Sidhu’s View

Jay Sidhu knows a thing or two about building a banking franchise during a crisis. In 1989, at the peak of the savings-and-loan debacle, the Indian émigré took the helm of a struggling $400 million thrift in Wyomissing, Pennsylvania, and-largely by dint of some 30 acquisitions-transformed it into $80 billion Sovereign Bancorp.

Along the way, Sidhu, who resigned as Sovereign’s chairman and CEO in 2006, displayed a knack for ruffling feathers. Some critics viewed him as a serial acquirer. Others thought he was too combative with investors, who never assigned Sovereign the valuations Sidhu thought it deserved.

A rough patch in performance led to a nasty confrontation and resulted in Sovereign giving two board seats to activist shareholder Ralph Whitworth’s Relational Investors and a 24.9% stake in the company to Spain’s Grupo Santander-decisions Sidhu now says were mistakes. In 2008, Santander took control of Sovereign, buying the other three-quarters for just $1.9 billion, or $3.81 per share.

Despite the noise, Sidhu’s acquiring ways generally paid off for shareholders. One dollar invested in Sovereign stock in 1991 was worth $30 by the end of 2006, according to figures supplied by his firm. In contrast, the S&P 500 rose fourfold over that same time.

Under pressure, Sidhu left in October 2006, and spent a year caring for a brother with leukemia while plotting his next move from a second home in Florida. Now, he’s back, seeking to put the lessons learned during the last crisis to work in this one with two funds-Sidhu Capital Partners, a private-equity play, and Sidhu Special Purpose Acquisition Co., which is registered with the Securities and Exchange Commission-established to acquire banks.

The industry’s tough times, he argues, present a once-in-a-generation opportunity for smart buyers who can bring capital and management expertise to the table. “The state of the industry today is acquire and grow, or get out,” he says. Even so, caution is required. Sidhu agreed in August to invest $30 million for a controlling stake in $640 million Federal Trust Corp., a struggling Sanford, Florida lender, only to back away a month later.

Always outspoken, Sidhu, 57, has plenty of opinions about the fate of his former institution and today’s Darwinian times. Too many bank boards and managements have dropped the ball in monitoring “critical success factors,” such as asset quality and capital strength, he argues. The government’s administration of the Troubled Asset Relief Program has come under heavy criticism, but Sidhu says it makes sense. Even so, he adds, don’t expect things to get better in 2009: A recession promises to make this year more difficult than the last, testing the mettle of bank boards everywhere.

Sidhu recently talked with Bank Director about what he’s been doing and what he thinks the future holds in store for the industry. The following is a transcript of that conversation.

You have launched two funds. What are they about?

They have two separate names, but it’s really one fund. Today, we have commitments for somewhere between $250 million to $500 million from an anchor investor who has committed to putting 24.9% into it, and several family offices. But you know, it’s been a very difficult market recently for fundraising.

The funds won’t just focus on capital, but also on what our team can bring to the table in terms of management and execution of strategy, as partners with a visionary board. We learned from Washington Mutual and National City that capital alone doesn’t always cut it. But we’re flexible. If there’s a great management team in place, we can simply provide the capital and advise them.

What types of banks are you targeting?

We’re looking for institutions that can grow and deliver at least 25% average annual returns over the next five years, with everything we can provide. That means [we’re looking for] banks in growing markets with good demographics that have an infrastructure in place to take advantage of opportunities. Generally speaking, they will be $500 million in assets or more in size, and in the Mid-Atlantic, Southeast, or Southwest.

Is this a good time to be buying banks?

The next 12 to 36 months will present unprecedented opportunities to acquire banks-either with assistance from the [Federal Deposit Insurance Corp.] or by acquiring them at close to tangible book value-and build market share.

The market might not reward you for deals in 2009. Investors will say, ‘My God, these guys are taking on integration and credit risk.’ But if they’re done well, the deals that are struck today will look very good three years down the road.

This is the kind of environment that separates the men from the boys. The deals struck now will lay the foundation for successful banks over the next five or 10 years. So if you’re on a board that is presented with the right long-term opportunity, you need to worry more about what happens to your stock price 30 months from now, and not so much about what happens in 30 days.

Let’s talk about the credit crisis. What’s your overall assessment of what’s gone wrong?

I’ve always lived by five critical success factors for running a bank: First, you need a strategy that always seeks to maintain superior asset quality. Second, you should maintain low interest rate risk. It shouldn’t matter if the yield curve is flat or steep, and you want to control funding costs by not relying too much on brokered or high-yielding deposits.

Third, you must have positive operating leverage, which means that your revenues must grow faster than expenses. No. 4 is that you must have a big enough capital cushion to align with the risks that you’re taking. Risk-adjusted capital is very critical. You need that cushion. And the last item is management. You need a culture that thrives on execution, and that requires good management. These are essentially the five components in the regulators’ CAMEL ratings.

So what went wrong? Some of these institutions didn’t have good risk management systems or sales or service cultures, or they didn’t build a strong enough core deposit franchise. But the biggest problems have been asset quality and capital, and as a result, a lack of positive operating leverage.

It’s very simple stuff, but many bank boards don’t get it. If expenses are going to go up 5%, but management is telling you they can’t grow loans or revenues, then you’d better do something fast, or guess what? Twelve months from now you’re going to be in worse shape, because you’ll have lost more money.

What should a smart board be doing?

I’d try to figure out how a recession and other external factors will impact the institution by asking management to provide a review of where the institution stands on the basis of those five critical success factors we discussed. If you focus on more than five or six things, chances are, everything will be done in a mediocre way.

Don’t most boards perform those kinds of reviews?

Most board members go through the motions. They’ll order a review, but will say, ‘We don’t really want to change anything or hear something that will make us change. So, don’t bring us any bad news.’ A lot of boards feel that way.

At a time like this, you must take your responsibilities very seriously and assess things in a very authentic, realistic manner. Do it today-immediately. And through that process, evaluate very honestly where the bank stands and whether or not you have the right management team-and board-in place. As a director, you need to hold yourself to the same standards that management is being held to.

Don’t be complacent about changing the leadership, because in the end, there’s no substitute for good management. You can have a very responsible board, but if the management is mediocre, it will lead to mediocre results.

And if you’re happy with management, then focus on helping them succeed. If they need more capital, get it sooner rather than later. If the credit standards need to change, change them today rather than after you’ve been whacked on the side of the head. Deal with your issues upfront. If you determine you can’t overcome them and grow, then maybe you need to sell and get out of the business.

We hear stories about boards that are getting burned out by all the bad news. What do you see?

A lot of board members are tired and desperate. They’ve had it and just want out-they’re saying, ‘The hell with it!’

If you’re tired, then you should get out. You’ve got to work hard and earn your success, and not stick your head in the sand. The way I think of it, tough times don’t last; tough people do.

Bankers have come under pressure to use their capital to lend, but with the environment so uncertain, can they be blamed for being tight-fisted?

The issue is about banks needing to lend to creditworthy customers.

I was with a group of nine CEOs this morning and I was the only banker in the room. Most of them are running healthy, decent companies, and all were concerned that their bankers are only looking at the absolute dark side of everything.

You need to understand your clients’ financial situations and help them succeed. That is the role of the banker, and that’s what the government is saying: ‘Help your clients succeed.’

This brings up a bigger point. If you don’t look at things from the customer’s point of view, it will get you in trouble. How did some banks stay out of subprime lending? Because they looked at it from a customer’s point of view and asked, ‘Will these guys succeed?’ rather than saying, ‘Let’s just give them the loan.’ The first question regarding a loan should always be, ‘What can go wrong?’ And the second should be, ‘Are we helping our customers succeed?’ After that, you can do the financial analysis to assess the risks.

Some people say the creation of new megabanks, with their national branch and ATM networks, will hasten the demise of the community bank model. What do you think?

If a community bank doesn’t look at the changing environment and wants to build based on the way things have been done over the last 10 years, there’s no future there. So you’ve got to remake yourself and pay close attention to the external environment.

If I were running a community bank, I would be emphasizing where these megabanks are making their decisions-outside of the community-and build the capabilities to compete with them. Yes, they have a lot of ATMs, for instance. But I could get into a national ATM network and have the same kind of reach they have. And why can’t I go to customers’ homes to open accounts and sell products? Why can’t I sell insurance for customers’ homes, or merge a life insurance distribution model with a banking model in a way the large banks can’t think about duplicating? Consumers and small businesses have driven the American economy, and community banks are really the best positioned to serve those customers.

The key to success is execution, and good community banks have the agility that is critical to superior execution. I ran a $500 million bank and I ran a $90 billion bank. I am telling you, it is so much easier and better to run a $500 million bank. With a $90 billion bank, it can take years to make change. Half the people misunderstand when you try to communicate the strategy, and it’s very difficult to steer that giant ship even if they do understand.

What are the implications for the M&A market in 2009?

The stresses on the banks will continue to be very high. Credit quality will become an even bigger factor. That means in 2009, we’ll see the government forcing more desperation deals, and we’ll see a limited number of deals done by strong institutions that feel confident and can foresee what is coming next.

Overall, I think the big banks are done for now in terms of M&A growth, unless it’s a desperation deal. Wells Fargo might have had interest in a $2 billion company before the Wachovia deal, but now its targets will be $10 billion companies. Transactions will need to be that big to move the needle.

That’s going to open a window of opportunity for good, solid community banks that have capital. They should be able to do FDIC-assisted deals and acquire other unhealthy companies at very attractive prices to gain market share and position themselves for the next 10 years.

How does the injection of all this government capital into the industry impact the M&A market?

In the short-term, it allows some of these struggling banks to think they might survive. That will put a damper on the market. But that capital could get eaten up very quickly in a bad economic environment, which means there’s a very good chance that six months from now, banks that aren’t paying attention to those five critical success factors will wipe out their government money. They’ll be in worse shape and get swallowed up on the cheap.

So how does the M&A market play out?

In 2009, it will be mostly desperation deals. In 2010, asset quality will begin to improve and we’ll see signs of a better economy. Valuations of good banks-those that find a way to grow revenues and not get destroyed by asset-quality issues in 2009-will improve dramatically. Weaker banks’ valuations will get better, too, but not as much. A combination of clarity and greater valuation differences between the good and weaker banks will help drive activity.

How does a good buyer go about assessing a potential acquisition in this environment?

It’s very difficult to buy anything on the basis of earnings today, because you don’t know if they’re sustainable. So you need to look at real tangible book value, longer term franchise enhancement opportunities, and the value of core deposits. At a time when liquidity is so important, you want the highest percentage of non-CD deposits-DDAs, savings, and money markets. Jumbo CDs aren’t very attractive, and brokered CDs get zero value.

And then you have to put a real value on the loan and investment portfolio. Due diligence becomes absolutely critical, and if you don’t feel that you’ve been able to wrap your arms around the loan portfolio by the end of the process, then it’s better to simply walk away.

You have to be patient. But these are the kind of times that provide the best opportunities for competent management teams.

What do you see happening in terms of sellers’ pricing expectations?

Sellers’ expectations are still too high, because they are not recognizing that the market’s valuations are much lower today.

Today, 700 banks are trading below tangible book, and if you’re trading at or above tangible book, you’re considered by the equity markets to be healthy. The number of sellers is rising, so it’s a buyer’s market. That means if you’re expecting to get 2.5 times book in a sale, you’re going to be sitting alone like a pretty girl who can’t get a date.

Think about it this way: Valuations are depressed for the entire industry, so if you get offered a 125% premium from a buyer that has good management and execution abilities and is trading at tangible book, you can ride the market with them. You might get 2.5 times book three years from now, but by that time, the buyer might be trading at 3 times book, so it could be worse.

If you were on the board of a potential seller, what sort of questions would you ask about a likely deal?

First, I’d consider my options. If you believe you have the earnings power to raise the franchise’s value in a better environment, then it might be best to hunker down, watch the credit side closely, cut expenses, and build core deposits. Ride out the storm if you can.

If you decide to sell, the preference today should be to take cash, because it’s more certain. We’re probably going to be seeing capital gains tax increases from the new Congress and administration. So evaluate how much of the sale price is actually going to come into your pocket.

If you can’t get cash, then you’ve really got to think about the buyer’s currency. Examine the asset quality and evaluate management as you would your own, because execution will become very critical. And assess the strength of their deposits and future growth prospects.

In a normal environment, you can see a track record of earnings and feel comfortable knowing you can always sell the stock you get in a deal. Today, no one knows what is happening. But owning 20% of a good bank could be better than owning 100% of a lousy one.

I know you’re not directly involved in Sovereign any more, but you’ve remained a shareholder. Were you happy with the sale to Santander?

As a shareholder, I was disappointed with the deal. After I left, they went after yield and forgot asset quality. They put on $6.5 billion of auto loans from all over the country, and bought or held onto $600 million in preferred stock of Fannie Mae and Freddie Mac, thinking the environment hadn’t changed.

They didn’t pay attention to positive operating leverage. Rather than focusing on revenue growth, the board and management prided themselves on layoffs and cost reductions. That’s a recipe for disaster.

And when the environment turned against them, they panicked. They were all smart people. They all meant well. But they announced the deal the night before the TARP was announced. That’s silly. They could have gotten capital. Instead, Santander paid $1.9 billion, and now its management is telling the world it will make $750 million off of it within two years. That values the deal at about two times earnings. Have you ever heard of anything like that?

In the end they failed to recognize the value they had, and in my opinion, cut a deal without fully analyzing it. It’s crazy how much shareholder value was destroyed.

You had a conflict with an activist investor group led by Relational Investors and gave them two board seats. What did you learn about dealing with activists?

In retrospect, we made a bad decision. You need to have strategic alignment between the board and management and focus on the longer-term horizon, not quarter to quarter. Sometimes you need to make decisions that, even though they might hurt stock price in the short term, are very good in the long term.

Sovereign’s strategy changed drastically [with Relational on the board]. They said M&A growth wasn’t an option, and what happened? TD BankNorth took advantage of all the opportunities in Sovereign’s market area over the last two years. Today, TD BankNorth is on every street corner and is doing well. PNC also took advantage.

And then it made some really bad moves. In 2005, Sovereign acquired Independence Bancorp, which had expertise in multifamily lending in rent control districts of New York. The asset quality was good, but it was at a lower rate, so Sovereign sold those loans and made car loans instead to chase yield. It was a very bad decision.

What do you see happening to the industry in 2009?

In my opinion, the chances are greater than 80% that things will be much tougher in 2009 than they were in 2008. The impact of a recession on banks traditionally lags; it continues on after the recovery has started.

And the problem is that many bank boards have yet to accept the fact that their balance sheets will be even more challenged this year, as even more severe credit problems emerge. So I think 2009 is going to be rough.

Three to five years from now, how do you believe we will assess this period?

We will look back at 2008 and 2009 and say, ‘Those were tough years, but they were also the years that presented the greatest opportunities.’ The industry will be much stronger. We’ll have better risk management, better capital. And the winners in 2012 will be the banks that make the right decisions today.