Thursday, January 28, 2016

A Solution for Closely Held Banks

If you are a family bank and want to sell your shares without selling the bank, what do you do? So was the question that my colleague, Sharon Lorman, put to me in my firm's very first podcast edition of This Month In Banking (follow link to listen!).

The question is not for family banks alone. But all banks that are privately held or have one or a few very large shareholders. How do those shareholders exit if they need liquidity for whatever reason?

This month, Old Fort Banking Company in Tiffin, Ohio gave us an answer... form an Employee Stock Ownership Plan (ESOP). Old Fort, founded in 1916, was run for generations by the Gillmor family. Dianne Gillmor Krumsee is the current Chairman. Looking to divest a portion of her stake, the bank's CEO, Mike Spragg, proposed establishing an ESOP to buy $15 million of her shares and therefore preserve its independence and the Gillmor family legacy.

An ESOP is a trust that is a qualified retirement plan designed to provide employees with an ownership interest in their company by investing primarily in stock of the employer. The ESOP is funded with tax-deductible contributions by the employer in the form of company stock, or in the case of the Old Fort ESOP, with cash that was used to purchase company stock. In this case from its Chairman. The bank's press release did not specify if the ESOP was leveraged, meaning it borrowed to fund the purchase. My guess is that it was leveraged with a loan from a financial institution or Ms. Krumsee herself. Either way, Old Fort would have likely secured the loan.

The bank can then make tax-deductible contributions to the ESOP to service the loan. As the loan is repaid, shares held by the ESOP are released and allocated to employee accounts.

Their may be tax benefits to the selling shareholder. According to Internal Revenue Code Section 1042, an owner of a closely held C corporation can defer, and potentially eliminate, all state and federal capital gains taxes on their sale of stock to an ESOP. This is done by reinvesting the sale proceeds in a Qualified Replacement Property (QRP) within 12 months of the sale. Don't take my word for it. Check with your tax adviser. That's another test I didn't take.

Chase has an excellent ESOP primer that I checked out for this post. Check it out for more information.

The benefits of an ESOP go beyond tax benefits for the seller and independence for the bank, in my opinion. Studies show that employees with ownership stakes in their companies tend to run the companies better... i.e. they perform better. A recent FDIC analysis concluded this. 

Indeed, I checked all the Sub S banks in the US, which are mostly closely held banks with significant employee and family ownership, for their financial performance. The table represents my findings.

For its part, Old Fort had a 2015 ROA of 0.96% and ROE of 10.90%. Not too bad for a $475 million in asset bank. By comparison, FirstMerit, also of Ohio, had a 0.91% ROA and a 7.90% ROE for the same period. Oh, and FirstMerit is $25 billion in assets. And just threw in the towel by selling to Huntington Bancshares (ROA: 1.01%, ROE: 10.60%, Total Assets $71B).

The twist for Old Fort, is the $15 million share purchase represented a 45% stake in the bank, which required the ESOP to apply to be a bank holding company. Which it did. And apparently succeeded, because the transaction closed last month.

Well done to Ms. Krumsee, Mr. Spragg, and all the employee-owners at Old Fort Banking Company for executing on an idea to perpetuate the family involvement, provide liquidity, and keep their well-run bank independent.

~ Jeff

Saturday, January 16, 2016

Guest Post: Fourth Quarter and Year End Economic Commentary by Dorothy Jaworski

Into 2016 We Go
This is no way to ring in a new year!  US stocks fell 6% to 7% during the first week of January, following world stock markets in a downward spiral.  It is the worst first week of trading in years, maybe ever.  There were several drivers of this nervous selling activity.  First and foremost, China is at it again.  Its stock markets are said to have led the world markets plunge, with clumsy attempts by their regulators’ circuit breakers to stem declines actually making them worse.  China’s manufacturing data fell for the fifth consecutive month, pulling their GDP growth down to 5.5%, as the painful transition of this Asian economy from a manufacturing one to a consumer one marches on.  And China surprised the markets by devaluing their currency- the yuan- again, similar to the sneak attack last August.

However, this time the red-faced and embarrassed International Monetary Fund, who granted China reserve currency status just weeks ago, has to acknowledge that this type of behavior breaks their regulations.  China is paying the price for these actions.  They used to hold reserves of $4 trillion in 2014.  Between February and November, 2015, foreign capital was pulled out of the country to the tune of $843 billion.  Their foreign exchange reserves are down in 2015 by 13%, or $500 billion, which is the first decline since 1992.  Ah, the price to pay…

Middle Eastern tensions escalated recently between Saudi Arabia and Iran.  The Saudis executed dozens of people including a Shiite cleric and Iran torched the Saudi embassy in Tehran.  In days gone by, oil prices may have spiked, but in today’s supply-glut-driven energy market, oil prices steadily fell, down by 10% during the first week of January, hitting $32 per barrel.  This decline will continue to harm the energy industry, of which many firms are already in decline or recession.

The Fed
The only Christmas present the markets received in December was a Federal Reserve rate hike of 25 basis points.  They said they would raise rates in 2015 and they did.  Merry Christmas to consumers and to small businesses, who will pay higher interest rates.  The Fed made their decision solely on the “low” unemployment rate of 5.0%, which they tout as proof that their zero rate campaign, which lasted six years, “worked.”  Well, certainly it “worked” because so many people dropped out of the labor force, which when coupled with moderate job growth, makes the unemployment rate of 5.0% look pretty good.  Record warmth in December contributed to a rise in payroll jobs of 292,000 and household jobs of 485,000, which the Fed uses as vindication that they were “right.”

One look at most of the other economic data shows slowing momentum in both the manufacturing and services sectors.  Housing is volatile, especially at this time of year.  GDP in the 4Q15 is tracking at 1.0%, according to the Atlanta Fed.  In our region, the Philly Fed indices of business activity all turned negative in December, but, hey, higher rates will help, right?  Why is the Fed trying to slow down GDP growth of 1%?  With the average growth in GDP achieved in the past six years at 2%, why try to slow this down?  Inflation readings and inflationary expectations are still quite low and the dollar is strengthening; it makes one wonder why they are so anxious to raise rates.  Usually the Fed would tighten in the face of strong GDP, rising inflation and wage growth, and a weak dollar, not the opposite.  Well, it is all still “data dependent” says Fed Chair Janet Yellen, so we shall see where the data takes us.

Oh, the Taylor Rule
Oh, wait!  I forgot!  The Fed follows the Taylor Rule, which is a formula that shows where the short term Fed Funds rate should be- and currently says Fed funds should be above 1%.  As a matter of fact, the formula has pointed to above 1% since 2009.  But many economists and market participants think that productivity, labor force participation, massive increases in regulatory burden during the past six years, still-high debt levels of businesses and households, financial market behavior, and corporate profits should all be adjustments to formulas such as the Taylor Rule, which considers inflation and unemployment but not other variables.  In an environment such as the one in which we finds ourselves, with slow 2% growth, “low” unemployment, high numbers not in the labor force, and slow wage growth, there is little to propel consumer spending, which makes up over two thirds of our GDP.  Low oil and gas prices did not propel spending and there is not much on the horizon to do so- unless whoever wins the $1 billion plus Powerball jackpot decides to spend it all.

Despite the waning momentum in the economy, most people, including myself, do not see a severe slowdown leading to recession.  One notable exception is Citibank, who has a poor economic forecast.  I believe that we will continue to grow between 1% and 2% GDP.  Inflation will remain low after rising slightly from a bottom, but the Fed may tighten again this year, not because they see something in the data that tells them to but because they say they must.  So I guess they will.

Large Hadron Collider Update
In December, it was announced that an unusual “bump” in the particle collisions data recorded by the Collider.  Is it a new particle or two new particles previously unknown to the Standard Model of physics?  Is it another form of the Higgs Boson?  In any event, it is an unexpected result of the particle collisions now occurring at up to 13 teraelectronvolts, or “TeVs,” which is up from the 8 TeVs between 2009 and 2013.

China is expected to build its own “Larger” Hadron Collider with a circumference of 30 to 62 miles, compared to Switzerland’s 17 miles.  CERN, the operator of the Collider, is eyeing its own future construction of a bigger machine to triple its distance.  Pretty soon, we will have to worry what is underneath every mountain.

Stay tuned!  Thanks for reading DJ 01/10/16

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.

Sunday, January 10, 2016

The Golden Age of Banking? Depends on Us.

Jerry Reeves, President & CEO of Sturdy Savings Bank of Cape May Court House in New Jersey and current Chairman of the NJ Bankers Association, penned an article The Golden Age of Banking in the NJBA's winter 2016 edition of New Jersey Banker magazine. He romanticized that more seasoned bankers might be reminiscing back to the "good old days", but newer bankers might see today as banking's golden age.

In that, I agree with Jerry. His optimism was palpable, citing the education levels of new bankers, technology innovations that can be implemented by large and small banks alike, and the stratification of seasoned and new bankers that can pave the way to future industry leadership.

His leadership transition comment brought to mind a comment by an industry FinTech professional, and my friend, Mark Zmarzly:

"We build moats in our industry... we need to build bridges."

- Mark Zmarzly, CEO, Hip Pocket

How does Mark's quote relate to the mix of seasoned and new professional bankers? Because there is tremendous friction in ushering in new leadership in our industry that weighs like a millstone around our collective necks that will likely lead to the continued shrinking of our ranks.

Some friction is sewed into our fabric and is largely out of our control. It relates to the regulatory scheme. A bank CEO recently told me that the CEO job at his bank could have only gone to an experienced bank CEO that came through the commercial lending ranks and his/her experience could not be with a troubled bank. Why the rigid criteria? Because regulators would approve no one else. Such attitudes bleed into the board room, as they create similar rigidity based on past bias or perceived regulatory preference. This ignores the fact that some of the most dynamic and forward looking bank leaders don't fit that criteria.

In other words, it is extremely short sighted. But it is the safe choice, as boards seek similar leadership to what they got in the past in spite of the rapid changes occurring before us.

Although some barriers to future leadership are beyond our control, most are within it. Humans protect what we have. Teachers ensure that only those with teaching credentials can teach. Even though there may be willing retired government officials available to teach Civics class, they couldn't break through the "teacher" barrier. Similarly, you can only practice law with a law degree. Three extra years of education and passing a bar exam. Abraham Lincoln practiced law with an elementary school education. We erect barriers to keep people out.

And so it goes in banking. What we need are development plans to turn our young bankers into future bank executives. Exposing them to multiple areas of the bank, formal training, and executive mentorship should be part of the transition. As executives near retirement, there should be multiple internal candidates to fill that role. 

Instead we turn to outsiders, or to the investment banker to help sell our bank. Successful banks of the future will purposefully hire, develop, and turn the keys over to their future leaders. Current leaders will have the resolve and humility to make it happen. Less than successful banks will call the investment banker and turn the keys over to someone else.

~ Jeff