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BirdsEye View

Today's article is yet another example of how I continue to put my foot in my mouth. Below is my first "take" on 2008. Given current market turmoil this certainly isn't a wise thing to do, but that never stopped me before... Thanks in advance for setting me straight with your own perspective on what lies ahead!

Also, thanks to Sandler, O'Neill for their input to this article.

2008 Outlook - The First Stab

The last few weeks have been difficult ones for banks. Our stocks have been hammered, our credit quality is deteriorating rapidly, and shareholders are getting nervous. The current picture looks anything but rosy: housing, a major factor in the economy (responsible for 33% of new jobs; 50% of US GDP is tied to housing) and in many bank earnings, in sputtering; new construction is down significantly (unsold inventory of homes is the highest since 1993). Further, the asset quality melt-down we have been predicting is well underway; non-current loans have risen in each of the last three quarters, and reserves, provisions and write-offs are soon to follow. Growth prospects aren't too promising either: during the twelve months ended March 31, 2007, assets of FDIC insured institutions grew by 6/9%, the slowest 12 months growth rate in 4.5 years.

Market performance trends have been mixed to negative. 52% of the largest 50 banks and thrifts have seen reduced estimates for 2007 EPS, and 68% of the same universe are trading at less than 90% of their 52 week high.

Other elements in the quiver of the bears: our economy is overdue for a downturn, having experienced 16 consecutive years of consumer expansion and unprecedented residential mortgage volume and price appreciation. The yield curve is still flat, and robust loan demand continues to put pressure on liquidity. Is it time to call it a day and sell to the highest bidder? My outlook says, pressures are mounting, but opportunities are ever-present.

1. Margin Management

   Margin pressures will persist for many banks throughout 2008, mainly due to stiff pricing competition. At the same time, the yield curve is showing signs of curving, which might bring about limited relief in 2008. Trends are still unclear, and depend greatly on the heat of the economy, inflation fears and the perceived "credit crunch". Additional pressure is put on the margin by the on-going shrinkage of non-interest bearing accounts as a percent of total deposits, down from 55% in 1960 to 10% in 2006. Margin won't experience relief from additional deployment of liquidity, since industry-wide loan-to-deposit ratios have climbed from 52% in 1960 to 89% in 2006. Further negative impetus is caused by the shift in deposit mix away from DDAs and into CDs, a trend that was most pronounced in 2007.

   At the same time, one must note that there is a wide range of bank responses to this uncertain rate environment, from heavy margin compression to great expansion. Further, pricing rationalization is evident in small pockets, and might expand as some players exit markets and others realize that irrational pricing cannot be justified over the long haul. Overall, compression is expected to continue through the first half of 2008, but it is not inevitable: effective DDA and deposit strategy development and execution at the individual bank level might shift the picture significantly for any bank.

2. The credit crunch?

   A credit crunch might still come in 2008, but the rumors of its presence are greatly exaggerated. Loan growth is robust in most parts of the country, including those with modest economic growth and even areas where banks are experiencing asset quality weakness. C&I loans are growing at a brisk 11% in some markets, and even construction loans are holding up surprisingly well. Certain credit markets are under pressure, particularly housing-related, for both commercial and retail customers (e.g. contractors; Alt A mortgages). That situation has been exacerbated by the almost instant drying up of the secondary markets for certain credit products such as sub-prime retail product and some home equity loans, causing both alarm and a perception (in some cases, a reality) of a crunch.

   If there is a credit crunch in certain credit markets, it is a good thing. We have compromised too long on terms and covenants and on basic pricing, and, as an industry, have not been fairly compensated for the risk we take in certain loans. A correction, a shakeup if you will, could improve overall industry health in 2008 and result in better pricing as we work out our credit problems next year.

   As always, being a contrarian in this market presents opportunities to snag bargains and establish a foothold at a time of weakness.

3. The deposit story: the next chapter

   Deposit balances are growing, albeit at a slower pace than loans. Competition is still intense but growth is comfortable in many markets. Consumers are willing to invest in CDs, a 2007 phenomenon, and might be willing to lengthen maturities further in 2008 depending upon the yield curve movements. The greatest issue on the deposit front is the precipitous decline of interest-free transaction accounts. This shift is occurring at almost all banks. Even DDA-rich banks are experiencing declines from stratospheric DDA levels (say, 40%) to lower levels (say, 35%), which, while great by any standard, are still below their traditional highs. Banks continue to address the problem by offering high-yield deposit accounts through all channels, with special attention to the internet, thereby averting liquidity issues but prolonging margin problems. Addressing the DDA issue in 2008 is a first order of business for any bank and industry-wide, since its impact on profitability and other key ratios is so profound.

4. Credit is finally getting worse

   The long-predicted credit deterioration has started; liberalized terms, covenants and razor-thin pricing have come home to roost and will get worse in 2008 as foreclosures start working their way through the system. Also, given the liberal terms many borrowers enjoyed, they will enter non-accrual much later in the cycle than in past cycles, which means that the magnitude of credit problems has been understated in 2008 and will be fully revealed in 2008.

   Some sectors, particularly real-estate related, have been hit hard in some parts of the country. The housing inventory also will not fully reflect the sub-prime impact until foreclosures run their course throughout 2008. In the meantime, real estate development has halted in many markets. Builders are sitting on unimproved land and waiting for the storm to pass and the market to turn. Some are strong enough to get through it; others won't be able to weather the storm to its conclusion.

   This is a good time to encourage and enliven an "early warning" culture among lenders and relationship managers, to ensure that problems are spotted early and worked out while the borrower still has assets that can be salvaged.

5. The payment opportunity - still underutilized and growing

   Payments continue to grow, and astute players are making early moves to capture an even greater share of the market. Capital One has decoupled the debit card from its originating bank such that their own rewards program might win the war over the customers' loyalty to Plastic. The opportunity for banks is still large, growing and non-capital intensive. Debit and credit card acquisition, building and activation are significant opportunities, but the window will close as major players trump SuperCommunity Banks' hands with unbeatable offers and technology.

   Similarly, remote capture is still on a steep growth trajectory, but the opportunity window is beginning to close as players start offering limited time fee waivers, and others lead the way to retail remote capture (check out USAA's usage of any scanner to allow consumers to deposit checks through these devices; they are reportedly acquiring upward of 100,000 customers a month using this technique).

   The Payments Business will ultimately call for out-of-the-box thinking, but the fruit on the ground (not even the low hanging fruit) is plentiful and available.

6. The acquisition business - hot and heavy

   The acquisition market started heating up in 2007, despite depressed bank valuations, for banks of all sizes. The persistently flat yield curve and high regulatory compliance costs drove banks at all levels to seek mergers, and the larger banks are capitalizing upon their buying power to pick off franchises. Pricing is getting better, and will improve even further in 2008 among credit-pressed banks, but it is still not rational, especially in growth market.

   An important trend in 2008 is the major role mega banks will play in the acquisition market. Their performance is measurably better than smaller banks, given the major strides they made in efficiency gains and revenue source diversification. They have the currency and they are shopping. Aggregators at all levels are following suit, and 2008 will see more of these deals.

   There are more sellers than buyers in the market, and many "busted" deals and failed auctions that are not publicized.

   The sense of urgency on deal closing will also increase, as unpleasant surprises in the credit and secondary markets might cause deal terms to be broken through, so timeliness will become more relevant going forward.

   Competition for deals will intensify in 2008 as de novos slow down, bank growth decelerates and deposit premiums continue to break 30%.

7. What's on the regulators' mind?

   Credit will be a key word in 2008 on the regulatory calendar, as further credit deterioration seeps through the system. This, coupled with greater fraud risk for both commercial and retail customers, will give the regulators plenty to worry about. While BSA never goes off the map, including civil money penalties, 2008 will be the year of credit quality for the examiners, possibly to be followed by renewed attention to liquidity, given the anticipated credit issues.

8. Industry trends and the street

   Consider the following facts:

   • Efficiency ratio of banks with assets less than $1B has hovered around 65% since 1992; it is now 56% among banks with assets greater than $1B
   • NIM declined system-wide from 4.41 in 1992 to 3.38 as of March 31, 2007
   • The number of bank charters has dropped during the last 10 years from 10,000 to just under 7,500 (-22.8% CAGR change), but the number of branches has grown from 66,000 to 80,000 (21.9% CAGR change)
   • In 1996 bank ROA did not vary meaningfully among bank sizes (as low as 1.13% for banks with assets under $500M and as high as 1.26% for banks with assets between $5-$10B. In 2006 the picture was dramatically different, with ROA directly related to size, from a low of 0.93% for the under $500M< banks to a high of 1.39% for the $10B+ banks.
   • Banks under $500M and over $10B in assets suffered the greatest loss of margin in the past 10 years (83 and 104 b.p. respectively), with banks with assets between $5-$10B doing the best (53b.p. loss); however, as we know, mega-banks have greater non-margin driven sources of income
   • The industry continues to concentrate, with assets held by the 10 largest banks growing from 30% of the system to 45% of the system in the last ten years, and the top 5 banks are at 35.6% 6/30/07

   These facts paint a clear picture: the industry continues to be profitable, but growth is decelerating (6.9% for the 12 months ending 3/31/07, the slowest in 4.5 years) and larger banks are clearly more profitable than smaller ones. The big banks are doing better than mid- and small cap companies, primarily because of their diversified revenue streams. More banks are having profitability hiccups; median data for 141 community banks show all five major performance measures (margin; efficiency; charge-offs; NPL; provision coverage) weakening 6/30/06-6/30/07.

2008 will be a tough year for banks, but also a year of great opportunity to separate your bank from the pack, show your uniqueness and demonstrate to liquidity-flushed investors why your institution is the right one for them to invest in. Staying the course on prudent C&I lending while improving deposit gathering tactics and making major strides in the payments business can be a winning combination for SuperCommunity Banks, one which the markets will reward.