A Tale of Two SIFIs

The Best of Managements,

The Worst of Managements

My apologies; neither of the banks I am about to discuss was ever large enough to be considered a SIFI (Systemically Important Financial Institution.)   I simply could not resist that title.

Often you’ll hear some especially specious reasoning from uber regulation advocates that goes something like this; “Banks need much more capital because if they have only 5% capital and asset prices drop 6%, they’ll be out of business.”  Statements like that are evidence of a profound ignorance of how the industry works.  First of all, loans typically represent only 2/3 of a bank’s balance sheet.  Plus, banks seldom extend in credit more than 90% of the value of any collateral. and usually much less.  At 90%, collateral values need to drop 11% before a loan is impaired.  Plus, banks typically have secondary sources of payment, such as personal guarantees.  Plus, banks have a loan loss reserve to dampen the impact of any losses they do incur.  Plus, any bank losses are deductible, so only 2/3 of any loss hits the P&L.  Plus, banks have earnings, and bank earnings are always under appreciated as a loss absorbing mechanism.

But above and beyond everything else, banks have management.  A really skilled bank management team can negotiate its way past almost any barrier the economy throws in its path. At its core, banking is about good management. And good management means operating efficiency and disciplined credit underwriting.  It is really all that matters.

TriCo Bancshares is a small regional bank with headquarters in Chico, CA.  Its footprint just happens to include California’s Central Valley, one of the the epicenters of the sub prime housing collapse.  In most of Tricos markets, home prices fell by more than 30% from their peak.  Worse, most of the local economies were dominated by home construction, the cessation of which produced massive unemployment. As foreclosures swept through these communities, banks both large and small incurred big losses.  Some smaller banks failed.

Trico did not seem well positioned to survive this conflagration.  At the close of 2006, it had $1.9 billion in assets and $1.5 billion in loans.  Of these loans, $150 million were construction-related and $500 million were consumer — largely home equity lines of credit.  This, against $169 million in equity.  Over the ensuing five years, Trico wrote off $87 million (7% of 2006 loans), including 10% of the higher risk categories.  (Its $500 million first mortgage portfolio produced minimal charge-offs.) Yet the bank never suffered a loss, much less had its solvency tested.

What was Trico’s secret?  Not excess capital.  Trico had two secrets; disciplined underwriting and strong core profitability.  In other words, good management.  In the five years we are discussing, Trico generated earnings before taxes and provisions of $239 million.   In just about the country’s worst market, Trico could have written off nearly three times what it did and still not have compromised its equity.

With its monomaniacal focus on capital adequacy, the current regulatory regime studiously ignores both the importance of bank earnings as the first line of defense against loan losses and the importance of cultivating top-notch management to produce those earnings.  In fact, it sometimes seems that regulators are intentionally doing what they can to drive down bank profitability and discourage the most talented managements.

In case you think I’m exaggerating, consider the following quote from an economist representing the “Basel” viewpoint at a Nov. 17,2015 Brookings Institution conference.   “The whole point … is to drive ROE’s down into the realm where you have safer institutions.”  Jaw-dropping stuff.

Now let’s shift our gaze from the sacred to the profane.

Corus Bank was a mid sized regional bank based in Chicago.  In the 90’s it had changed its name from River Forest Bancorp.  Famously conservative, River Forest went many years without taking a loan loss provision.  When queried about this, the then CEO observed, “We’re not in the business of making bad loans.”

But in the late 90’s Corus hit some serious turbulence in an attempt to aggressively grow its student loan business.  Problems were not debilitating, but this was a bank that should have been very much on the regulator’s radar screens.

So one would have thought that the regulators might have paid attention when Corus’ management in the early 2000’s decided to pursue a brand new strategy; making huge construction loans — mostly condominium loans — in Los Angeles, Chicago, and Miami.

For bank analysts, there are three traditional indicators that portend future loan problems: 1) extending new credit so the borrower has the cash to stay current on interest payments (often referred to as “extend and pretend.”.  Construction loans do this almost by definition.) 2) lending into unfamiliar markets and 3) very rapid loan growth.

Corus’ condo construction portfolio tripled in 2003.  It nearly doubled in 2004. It more than doubled in 2005, and increased 36% in 2006.  All told, in those five years, these credits increased from $123 million in 2002 to $2.6 billion in 2006.   True to its strategy, half of these loans were domiciled either in Florida or LA.  Ninety-nine percent of the company’s $4 billion loan book was some kind of commercial real estate.  Corus failed in 2010.

One can’t fairly blame Corus’ problems on regulators. Management concocted the strategy, management made the loans, and, for the year or two in which the strategy seemed to be working, management reaped the rewards. Yet still, in light of the bank’s prior record, one has to wonder, “Why didn’t the regulators stop them?’’

There’s a simple answer and the answer is. . . . .  Corus had too much capital.

In 2002 Corus was by far the best capitalized bank of its size in the country. We’ve talked a little bit about capital ratios.  Corus set a new standard.  In 2002, its tangible equity ratio was 17% — more than twice the bank average.  However, if one excludes from assets $725 million in “Fed Funds Sold” (i.e. cash),  the tangible ratio rises to 23%.  To many observers, this magnitude of squandered capital by itself raised questions about management competence.  But the regulators, awed by Corus’ capital base, pretty much allowed the bank to do whatever it chose.  Once they caught on, it was far too late.

To digress a bit, the Corus saga does not end here.  Corus was shut down in 2010 and its deposits assumed by the Bank of Montreal.  Most of its assets were bought at fire sale prices from the FDIC by a group led by Barry Sternlicht, CEO of Starwood.  Within three years, the value of these assets had rebounded to Corus’ carrying value and beyond. In other words, if regulators had waited just three years, Corus would not have been insolvent.  At the time of Corus’ failure, Miami had something like 23 years of condominium supply. But have you been there recently? Not only are all of those condos full, but there is much new construction.  I wouldn’t second guess the FDIC about shutting down Corus but it’s clear in retrospect that blowing out its assets at the bottom cost the agency dearly.

This happens every cycle. Bank losses in the ’80’s Texas collapse resulted predominately from real estate.  Once back then when I was in Dallas, I visited an expansive development outside the city that had been a total write-off for several banks.  It had a lavish office and retail center – empty – and hundreds of unoccupied new homes dotting hundreds of acres.  At the time, it seemed like a post-apocalyptic landscape; there were literally tumbleweeds blowing down the streets.

The name of that development was Las Colinas. If you visit Las Colinas today — or if you had visited even five years after I did — you would find one of the most vibrant micro economies in the country. Every office is full, every home is occupied, and the project has been greatly expanded.

Regulators must stop the practice of dumping the assets of troubled banks in a crisis. Doing this is totally counter productive. Not only does it transfer wealth from the FDIC (ultimately backed by taxpayers) to private investors, but it drives down the prices of these assets when things are worst, exacerbating the very problems the FDIC is trying to resolve.  This is especially the case now, under a mark to market accounting regime.  The FDIC should be given the capacity to manage a problem bank without dumping the assets into a weak market.  Or, at least, it should be allowed to hold on to the assets and hire private enterprises to manage them.  One thing’s for sure; if Barry Sternlicht is the bidder, that’s a bid I don’t want to hit.

To conclude.  I believe that there is no regulatory goal more important than to provide incentives that encourage the best people to enter the industry and employ the best practices once they get there.  Preventing banks from earning money, and regarding bank managements as incompetent at best and incipient criminals at worst is no way to accomplish this objective.

 

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