Hung Up On Asset Quality

It’s starting to look like the great wave of bank consolidation many predicted is going to be more of a steady ripple, unless buyers and sellers can reconcile sharply divergent views about pricing expectations and asset quality concerns. This is according to the 2013 Bank Director & Crowe Horwath LLP M&A survey, which finds that potential buyers have slightly increased this year-especially those in the market for healthy banks-while few bankers seem poised to sell. And who can blame them? Bankers who have made it through the last four years without selling, or being forced to sell, likely are in no mood to settle for the low prices currently on offer.

According to the survey, which was completed by 224 CEOs, senior officers and directors in October of 2012, 57 percent of the respondents hope to make some form of acquisition this year, up from 52 percent last year. Of those, 46 percent would like to buy a healthy bank, 21 percent are interested in branches and 17 percent seek to buy a failed bank. Last year, there was less interest in healthy banks, at 37 percent, but more interest in branches and Federal Deposit Insurance Corp. assisted transactions-at 27 percent and 24 percent, respectively.

For potential buyers, the top three reasons for making an acquisition did not change this year, with 63 percent of respondents wanting to supplement organic growth, 60 percent looking to increase market share and 41 percent trying to rationalize the cost of regulation over a wider base.

Still, while the number of respondents interested in buying a healthy bank has jumped almost 10 percent since last year, 43 percent of respondents have no plans to make an acquisition in 2013. Robert Hulsey, president and chief executive officer (CEO) of American National Bank of Texas, a $2.1-billion asset institution in Terrel, says he has cooled on acquisitions since American National purchased a bank in 2007 and another in 2008. Hulsey says he needs time to absorb those deals, but it’s also unclear to him what the value of an acquisition would be right now.

“It used to be you were looking for core deposits,” says Hulsey. “Everybody’s so liquid right now that deposits are not what you need. You need good earning assets, and in acquisitions it’s really tough to judge the quality of those earning assets until you get into them. And, most of the time, they are lower quality than what you thought they were.”

The survey results mirror Hulsey’s concern and highlight the disconnection between buyers and sellers when it comes to asset quality. Fifty-nine percent of buyers listed the asset quality of potential targets as a top barrier to an acquisition, while only 5 percent of sellers report subpar asset quality as a barrier to selling their bank.

“From the perspective of an acquirer, there is still significant concern about what the seller is reporting as their asset quality,” says Chad Kellar, senior manager at Crowe Horwath LLP. “Through a number of transactions where we go in and say, ‘Here’s the potential loss,’ it’s still a multiple of what the seller’s board is thinking. So in a lot of these situations there is a pretty big divide between an acquirer that’s healthy enough to go do a transaction and the seller.”

Hulsey says that while no large acquisitions are on the horizon for his bank, he is interested in smaller purchases in either the insurance or the wealth management area, where he is keeping his eye out for businesses with proven track records. According to the survey, he is not alone. Nearly 30 percent of respondents are looking for acquisitions outside of their core branch banking franchise in the next year. This group reports particular interest in investment management and/or trust businesses at 40 percent and insurance brokerage and/or agency businesses at 30 percent. Twenty-nine percent of those looking at acquisitions outside of their core banking franchise hope to acquire a residential mortgage origination business.

Kellar explains that acquisitions of mortgage origination platforms are of interest right now given the relatively strong position of mortgage companies that made it through the worst of the financial crisis.

“Sales are very strong right now, and obviously the refinancing boom is continuing,” says Kellar. “So those [mortgage companies] specializing in refinance, in particular, are going gangbusters this year and last year relative to what they had been doing even before the downturn.”

Not surprisingly, pricing is reported as the number-one barrier for both buyers and sellers this year. Sixty-two percent of buyers cite unrealistically high pricing expectations as a top barrier to an acquisition, and 71 percent of potential sellers feel the pricing is too low to make a deal.

Rick Childs, director at Crowe, says that while there are still some potential sellers out there thinking they are going to get somewhere around two and a half times tangible book value, the current pricing benchmark is much closer to one and a half.

“If you just look at the average on each deal, still more than about half of the deals are done at less than one times tangible book value,” says Childs. “There’s a nice little slew that come into that 1.2 range, and there are a few deals that hit the 1.5 range.”

Childs says the deals that are getting around two times tangible book value are in New England, the mid-Atlantic and Texas, where some of the banks weathered the 2008-2009 financial crisis in reasonably good shape and can command a higher price.

It does not appear, however, that these lower prices are enticing enough to most sellers. Eighty-nine percent of respondents say they have no intention of selling a bank, branch, line of business or loan portfolio in the next year. Only 2 percent of respondents indicated they are planning to sell a bank, which could be bad news for the 46 percent who say they want to buy one.

This is especially interesting given the high percentage of respondents reporting that smaller banks can no longer be competitive in today’s market.

Of the respondents, 21 percent were from banks with less than $250 million in assets, 23 percent from banks with between $251 and $500 million, 20 percent between $501 million and $1 billion, 23 percent from $1.1 to $5 billion and 13 percent $5.1 billion and up.

For respondents in the $500 million and under range, nearly 40 percent of them report that a bank needs more than $500 million in assets to stay competitive in today’s market-compared to 61 percent of respondents as a whole. Less than a third of all respondents report that size is not a determination of competitive strength.

Cyril Spiro, chairman and CEO of the $427-million asset Regent Bancorp Inc. in Davie, Florida, says he can understand why senior executives and directors at some smaller banks believe their size places them at a competitive disadvantage, and he thinks it will only get tougher with the new capital requirements.

“I think a lot of people are still looking at the regulatory environment and the regulatory burden, which is obviously a fixed cost,” says Spiro. “You have to have a certain size to overcome that.”

Regardless, Spiro has no plans of selling anytime soon, and he feels that a bank does not necessarily need to be all that large as long as it can keep a strong bottom line.

Hulsey adds that another consideration is location, and he thinks banks operating in rural areas could survive with well below $500 million in assets; however, the same might not apply for banks trying to serve larger cities.

“If you are in a metropolitan area governed by the regulatory requirements of today, I would say $500 [million] ought to be a minimum,” says Hulsey. “You can get away with less as long as you don’t get in trouble [with loans] and the regulators let you get by with a little less emphasis on compliance.”

With an increased regulatory burden, increased capital requirements and 30 percent of respondents saying that federal regulatory agencies are putting pressure on small banks to sell out because of a perceived bias against small institutions, it is perhaps counter-intuitive that the number of people with no intention of selling anything is increasing-89 percent this year compared with 80 percent last year.

Results indicate that respondents may feel more comfortable waiting for pricing to improve this year. Significantly fewer people are worried about the economic outlook, at 34 percent compared with 41 percent last year. Respondents also report being slightly less concerned about regulatory outlook, shareholder expectations and subpar asset quality. Further, a strong majority of both buyers and sellers report they are prepared for an acquisition in terms of due diligence, strategic fit, pricing, integration and social issues. It seems to all come down to price, and how asset quality is affecting that price.

Childs says that for many of the banks with asset quality issues, delaying a sale until their loan problems have been fixed will be well worth the effort.

“If you’ve got loan problems, do not sell now,” says Childs. “Putting a little effort into fixing your loan problems is actually a reasonably easy thing to do. It’s painful from a capital standpoint, and it’s personally a little painful to do it. If you look at community organizations in particular, the problem loans are probably people that they’ve lent to for a long period of time, and they loathe pulling the trigger on them. But if they were to clean up their loan portfolio, their price would be dramatically better.”

For the industry as a whole, the survey suggests that there is a ways to go until deals start to pick up, and even with considerable challenges, bankers are not panicking to sell quickly.

Childs says that while the level of non-performing assets in the industry continues to decline, it is still at historic highs. He expects no significant increase in deal flow until that number goes down further.

“While waves of consolidation have been predicted for a number of years, the survey indicates that credit quality and pricing concerns have really held back the level of consolidation,” says Childs. “I think banks aren’t as interested in selling as the predictions would suggest. Certainly, increased regulation creates headwinds, and the survey shows that banking is not as fun [as it used to be]. But I think these people are still committed to independence, not wanting to have the hometown bank owned by somebody else. There’s still a lot of pride in that.”