regarding the quality of the bank loan portfolio. I am also seeing a rise in bank cash positions and a decline in business loan (C&I) portfolios (see chart). As I understand it, government officials (excluding regulators) want banks to lend, banks have the cash to lend, bankers are hesitant to lend, and regulators would just as soon have you hire another compliance officer and purchase a U.S. Treasury.

Much of the standoff revolves around real estate secured lending. There is little doubt that bankers like real estate as collateral for loans. Countless bank CEO's, senior lenders, and bank directors tell me so. This preference resulted in real estate assets (including mortgage-backed securities) representing 44.1% of total assets at March 31, 2010 (see link below).

Regulators are slightly schizophrenic on the subject. They imposed limitations on the amount of non-owner occupied commercial real estate (CRE) a bank should carry, and they link the value of the loan to the value of the collateral backing it. How will these conflicting views on real estate work itself out over the near term?

What I suggest regulators consider is collateral alternatives. Our current slump, which started at the end of 2007 was real estate driven. When sub prime and similar loans began to default, other borrowers began tightening their belts and began to de-leverage, leading to a recession. Pundits spoke confidently and often about prime mortgages and CRE being the next shoe to drop. The result was a decline in real estate values (see table below).

Amidst all of the calamity, the median home price in the U.S. dropped 24% from 2007 through the first quarter 2010. It makes you wonder what has happened to the values of alternative collateral such as vehicles, inventory, or receivables? Are these more reliable? One regulator, on a panel at a banking conference, told a tale of a recent conversation he had with his regional director. A bank this regulator examined was increasing the level of CRE on its books beyond the 300% of capital target. The regional director voiced his concern, to which the examiner responded "what alternative to real estate as collateral should I suggest?" He didn't hear from his boss on the subject again.

Bankers, on the other hand, should study carefully the direction of the national and their regional economies. What segments are growing? Do these segments typically have real estate to offer as collateral?

Let me offer a story. Let's say Ted owns an environmental engineering firm that he started five years ago. He used his own money and a home equity loan to get it going. Today he has $2 million in revenue, $200k in capital, and 10 employees headquartered in a leased office. An opportunity presents itself to pick up five new employees. However, Ted projects the growth will put him in the red for two years. He would like to get a loan from his bank but doesn't want to use his home as collateral because he is not confident he has enough equity and his wife was none-too pleased about doing it the first time.

Would your bank lend to Ted? Let's take the story further, assuming the firm secured a C&I loan from a bank. Now the economy goes in the tank and the firm has a pretty bad year. He puts some additional equity in the business to get them through, but when submitting his financials to the bank, the loan now doesn't cash flow. Will the bank write down the loan at the behest of regulators or on their own accord? Will they encourage Ted to refinance with another bank? Or will the bank see Ted through this difficult period?

If you're a regulator reading this, my guess is you would make the bank take a larger provision and/or write down the loan. If you're a banker reading this, my guess is you wouldn't make that loan without real estate as collateral. But we have to ask ourselves how long we can continue to lend to commercial building owners while avoiding lending to the businesses, like Ted's, within the building? It's those businesses that are likely to drive our economy in the future.

This has been an unusually long post. So I must summarize. Real estate continues to be a reliable source of collateral to lend against, even considering the recent downturn. Regulators should take note. But the businesses likely to fuel the U.S. economy into the future may not have real estate to offer as collateral. Bankers should take note and be prepared to finance them.

- Jeff

FDIC: Quarterly Change in C&I Loans

FDIC: Real Estate Assets as % of Total Assets

National Association of Realtors: 1st Quarter 2010 Median Sales Price of Existing Family Homes

Friday, June 18, 2010

Branch Math: To branch or not to branch?

Opinions are wide and varied on the subject of branching. Trends indicate that more customers are using electronic means to interface with their bank and are visiting branches much less. However, customer surveys continue to favor branch locations as a critical factor in determining where to bank. In the mid 1990's, many industry professionals feared branch extinction. The former Commerce Bank of Cherry Hill, New Jersey proved these fears wrong by racking up impressive growth and profitability numbers through de novo branching.

But as branch lobbies become emptier, senior managers are wondering again if branching is becoming a dinosaur. I predict branches as we know them will slowly become obsolete. I do not know the date of their obsolescence.

I do think banks must be more exact in the communities they select and the types of branches they build. Reasons for branching into a community are wide and varied. But typical themes I have heard include: a builder saved a pad site for the bank; a senior manager lives in that community; and the CEO has a second home there. Before branches popped up on every street corner, margins were greater, and the cost to erect a branch was not so dear, this approach may have still yielded positive results. Today, a branch built without rigorous analysis is more likely to be unprofitable and a candidate for closure.

Here are a few questions senior managers should ask themselves prior to branching:

1. What customers are the focus of our strategy?
2. Where are concentrations of these customers located?
3. What are the market demographics of the communities where these customers are located (growing, shrinking, etc.)?
4. How many competitors are there?
5. Is average branch deposit sizes growing or shrinking in these communities?
6. Do we have the ability to attract quality bankers to serve these communities?
7. Are there attractive sites to open a branch that is convenient and consistent with our brand?

After answering the above, senior managers may want to get busy with Branch Math. I built a branch profitability model designed to estimate the income statement impact of a prospective branch (see below).

Assumptions, such as deposit growth, can be tested looking at other branches in the community or nearby communities, and past experiences the bank has had opening branches. Senior managers can model base, worst, and best case scenarios in order to make an informed decision and give the Branch Administrator and prospective Branch Manager a template to guage success.

Note that the branch is charged the opportunity cost of building the branch (i.e. the interest income foregone by buying land and paying a builder to erect the branch). This gives senior managers an idea of the higher hurdles they are creating for hitting profit targets if they build a palace. I often see this expense overlooked.

The future of banking is being determined at a pace not seen since the Great Depression. Much of it is being decided in the halls of Congress. But most is being decided in the minds of our customers and prospective customers. Part of that future will be the importance of branches. To give new branches the greatest chance to succeed in this evolving world, we must inject greater analytical rigor in determining where to branch, and the type of branch to construct. In a highly competitive marketplace, having a higher percentage of branches delivering desired profitability will help your bank stand out in the crowd.

- Jeff

Saturday, June 12, 2010

Book Report: Being Strategic by Erika Andersen

A The Elizabethtown Public Library should send me Christmas cards because I don't seem to be able to read a book in the allotted time. This generates late fees, manna from heaven for a public library. What it also does is force me to choose the books I read wisely because I don't read as many as others. In this context, Being Strategic by Erika Andersen is an odd choice.

There are a myriad of books written by consultants trying to get noticed and college professors trying to get published on the subject of strategic planning. This book was written by a consultant, which typically gives me pause. Odd since I'm a consultant.

But I'm sensing a very positive trend in banking based on conversations with bankers, the engagements we receive, and regulatory fiat. Senior executives are starting to look beyond the current crisis and the next budgeting season. They are starting to discuss competitive advantage and the bank they hope to become. Collectively, I sense we are becoming more strategic.

That is why Being Strategic is so timely. It doesn't simply provide a strategic planning model, it provides practical advice and exercises to help the reader incorporate strategic thinking into everyday decision making. With so many tactical challenges facing us, senior leaders in banking (general term for banks, thrifts, cu's) need to focus more than ever on the bank we want to become.

This book provides an excellent and simple method to transform your leadership team from a group of tacticians to tacticians with a purpose... To make daily progress moving your bank to a relevant future.

Here is what I like about the book:

1. Discusses the "vision thing" in common sense terms. Before you chart your course, decide your hoped-for future.

2. Provides many examples of the author's approach as it can be applied to the reader's day-to-day routine. Even the Welsh castle story clarified theory, although I would rethink the authentic Welsh names which were hard for my internal voice to pronounce.

3. Had a very helpful segment on facilitating a strategy session. Although this is what I do for a living, I could always do it better.

What I didn't like about this book:

1. It was written by a consultant. Partnering with a client would have highlighted the challenges of being strategic and brought more credibility to the book.

However, I don't want this to diminish the value of the book to a great degree. The author clearly has a great deal of experience in the subject matter. I think if all bank senior leaders adopted the approach in Being Strategic, we would be far better prepared for the challenges ahead.

- Jeff

Book Report note: I will occasionally read books that I believe are relevant to the banking industry. To help you determine if the book is a worthwhile read for your purposes, I will review them here. My mother said if I did not have something nice to say about someone, then don’t say it. In that vein, I will only review books that I perceive to be a “B” grade or better. Disclosure: I will typically have the reviewed book on my bookshelf on the right margin of this blog. If you click on any book on the shelf and buy it, I receive a small commission; typically not enough to buy a Starbucks skinny decaf latte with a sugar-free caramel shot, but perhaps enough to buy a small coffee at Wawa.

Saturday, June 05, 2010

A Few Good Commercial Lenders

My boss loosens up strategic planning retreats with funny stories and anecdotes. Below is one of my favorites. The commercial lender's part is played by Jack Nicholson and the finance part is played by Tom Cruise from A Few Good Men. If you haven't seen the movie or don't remember the sequence, I have it embedded below. Enjoy!


Lender: "You want answers?"

Finance: "I think we are entitled to them!"

Lender: "You want answers?!"

Finance: "I want the truth!"

Lender: "You can't handle the truth!!!"

Lender (continuing): "Son, we live in a world that requires revenue. And that revenue must be brought in by people with special skills.

Who's going to find it? You Mr. Finance? You, Mr. Operations?

We have a greater responsibility than you can possibly fathom.

You scoff at the Lending division and you curse our lucrative incentives.

You have that luxury. You have the luxury of not knowing what we know: That while the cost-of-business results are significant, they drive revenues.

And my very existence, while grotesque and incomprehensible to you, Drives REVENUE!

You don't want to know the truth because deep down in places you don't talk about at staff meetings ... you want me on that call. You NEED me on that call!

We use words like another round, top-shelf, medium-rare, on-the-rocks, cabernet, cognac, luxury box, Cohiba and foursome. We use these words as the backbone of a life spent negotiating something. You use them as a punch line!

I have neither the time nor the inclination to explain myself to people who rise and sleep under the very blanket of revenue I provide and then question the manner in which I provide it.

I would rather you just said "thank you" and went on your way.

Otherwise I suggest you pick up a phone and call on some customers and prospects. Either way, I don't give a damn what you think you're entitled to!"

Finance: "Did you expense the lap dancers?"

Lender: "I did the job I was hired to do."

Finance: "Did you expense the lap dancers?!"

Lender: "You're g**damn right I did!"