2010 Outlook

The last quarter of 2009 has been a loss quarter form the banking industry, as, I anticipate, the entire year. The fall Forum season was the bleakest in memory. CEOs who were cautiously optimistic in the spring revised their outlook and are hunkering down for another difficult year. Despite spotty encouraging economic news, I agree with the general sentiment – with some notable exceptions.

Earnings. 4Q2009 expected to show yet another earnings decline for our industry (some say down 12% y-O-y). Next year will continue to be a very difficult year as no relief to earnings pressure appears on the horizon: margins will not improve greatly, credit remains under intense pressure and consumer fee income, a past earnings savior, is being regulated into submission.

Credit. Losses will follow as non-performing assets continue to rise (from 3.2% to 3.6% in 4Q09). Many predict a Commercial real Estate melt-down, and others anticipate consumer credit defaults. I agree that both are likely to occur, which means that banks with significant CRE and/or consumer exposure will be hurting in 2010. Further, banks with deferred tax assets might also face capital issues as valuations get rewritten. Last, major owners of Trust Preferred securities could face even deeper write-downs.

Keefe, Bruyette has developed the New Misery Index, consisting of unemployment plus households in distress (as opposed to the old Misery Index, consisting of unemployment plus inflation). The new index reflects the record (and growing) number of consumers who will remain under significant financial stress in 2010. While it does appear that the worst in provisioning expense is behind us, I don't expect a V-like recovery on the credit side.

Consequently, the banks that have faced their issues early on, cleaned up their balance sheets, shored up their capital and have strong acquisition and management skills are well positioned to capitalize upon the opportunities 2010 will present. Conversely, the banks who are still knee-deep in CRE and other assets that are likely to deteriorate, and especially those whose credit woes are coupled within thinning capital, will find 2010 to be a difficult, if not terminal, year. These, and other banks with credit exposure, will continue to focus on asset quality and strengthening their balance sheets in 2010.

Margin. The margin expansion we witnessed in recent months is likely to decelerate as funding costs reach their nadir. Some opportunities for further margin expansion certainly exist, but the expansion we witnessed in the past two quarters is unlikely to repeat itself. Further, prudent loan pricing, which today includes floors, implies a lag to higher margins as rates do rise.

Fee income will continue to be a challenge, and will vary widely, depending upon each bank's lines of business. Mortgage banking has been a boon to many in 2009, but the markets have not fully recovered. Wealth management should enjoy a better year in 2010 as well. However, those positives can be dwarfed by declines in NSF fee income and other consumer-related fees under attack by the regulators and the administration.

Expenses will continue to rise, despite major expense control measures many banks are taking, as workout costs and non-performing costs continue to climb.

Shrinkage. Banks' balance sheets will continue to shrink as some reduce footings in an effort to improve capital ratios, and others see certain loan portfolios (construction, for example) continue to contract. Overall, loan demand is weak, and the securities markets might not offer sufficient investment sufficient for banks to which still seek growth.

On top of adverse market trends, the regulators will continue to expect 8% and 12% capital levels, and are likely to formalize this requirement in 2010, thereby increasing pressure on thinly capitalized banks and those who have significant credit exposure. While capital markets are still open, the price of raising capital has been increasing in the last quarter of 2009, and could become prohibitive, if not altogether unavailable, to distressed banks. Overall, the cost of regulation and compliance will increase with growing consumer protection regulations and other regulatory burdens, which are likely to push another tier of banks who are teetering on the edge into failure.

This coming year will see a more clear delineation of winners and losers across all bank sizes. By year-end 2010, I believe we will witness a group of mid and small cap banks who emerged as clear winners and who are even better positioned to take advantage of opportunities in 2010 and beyond.

The coming year will bring several positive opportunities:

· The capital markets for mid and small cap banks have opened wide in 2009. A staggering $140B was raised by the large banks, and smaller banks have followed. While some anticipate tightening capital markets in 2010 (I’m one of those), and others expect even a full dry-out, I believe that mid and small cap banks with strong management and a clear strategy will find capital availability in 2010 as well. It is those banks that have FDIC assisted acquisition opportunities, and who have come to grips with their credit woes early, that will be able to raise even more capital, albeit at dear prices. Investors have been more selective in 4Q, which means that weaker players will have to pay dearly for new capital, or possibly not be able to raise it altogether.

· Assisted acquisitions will rise. The FDIC ended 2009 with a bang, seizing more banks toward year-end and accelerating the pace of takeovers. FDIC is now fully staffed and its people trained and ready to go. There are 400+ banks with $200B+ of assets that have Texas ratios in excess of 100%. The opportunities for accretive deals in 2010 will be even greater than we’ve witnessed thus far.

At the same time, while all FDIC deals are economically attractive, few of the deals are strategically enhancing. Ultimately, deals that offer franchise value creation will be the ones that will gain the greatest capital markets support and will produce the greatest long term benefit.

· Re-intermediation. The disappearance of many segments of the shadow banking system presents opportunities for the traditional banking system. This is true for both loans and core deposits, as non-traditional players on both sides are either gone or severely weakened. Longer-term credit is all but gone, which will create opportunities for banks which can handle the interest rate risk associated with the credit. Plus, the non-traditional deposit markets have receded greatly, helping deposit markets nationwide to rationalize some, even in Chicagoland.

· Market share is there for the taking, as credit-embattled banks continue their inward focus and market retreats. Stronger banks, and those banks who have previously successfully invested in their brand identity, are positioned to take share from their brethren who have not done so.

Next year’s profitability trends will remain unclear until certain credit markets, most notably real estate and consumer, trough and rebound. At the same time, winners will emerge across all asset sizes, and once-in-a-lifetime opportunities continue to blossom for those who are capable of seizing them.