Florida sunburned by mortgage crisis and not enough SPF to protect from commercial pain
Original Link ⇐ Back to Article ListFrom: Bank & Thrift - Industry News
By Laurie Hunsicker
Mar 04, 2008
Laurie: We have a wonderful lineup here of industry experts joining us to talk about Florida. As we have all seen, Florida has been badly burned by the mortgage crisis. So, I would like to start out by focusing on credit. What are you seeing? Specifically on commercial real estate, as that appears to be the next shoe to drop on further credit deterioration. We recently saw John Dugan's comments that more than 60% of Florida banks have commercial real estate loans exceeding 300% of their capital. And more than half have construction development loans exceeding 100% of their capital. How concerned are you about that specific piece of commercial real estate? When does it turn? Where are we in the credit cycle? And Tom, maybe we'll go ahead and lead off with you.
Tom: In regard to where we are in the credit cycle and when will it turn, it all depends on what loan portfolio you're looking at. Residential real estate loans, commercial loans and condominium conversions all have different time frames in order to work them out. The feedback that I'm getting from my clients in Florida is that it's going to be another six to 12 months before the banks will see some improvement. The banks are still in the discovery stage in identifying their troubled loans. I agree that the commercial real estate loans will be the next loan portfolio to worry about and that it's going to take a good six to nine months before we see any improvement. Stanford was one of the sponsors at the [Florida Bankers Association] Annual Bank Directors Workshop last week in Orlando, and the mood of the banks and the regulators was not very positive. The general consensus among everyone that I spoke with was it is going to take quite some time to work through these problems.
Laurie: Great. Mindi?
Mindi: Well, we think that the construction and land development business for the community banks is going to be what the commercial construction business was to the community banks and the S&Ls in the late '80s — and that is, so much of the construction was fueled by situations that were really relatively uneconomic. Even though the community banks have dodged the bullet of having direct exposure to subprime they do have a substantial amount of exposure in the form of asset prices that were substantially bid up by the esoteric mortgage products that were offered to them in the last half of this decade. Just to give you a perspective, since 2001 community bank loan portfolios dedicated to residential land development and construction doubled and went from 8% to 15% nationwide. In markets like Florida, we're seeing banks that have 30%, 40%, 50% even 60% of their portfolios dedicated to this asset class.
And what we're seeing is a beginning of a realization. The 2006 exam reports were fabulous. Most of the banks were very profitable. The regulators had a relatively good view of the asset quality. And since that time, the late 2007 and early 2008 exams have been a very different situation. John Dugan's remarks were pretty clear in that the regulators have recognized that there has been a major reset in asset values, particularly in the high-growth markets, and I'll quote from John Dugan: "This will almost certainly require the banks to downgrade many of their assets." What we haven't seen yet is a wholesale realization by the community banks of this problem. To give you an example, we called on five banks in the same MSA, all of whom were less than a billion dollars, all of whom had greater than 30% of their asset portfolios in land development and construction assets, and only one of them had greater than 1% nonperforming assets, and that bank had a 6% nonperforming asset ratio. And guess what? It was the one institution that had a new management team. We think that it's going to take through the end of this year for the banks to really recognize the depth of the problem. And they're going to have a lot of assistance from the regulators.
Laurie: Great points. Dave, I'll turn it to you. What are you seeing and when do we see the turn in credit?
Dave: Yes, as to the latter point, that's just an unknown, an unanswerable at this point. We recently returned from the Treasure Coast side of the state and things are just locked up, especially on the residential side of the equation. There's just so much inventory, and whether it is speculative inventory or people who have been down there for years and sitting on equity behind the homes, it is impacting inventory. You talk to management teams down there and the one positive is that the pace of new inventory of these homes is not coming on the market maybe as fast as it was, and data supports this. So things are improving. But in talking to management teams, under some of the more pessimistic scenarios they are saying that we may have 24 to 36 months in some of these markets before we see recovery. The concern is whether this bleeds into the commercial side of things as some of their residential borrowers experience weakness — does this exposure unravel into the commercial side of the equation? Some are starting to see a slight deterioration on the commercial side as well. Most of the banks we speak with note that they have an industrial property performing with a certain borrower with the caveat that they are closely monitoring performance for signs of degradation as a result of residential weakness. So we are of the view that you are going to continue to see elevated provisioning and reserve build as we go through '08.
Laurie: Absolutely agree. Jefferson?
Jefferson: I think the Florida banks, especially the larger community banks, the publicly traded ones, have had a pretty significant period of time to look at the residential construction book. They may not have identified all of their NPAs like they should have, but they have had six to nine months to really take a look at their book. I think the bigger surprises are going to come out of the commercial side. I think you are going to continue seeing higher provisioning and higher losses on the residential construction side, especially with continued drops in the home prices.
But the part that seems the most worrisome to me is the commercial side of things. The banks that weren't getting their growth from the construction in 2007 were turning to commercial as their form of growth. You are starting to see some weakness, at least in the retail piece of commercial real estate, and with the absence of the levered buyer for commercial real estate you're seeing cap rates increase and you're going to see commercial projects deteriorate. You're seeing this in the CMBS market with some significant spreads created in the CMBS market. So I think that most banks have the capital to be able to absorb significant losses within residential real estate, but if this problem bleeds more into a commercial quagmire anywhere close to what we've seen in residential, then it could create significant capital issues for the banks.
Laurie: Yeah. Jefferson, I agree. Absolutely agree. I think the bigger surprise is going to be on the commercial side. I was just talking to a Florida CEO, who asked to remain anonymous, and those are some of his concerns as well. His concerns center around what specifically happens when the support businesses die off in a shopping center? What happens when the tiler goes out of business, etc? We haven't really seen that yet. So I would pose that question back to you all. What are you hearing or seeing locally? Do you all have any anecdotal stories to share? Jefferson?
Jefferson: All right. We've seen commercial projects become problems because a developer also has residential projects. We've seen a net out-migration in some parts of Florida. We think a lot of that is the service industries to residential builders. We've heard a lot about stress on these, the support for residential real estate, but I haven't seen specific incidences. I think a lot of these are going to be in the C&I portfolio, and so we could have more exposure. And we believe a lot of these banks feel it hitting the C&I portfolios in the form of the granite guy, the tile guy, the plumbers and that sort of thing. So I think you are going to see significant issues along those lines, we just haven't seen a lot of it yet.
Laurie: Yep. Agree. Dave?
Dave: I tend to agree. I mean, obviously in Florida real estate is a key industry of the economy along with services, and as you look through some of the top employers in some of these MSAs and counties, it is typically a school district or a Publix. But what's not captured most of the time are the smaller private contractors and residential construction guys that in aggregate are a large part of the economy. Like you said, as the tile workers and such lose work it has an impact as we go along here in terms of just the overall economy.
What's interesting from an anecdotal perspective, maybe not on the more commercial side, but we spoke to one bank down there — and this is more from an auto-loan perspective, where borrowers who had not missed even one payment were coming into the bank and handing back the keys due to lack of employment — and a common theme tends to be former construction or housing-related employment. So you see, that bleed-over into the consumer market is definitely a concern. And then, as Jefferson alluded to before, on the retail side, just sort of visiting some of the retail shopping centers down there you drive by a big supermarket and bank branches within the center and there are some store vacancies, maybe not enough to imperil cash flow but this may have a dampening effect on rental rates.
Laurie: Yes, good point. Tom?
Tom: What I've been seeing is a number of the banks are in the process of redoing their business plans that they set up in 2006 and in early 2007. These banks are cutting back revenue by 20% to 30%. They are also starting to hire consultants to advise them on how to reduce unnecessary expenses. I agree with the other comments that these problems are leaking into the other industries. The plumbers, electricians, even the restaurants are starting to see a significant slowdown. I believe these businesses are off by 10% to 20%. Also, for the first time ever Florida is starting to experience a negative growth rate. People are leaving certain counties for a variety of different reasons and moving out of state, which is certainly not helpful and creates a negative to a flat environment. Another thing is that the bank examiners are now focusing on over 50% of the banks' loan portfolios, where before it would be approximately 30%. It's been a tough, tough exam period for the last several months.
When you add this up, it does not bode well for 2008. I think there are flickers of hope depending on what region you're looking at within Florida. If you look at the east coast of Florida from Palm Beach down to Miami, it's a whole different world than from Fort Pierce north. The same can be said for Bradenton down to Naples. The whole west coast of Florida has experienced significant problems that the banks are working their way through on. In spite of these problems, there are a lot of banks there that have done quite well because they've avoided the residential real estate and land development loans. Although some of them are starting to see these problems leak into their loan portfolios. So as you can understand, they're being extremely cautious at this moment.
Mindi: And affordability has become a major issue, even absent the cost of the mortgage. You look at what's happened to the price of insurance in Florida, we just saw that State Farm has just notified that they do not intend to write new policies in Florida. They currently have a million customers in Florida, and they won't write any new policies. Homeowners down there are in some cases paying almost 5x what they used to pay for wind insurance. And so when you think about that in the context of the overall affordability and discretionary income, it adds up to something that is a little bit scary from a broader economic standpoint.
Laurie: Yeah. It is scary. And yet as we look generally at Florida, it is still a place where people want to live. The cost of living is still certainly very affordable relative to the rest of the country. I think the latest numbers still indicate that there are approximately 1,000 people moving into the state of Florida every day. However, the mortgage crisis seems to be showing no signs of recovery and the commercial credit is likely at the beginning stages of deterioration, and so forth. So many things in Florida are still looking pretty bleak. If you line all of these factors up, what does this mean for recapping some of the banks that are probably in desperate need of capital? And what does this mean for M&A and for management teams that may want to get out now? Mindi, what do you see? What would you suggest on the recap and M&A front?
Mindi: Well, I think one silver lining of the stock price erosion that we've seen, which is over 30% across the board for community banks and even more in Florida, is the regulatory pressure. John Dugan certainly sent a shot across the bow to every community banker in his most recent speech at the end of January. Management teams and boards of directors can really rest assured that shareholders and regulators are pricing in and managing to a substantial credit downturn. It's up to those management teams and the boards to make the decision to clean up the balance sheet and bolster capital levels here.
It is a little bit counterintuitive to think that taking a loss on an asset can be a good thing. But once you factor in the cost of managing a problem loan portfolio and the cost of setting up the infrastructure to deal with problem assets it can be a better alternative, because remember, a development deal gone bad can be an extremely complex situation with lots of lawsuits. And it doesn't take six months to clean up — it really takes a couple of years. There can be a real benefit to a management team of just recognizing the problems, selling loans for a discount and recapitalizing the institution, because clearly Florida is a desirable place to live and after the turn there will be a great opportunity to build market share. The key is to recognize that there has been a major asset price reset and management teams and boards need to address that quickly.
Laurie: Absolutely agree. Tom, what are your thoughts? We haven't seen a lot of rights offerings yet, certainly not really in Florida, except for one homebuilder that didn't work. Where do we stand in kind of the landscape of looking at recaps and M&A?
Tom: Right now there are a number of banks that are looking at the rights offerings. They are considering either a straight rights offering or a rights offering backstopped by investors or an investment fund of sorts. I'm aware of a couple of banks that are seriously looking at this and will probably announce something over the next 30 to 60 days. In regard to Florida's growth rate, I believe 360,000 people moved to Florida last year, which is I think the size of Tampa. Even with 1,000 people moving to the state every day, it continues to be a very expensive place to live, especially for people that are retired and relying on fixed income. Over the past few years homeowner insurance has gone up 3x to 5x, which is a big hit to the pocketbook. For the first time people are starting to leave the state go to other states like North Carolina and South Carolina. In regard to bank trading valuations, Florida publicly traded bank stocks are down 40% and in some cases close to 50%. Acquisition values have also come down over the past 12 months. For example, JAXB, Jacksonville Bancorp [Inc.], announced their transaction a few weeks ago with Heritage [Bancshares Inc.]. That transaction was done at less than 2x book and approximately 18x earnings.
One thing about Florida, it typically comes back faster than the rest of the country because of the number of people moving there bringing along all of their personal business. Unless these problems become significantly worse, most bankers believe that by the end of this year, 2008, they will begin to see a turn for the better. Once we get to the bottom the healthy banks will begin to raise capital. The not-so-healthy banks will recover to do rights offerings. There will be some banks that will not make it and will have to find a merger partner or go out of business. I'm aware of a few that are looking at that problem right now. We anticipate seeing institutional investors and retail investors begin to invest in Florida bank stocks. In fact, we are starting to see some of that now with the well-run banks whose stocks are trading at these very low levels.
Laurie: Right. We certainly are looking at some of these stocks, down 40% and even 50-plus%. Maybe the management teams are thinking about doing a rights offering, which would seem to make sense even though it is diluting book value. In times of credit deterioration, I think it's always nice to see a bullet of capital. Jefferson and Dave, I want to hear what you think. When do you think the market's going to turn? What are you hearing from investors? When will the fund flows shift back? And what are your thoughts for folks looking to invest in Florida? What do you like on the long and short side?
Jefferson: All right. I wanted to share some things the state government is doing. They've passed the portability of homestead tax basis, so if you want to move into a house you can actually take your tax basis with you instead of going up to the higher price. It could help a little bit over time. Anecdotally, it's true that insurance is up 3x to 5x. But you've had two summers and two falls without significant hurricanes, so you are seeing some anecdotal evidence at least of some break in insurance.
On recaps you have an interesting test case in the market right now in the form of Security Bank Corp., ticker symbol SBKC. They have a backstop for half of the money they want to raise, so they've already been successful in recapitalizing the bank to some degree. The bigger banks have obviously been able to recapitalize very quickly in the form of Bank of America and Wachovia [Corp.] — they can just go to the well whenever they need it. It's going to be a lot more interesting to see whether some of the Florida banks with some of the outside construction exposures are going to be able to get capital just as easily. We know that it's going to be expensive because you see where the stock prices are. And if you have to go for common equity you're going to dilute book value pretty hard. And it's going to be interesting to see whether investors will step up and participate in some of these rights offerings. On the M&A side I don't think you're going to see much M&A until you get some clarity on the range of these potential losses. On residential construction loans, a year ago I was using a 1% loss rate and now it is 2.25%. And going forward I don't know what rate to use for these loans.
Laurie: Yeah. That's a great point in terms of rising losses — hard to quantify. Obviously we've seen a massive slowdown year over year nationwide, and I think particularly geographies are difficult to quantify future losses. Is it fair to say that M&A in Florida is all but frozen?
Jefferson: In my opinion it is until you get some kind of clarity around what the loss rates could be. I think we need to walk down this process, as the other people on the call were saying — we need 12 to 18 to 24 months to get a better feel for what these loss rates are going to be. I think you have to walk some of the way down this path before a buyer is going to step up and take a risk and take that balance sheet on to their own.
Laurie: Yep. Great. And from the standpoint of what you're recommending to investors right now on the long and short side, what are stocks you like in Florida?
Jefferson: We have a lot of "market performs" on these Florida names right now. We recently visited Seacoast [Banking Corp. of Florida], and I've felt better about Seacoast's capital being sufficient to handle the most likely loss rates coming out of there. We don't have any "underperforms" on the banks down there because mainly we feel that the banks have been able to recapitalize. With recapitalizations being successful with every bank we've seen so far and at such cheap prices to book, it's hard to put an "underperform" call. You would almost have to bet that the bank is going out of business to put an "underperform" call on it right now, and we've seen investors step up every time so far to recapitalize these banks. So we have no "underperforms" at the current time.
Laurie: Okay, great. Dave, what about you? Where are you in terms of recommending long and shorts? And what's your take on recaps, M&A and generally when the Florida marketplace will turn?
Dave: Yeah, I tend to echo what Jefferson said in terms of our specific recommendations. We have a long [on] BankUnited [Financial Corp.] and admittedly have ridden this one down from $16 to $5, so we're still holding in there. We recently did a pretty extensive piece last week trying to look through historic HMDA origination data by MSA and region to examine potential loss content. We stressed tested potential NPAs and loss content from, I don't know if it's a worst-case scenario but a pretty significant deterioration in terms of NPAs and home price deterioration across some of its core footprints, where interestingly they have not seen quite the home price depreciation as they have in some of the west coast and western Florida markets. Based on our analysis of potential loss content and even factoring in some sort of dilutive equity offering, which would not surprise us in the near future here, we still calculate tangible book somewhere in the $10 to $11 range, implying 100% upside, and if capital was improved, probably takes a lot of the wind out of the bear camp here.
In terms of Jefferson's assessment of Seacoast, we were just down to visit them as well and got the sense that there was not a lot of new in-migration in terms of nonaccruals from the original bucket of potential problem assets identified last year. In our coverage, they were one of the first to try to attempt to sort of build reserves and provide for the proverbial rainy day, though I think they were somewhat limited in the amount from a regulatory standpoint. However, we did come away somewhat comforted that we are not seeing a tremendous amount of degradation on some of the early stages delinquency there, which is supported by recent call report data. And then our only other coverage in Florida is Capital City Bank Group [Inc.] up in Tallahassee, and I the story here is they have a nice franchise in the state capital and are generating good deposit growth from local relationships, but that is also one where we are seeing some delinquencies sort of spilling into the commercial real estate side. So we have a "market perform" on that as well.
And then in terms of M&A, I agree we're hearing the same thing from bankers there, that it is locked up from the standpoint of trying to figure out what are the potential problem issues in their own portfolios and nobody is inclined to jump into the M&A game and try to figure out what XYZ Bank is bringing to the table. The one thing that has been posited is that depending on what happens with the administration from a Democrat versus Republican perspective and what happens with the capital gains taxes, there could be more activity from some of the smaller, private banks that are looking for a liquidity event as their "retirement fund." Maybe this potential change in tax laws spurs them to flip the keys sooner rather than later.
Laurie: That's a great point. Especially if we do in fact see a Democrat president, then it is likely we're going to have some sort of retroactive jump to cap gains that will be effective Jan. 1 of '09. So yeah, that certainly is something to weigh in on as it pertains to M&A. The tax rate is definitely something that bank executives should be thinking about when thinking about whether or not to sell their bank now versus later. Great. Well, many thanks to you all for joining us.
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