OUTLOOK - THE SECOND HALF

July and the summer are already upon us, and the year is half over. Some early predictions by industry observers for banks during 2005 did not materialize, while others have been formed during the past six months. Taking stock of where we are and what the second half has in store is challenging but helpful.

1. Margin behavior not uniform across the system. As 2004 drew to a close, many predicted margin pressures will plague the business in 2005. At the same time, every bank I know predicted significant margin expansion since they were asset sensitive. In reality, of course, banks' balance sheets vary greatly. Those that have relied on FHLB advances and whose balance sheets resemble traditional thrifts' balance sheets are suffering the most. Their issues are compounded by the heavy carrying cost of the advances AND the reliance on rate surfers who expect and demand best rates at all times without much loyalty. Consequently, these banks' cost of funds rose faster than those who enjoy stronger core deposit mix, and this burden will continue throughout the year. No relief is in sight, short of major balance sheet restructuring. This entails not only selling the advances at heavy losses to start from a clean slate, like Integra, First Community of NY and many others have done. It also calls for the much more difficult task of shifting the customer base from hot money pursuers to core depositors, an extremely demanding task.

   Those banks which enjoy strong core deposits, however, did benefit from the rising rate environment and saw their margins expand. They continue to make variable rate, Prime or LIBOR based loans, and fund a portion of those by interest free DDAs and low cost money market accounts. Banks such as Frost, Sterling and others, with 35%+ in interest free checking account balances, are delivering margin expansion and will continue to do so.

   On the asset side, we continue to hear about shrinking margins, kamikaze pricing and deteriorating terms. Disciplined banks that have created superior value propositions for the commercial customers are less susceptible to such pressures and continue to do well in this environment.

   Current consensus suggests that continuing Fed tightening will put additional pressure on margins system-wide. This will be particularly impactful on heavy wholesale banks, which typically are the bigger banks. I still feel that banks with strong core deposits will not experience significant additional pressure during the second half of the year, but do recognize that the lag between Fed action and market reaction is two to seven months, which means that there is more pressure to come. The answer, of course, is more interest free DDAs and money market accounts with low interest rates, but those are hard to come buy in pure retail environments.

   In short, we have not seen the monolithic improvement nor deterioration predicted by some. Instead, the banks' individual balance sheet and customer focus have determined which banks are experiencing margin contraction and which are expanding their margins. This trend will continue throughout the year, since change is slow and hard to come by when it comes to balance sheet and business mix restructuring.

2. How much is too much real estate? Real estate lending, both commercial and residential, has been growing as a percentage of total loans in most banks. Concurrently, concerns about a real estate bubble have been growing as well. Bankers are telling me that real estate is where the business is, so their loan balances in various categories are growing rapidly. The analysts are expressing concerns in the face of a growing proportion of commercial real estate loans in banks' portfolios, and are not accepting the market demand reason offered by the bankers.

   First, not all real estate has been created equal. The risk profile of residential real estate varies widely from the lowest risk (standalone, low loan-to-value properties) to the highest (co-ops and spec multi-unit buildings). The same is true for commercial real estate. The debate still rages whether owner-occupied buildings are higher or lower risk than multi-purpose commercial structures. Majority opinion is that owner-occupied real estate is less risky than other types of commercial real estate. I concur, despite the fact that such buildings are typically single purpose, simply because the owner has a strong vested interest in keeping that building, which is often core to their business.

   Painting all commercial real estate with one broad brush is a mistake. Equally wrong is considering all real estate markets equal. Some hot markets, most notably Boston/Framingham, MA and several major markets in California, are high risk due to both rapid price escalation and low affordability (high income/home price ratio). Others, while expensive, are more affordable or experience a more moderate price ascent. Consequently, considering the risk of commercial real estate on a bank's balance sheet isn't an easy task. One has to know where the loans are domiciled, as well as what the foundation of the loan is, before making judgment.

   Another critical factor in all types of lending, including real estate, is the lender him/herself. An experienced lender with a loyal and proven stable of customers is dramatically different from a recent entry lender, which typically ends up being bottom fished by rejects from more knowledgeable banks.

   The growth of commercial real estate is, on the whole, not a negative factor in banks' balance sheet. It represents secured lending, which, by definition, is considered less risky than unsecured lending. However, when the values of the security are hugely inflated, or when the structure of the loan is faulty with little money on the line from the builder, the loans could be quite risky.

   My prediction is that real estate lending will continue to grow, since it is easier to deliver, typically is larger in average size than pure commercial lending, and is in high demand currently. This trend will continue throughout the year, and we should not anticipate sweeping credit problems in this sector yet. Such issues will arise in specific local markets in 2006, and there, early response by the impacted bank, combined with effective workout structures, might mitigate the credit issues that will arise.

3. So many buyers, so few desirable sellers. Foreign buyers continue to gobble up larger and larger banks in the US. Fueled by the need for growth and low returns in their local markets, they funnel capital into the US through their subsidiaries and pay up for size, not necessarily quality. Bulk matters more than ever to such buyers, whose hurdle rates and ROE requirements are significant lower than their domestic brethren. This trend will continue through 2005 and beyond, with larger sub performers getting the benefit through inflated prices that domestic buyers would and could not pay.

   Domestic consolidation will continue at the current relatively slow pace, as sellers see the prices break new records and feel they are worthy of such multiples regardless to size, location or performance. With the easing off of bank stock prices, fewer domestic acquirers are willing to pay the price of such external growth, a trend which has fueled the explosive growth in de novo branching two years ago. However, as that panacea failed to deliver in many cases (with some notable exceptions), the acquisition market is heating up not only for aggregators but also for others who are looking for market fill ins and expansion to better, higher growth markets outside their domicile.

   We will witness a slow down in branch de novos and an acceleration of acquisitions at all levels later this year and in 2006.

4. Talent is available, but is it right for you? There are more talented bankers available today, but the match between their talent and training and each bank's need is getting harder to achieve. For example, a well trained, successful commercial lender from many large banks could not fit into a strong commercial oriented community bank because they often lack the credit skills required to make loans. The typical division between hunters and skinners that the larger banks employ has intensified their bankers' sales skills and also their appetite for larger loans, but decreased their competency in underwriting and structuring, two key talents needed in many community banks, which use those skills to differentiate from the big guys.

   As banks recruit from each other, they should be mindful of the culture from which the recruit came, not only the technical skills on their resume. Poor fit is more often the reason for departure than poor performance, and as banks look for more specialized talent this will become a greater obstacle to successful integration of new recruits into the bank.

   There is more talent available today than two years ago during the extremely high employment rates. Despite the lower pace of acquisitions, on-going efficiency drives and change of business focus make good people available. The challenge is separating the wheat from the chaff.

5. Paying more attention to the business mix: revenue source diversification. The first six months of this year clearly demonstrated the importance of the quality of balance sheets. Becoming more deliberate about your business mix and ideal balance sheet composition is an opportunity available to all, but its importance is highlighted more than usual this year. Carefully considering business lines and their true contribution to the bank's bottom line and revenue source diversification is particularly important today. The process is difficult to unfold and even tougher to implement, but yields huge dividends in terms of optimizing risk-return relationships within the company.

   Analysts who are bemoaning commercial real estate growth are doing so not in a vacuum, but as a reaction to the growing dominance of this form of lending among others. It's a reaction to lack of revenue source diversification. Banks who have done so successfully, such as Wells Fargo among the giants and Wintrust among the SuperCommunity banks, have been rewarded time and time again. Analysts and other industry observers have become more sensitive to identifying revenue sources and their vulnerabilities as margin compression and other concerns have demonstrated the value of such diversification. In addition, more attention is being given to risk-based returns in the wake of Sarbanes-Oxley and the emergence of enterprise risk management. Developing long term plans for revenue diversification without over-extension is one answer to such concerns. It's a long term proposition but a valued one.

   Some banks have dabbled in many different lines of business, with little net impact on the bottom line. My recommendation is to choose the ones that give you the most leverage of existing competencies, and build on those. Select only a few expansion opportunities, since they do sap management's energy and require focus and commitment. Over-extension is a mistake many make, since they are weary of putting all the eggs on one basket, plus they know that some of the new initiatives will fail. But start-ups being as demanding as they are consume more time than is contemplated in most cases, and if they are too small and inconsequential they will not get the attention they need to flourish and grow their legs. This is one case when less is more.

This year was predicted to be an unexciting year for banks. This is true for bank stocks, and all sticks, in general, but not so when it comes to performance. The industry continues to deliver strong quality earnings, and the top performers have done well during the first half of 2005. Interestingly, insurmountable difficulties such as regulatory pressures, SOX, Bank Secrecy Act and others, have been absorbed into the current operating environment of most banks and are no longer at the forefront of issues. The challenge to all for the remainder of the year is to continue delivering strong performance while sowing the seeds for strong balance sheets and revenue source diversification in the future.