Lessons Learned: Banks that thrived during crisis grew loans slower prior to it.

The St. Louis Fed recently performed a study to uncover the characteristics of community banks that thrived during the financial crisis. Thriving banks were defined as under $10 billion in assets, and maintained a composite CAMELS 1 rating in each exam cycle from 2006-11, an impressive accomplishment. As with most government driven academic studies, there were numerous answers. But one struck me as particularly instructive.

Former legendary Fed Chairman William McChesney Martin, Jr. once quipped "I'm the fella that takes away the punch bowl just when the party is getting good." It appears that banks that had the ability to do the same during the heady lending times of 2004 - 2007 found it to be an enduring strategy (see table from Fed study).

Banks that failed during the financial crisis did so predominantly for two reasons: over-concentration, and foolishness. Both are related. Banks that thrived, however, had the discipline to stay on the sidelines while their competitors did aggressively priced, borrower friendly structured, and competitor beating loans. 

Sitting on the sidelines is difficult. Competitors have snarky smiles on their faces when they bump into you at the local Chamber meeting or industry get togethers, knowing that their pipeline is fuller than yours, and they just beat you for the latest big construction deal. If we learn anything from this study, it is that at least one member of senior management should be like William McChesney Martin.

In addition to that, here is what I think a bank should do to avoid the lending hubris that led up to the crisis:

1. Lend Consistent With Your Strategy. I've seen my share of banks that "chased assets", to keep their pipeline as full as the bank down the street. But keep to your knitting. Be known to specialize in certain asset classes and/or industries. And, unless your strategy says "do land loans out of our markets", don't do them. Come to think of it, even if your strategy says to do land loans out of your market, still don't do them. And fire your strategists.

2. But Diversify. Being great at serving specific industries is critical to developing a competitive advantage, but it doesn't mean your balance sheet should be chock full of loans to one or two industries. It just means that you strive to be great at a few things. Continue seeking quality loans in other loan categories and industries. 

3. Minimize Broker-Originated Loans. For some reason, brokers that originate loans but assume no risk of default, don't care too much if the loan goes bad. Go figure? In addition, since the broker owns the relationship, the borrower may be more apt to default on your loan because he/she barely knows you.

4. Include Clawbacks in Bonus Pools. I am not a fan of regulators running your bank. But they favor clawbacks to deter profligate risk taking in lending. This makes sense to me. Keep two pools for each lender, and senior management. One for performance today, and the other for multi-year portfolio performance. Let lenders see that bonus pool grow and plan for the backyard pool when it is released, to motivate them to bring good borrowers and well-structured transactions to the table. 

5. Build a Better Lending Function. Populate lending with a few well-connected, experienced, and respected lenders. Then build a structure that is designed to develop junior people into your lenders of the future. Start them as portfolio managers, or credit analysts, with a targeted development plan. Banks that chased "experienced" lenders all over town ended up with those that made loans at all costs to get deals done. I've seen one or two of these "cowboys" bring banks to their knees. Just like I suggest not chasing deals at all costs, don't chase "experienced lenders" at all costs. Build your own pipeline of next generation rain makers.

What should I add to this list?

~ Jeff

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

http://tinyurl.com/25rz9a

FDIC: Real Estate Assets as % of Total Assets
http://tinyurl.com/27go23m

National Association of Realtors: 1st Quarter 2010 Median Sales Price of Existing Family Homes
http://tinyurl.com/2692z7x

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!

A FEW GOOD COMMERCIAL LENDERS

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!"

Have we checked out of business banking?

Alex Pollack, a resident fellow at The American Enterprise Institute, had a sobering editorial in the March 3, 2010 American Banker. The context of his commentary was on the bubble that burst in the residential real estate market, and the more methodical decline in commercial real estate. He rattled off sobering facts: fifty five percent of commercial bank loans are tied to real estate. For commercial banks under $1 billion in assets, the number jumps to seventy four percent (see chart).

These statistics ignore the amount of real estate secured bonds and government agency bonds designed to fund real estate in banks’ securities portfolio. Clearly, commercial banks’ exposure to real estate contributed to the rising number of bank failures. What brought us to this point?

Commercial banks were the connoisseurs of commercial finance dating back to the National Banking Act of 1864. That Act did not permit national banks to lend on real estate. The value of real estate was certainly more volatile then than now. Times changed, however, and banks were permitted to do real estate lending, and these loans became twenty five percent of bank loan portfolios after World War II. It remained at that level for nearly three decades when real estate lending began its meteoric rise to today’s levels.

The decline in traditional business loans, in my opinion, was the result of two forces, one market and one not. The first was the government’s intervention in small business financing, beginning in the Great Depression through the formation of the Reconstruction Finance Corporation to today’s Small Business Administration. The second was large corporations gaining direct access to the capital markets, issuing short term notes and commercial paper instead of relying on bank financing.

But we as bankers have played a role in the decline of business lending. Banks rely on collateral as a backstop for businesses that can no longer service their loans. Real estate has been a very reliable source of collateral. But the trend away from business lending will continue to lead to increased government intervention in free markets.

According to the Bureau of Labor Statistics, service providing businesses are projected to grow from 73% of the labor market in 1998 to 79% in 2018 (see link below). Many if not most of these businesses don’t own the buildings where they operate. If a bank requires real estate as collateral, we may find ourselves unable to finance a growing economy. The government will increase its participation, picking winners and losers, and free markets will suffer.

Perhaps government intervention in private enterprise financing is deemed desirable, or at least not harmful, by readers. But Peter Leeson of George Mason University’s Mercatus Center disagrees. In his recent white paper “Two Cheers for Capitalism?” (see link below), he states “although many relationships in the social sector are unclear, capitalism’s relationship to development isn’t one of them. Unless one is ashamed of unprecedented increases in income, rising life expectancy, greater education, and more political freedom, there’s no reason to be a milquetoast defender of capitalism.”

Community banks have struggled to separate themselves from large financial institutions. We say we are closer to our communities than the big fat cat bankers. But we shy away from creative ways to finance entrepreneurial growth within those communities, and diversifying the risk that comes with such lending. We opt instead to finance the buildings, but not the businesses contained within them. These are the businesses that will fuel our nation’s growth, and we as an industry have to decide if we want to be a part of it, or cede that role to our burgeoning Uncle Sam.  - Jeff

Bureau of Labor Statistics employment projections by industry:
http://tinyurl.com/y9jeoqw

American Banker Viewpoint by Alex J. Pollack (note: requires American Banker subscription)
http://tinyurl.com/ybxl4h7

Two Cheers for Capitalism? Whitepaper by Peter Leeson
http://mercatus.org/publication/two-cheers-capitalism