Cleaning up California
Original Link ⇐ Back to Article ListFrom: Bank, Thrift & Broker/Dealer - Industry News
By Laurie Hunsicker
May 14, 2008
Laurie: Overall, California is feeling the credit pain more sharply than most, with approximately one in every 250 homes in foreclosure. Data points recently released show that the traditional spring home buying season is off to its worst start in 20 years, with sales so weak that foreclosures now account for more than one-third of all market activity.
According to Data Quick, nearly 38% of the Southern California homes sold in March had been foreclosed at some point in the prior year, and that's up from 8% in March of 2007. And Riverside County is clearly one of the worst hit — more than half of all home sales were foreclosures and clearly much of the Inland Empire is reeling from this. This area in particular has seen 20% to 35% drops in housing prices, while land values have slid in some cases 30% to as much as 70%.
Plummeting net income, rapidly deteriorating credit, escalating charge-offs and guidance of more bad news to come all seem to be prevalent themes among Southern California banks, particularly this quarter. How do the local banks recover from this? And when and where is the bottom? What trends are you watching on the credit front? Let's lead off with our analysts Chris and James.
Chris: Obviously we're watching [nonperforming assets], [other real estate owned] and delinquency levels when they're available. I think the data we're really interested in are the number of pages of OREO from Downey Financial Corp., Countrywide Financial Corp., IndyMac Bancorp Inc., etc. There seems to be thousands of listings of foreclosed or delinquent home sales in the Inland Empire, and the central interior portion of the state, but not as much in the Northern areas. But, until the supply of those pages stabilizes or reverses, I'm not sure what the motivation is for a lot of folks to buy new homes, particularly from a price perspective. So, there's still heavy pressure on most construction lenders unless we discover that home buyers are indifferent to buying a nondelinquent home or someone else's OREO disposition.
Certainly I think the banks are challenged — we're not at the bottom. I think that it's going to take a leveling of NPAs in terms of something that we're watching for and right now in the interim I think reserve coverage is the one measure that we think is valuable, and for a lot of these banks under 1x-coverage is just not good enough.
Laurie: Great points. James?
James: Yeah, I would echo that. The only thing that I would add to it is I'm looking more for a deceleration of the rise in NPAs rather than a stabilization of the NPAs. I think fundamentally that these companies will still have deterioration for some time to come but the stock market will begin to look through that as we start to see deceleration. But at this point, and particularly in California, it's still, in general, an acceleration [of NPAs] as opposed to deceleration.
Laurie: Yep, good points. As we look at where we are right now in the credit cycle, some folks are suggesting that this is 1990 revisited. Jeff, I would turn this question to you, particularly since you were with the FSLIC and the FDIC from '88 to '91. What are the parallels that you can draw, and what are the mistakes being repeated or the lessons learned?
Jeff: Well, I think certainly many of the things we see out there today have the feel of the late '80s and early '90s. SNL just published some data showing the largest bank failures in '90 to '94 and the level of NPAs and reserves that they had. [It was] around 12.5% of NPAs on average for those failed institutions. I think certainly we're starting to see some West Coast institutions creep towards that number and I think if many people took a realistic view of their portfolios, there'd be many more institutions that have NPAs certainly close to double digits.
So I think it certainly does feel like failures are coming.
And I think that we're certainly seeing some of the same mistakes being made from the last cycle — institutions playing games with interest carry and extensions, and refinancing loans from one institution to another to mask problems in the portfolio with the hope that regulators will give them more time. In my talks with the regulators, they're starting to see more of that as well. So it certainly has very much the same feel of the things that were going on back then. I think a mitigating factor is there seems to be a lot more capital around to help solve some of these problems. But I think nonetheless we will see far more problems inside the institutions approaching those of the late '80s, early '90s than many folks perceive.
Laurie: Great. John, I would like to hear from you. You operate in some of the areas in California that are being hardest hit. What are your thoughts on the Southern California marketplace and maybe you can give us a quick snapshot of your bank and explain how First Community Bancorp is poised to weather the current credit turmoil or even benefit from a fallout of customers?
John: I think the issues in California are not different than those in the rest of the country. It's very difficult to generalize about the country as a whole and I think that that is absolutely true in California. There are areas that have been severely impacted, the Inland Empire certainly being the most notable. There are other areas that to this point have felt only a minimal impact of the current environment. So as you look at institutions, it's really critical to understand where their loans are geographically and the types of loans that they were making in that geography.
Laurie: And how specifically do you feel in terms of what First Community has done on the credit side? And how do you see First Community going forward over the next several quarters?
John: Castle Creek Capital LLC has banks in other markets than just Southern California. We sensed that there was potential for a slowdown 18 months or more ago and began to take the appropriate steps. And so we have been working to build reserves. We've been conserving capital. We've been taking action as we looked at the portfolio in terms of how we were underwriting the credit and what mix we wanted in the portfolio. We began to take appropriate action on various pieces going back over the last 18 months. The objective was to position ourselves in a slowing economy so that we had a very strong balance sheet, positioned to take advantage of a slowing market. My experience has been that the best customers that you can ever have are those that you were able to take care of in an environment like this. And so it's incumbent on us as a financial institution to put ourselves in a position where you can do that.
Laurie: And certainly you've been more proactive than many banks. You talked about appropriate action — one of the things you all did this past quarter is that you sold a large portfolio of loans for 53 cents on the dollar. What details can you provide us about that loan sale?
John: Well, very few. It was very similar to the loan sale that we did in October at Centennial [now called Guaranty Bancorp] in Colorado. It is part of this overall strategy of wanting to be positioned with a clean balance sheet with strong capital and reserves. We saw an opportunity to move out of some loans that we knew were going to take time to work our way through. One lesson I learned a long time ago is it's very hard, if not impossible, to grow and fix at the same time. And so if we were really seeking to position ourselves to take advantage of this slowing economy, we needed to minimize the amount of time and distraction that went into fixing.
James: I was just going to say, if I might interject something here that, it touches upon what John talked about. We recently saw East West Bancorp Inc. raise capital, about $200 million and that was specifically, in my view, done to enhance the company's ability to grow as we come out of the cycle. I had a conversation with management [at East West] which led me to believe that they were not a 100% sure on whether they wanted to raise capital or not, thinking that they could make it through the cycle without doing so.
That is the mentality of a lot of banks out there, they think they can make it through the cycle without raising capital. And they might be right. But will they be competitive when they get through the cycle is the question. And I think the answer, and John had an interesting way of phrasing it, is you can't fix and grow at the same time. And that's probably true. The ones that do have capital, the ones that have clean balance sheets at that point are able to grow significantly, while the rest of the banks are still fixing and cleaning; it will be a major competitive advantage for those that are clean and have capital.
Jeff: We're an active buyer of assets from financial institutions, and we are seeing more activity from the standpoint of institutions showing us portfolios or showing us assets than we saw last quarter, which I think indicates a realization that fixing some of these things will be a benefit. However, I think there's still an awful lot of optimism in the marketplace for what distressed assets will sell for and so the bid/ask spread seems to still be wide in many cases, not in all, as we're starting to see a few trades. We are also a provider of capital to those same institutions. I think that in many cases if an institution thinks it can solve both sides of that equation, fix its problems, and then raise capital at the same time we will start to see more trades like that in the future.
Laurie: Right. I mean, clearly there is a hidden cost in terms of working out loan and regulatory issues. Selling loans was a great freeing up, if you will, going forward. Jeff, maybe if we can go back to something you said earlier on the loan sale side. What is the market now for different loan categories?
Jeff: When we started the effort of getting out in front of the financial institutions in the fourth quarter last year, most people didn't want to recognize that there was an issue, or they would have to in any way clean up the balance sheet. We're now starting to see far more portfolios, some things starting to trade. As I said most folks are still very optimistic about their own loan portfolios and not as optimistic about their competitors'. Which is I guess a natural thing to feel. But I would tell you that for California outside of the regulated financial institutions we're looking at loans on raw land that are 15 to 30 cents on the dollar. Buyers bought other loans that are not raw land at significant 50%, 60% discounts. So it's pretty severe. But as John said, that's certain parts of California and certainly not every part is experiencing the same level of problems.
Laurie: Thanks. Chris, let me turn it over to you. What are you seeing in terms of loan sales? Generally what loan categories are you carefully watching?
Chris: We're seeing loan sales of residential lots even though they're at very deep discounts as much as 80% or even greater. We are seeing some selective vertical house sales where the pricing is better but certainly it does depend on the type of house. Given the volume that exists, I think we're still at the tip of the iceberg, and a lot more product that could be sold. And, to Jeff's point, we see people still having their heads in the sand, and therefore they have yet to truly come clean on what is their new reality. But slowly after another round of FDIC call reports, folks will be painfully aware of where we are. So we are seeing increased volumes, at least in a lot more increased discussions with banks out there and that's not just a Southern California statement, although I think that is definitely pertinent to this discussion
Laurie: Right. And to the extent, Chris, that folks do become painfully aware — I mean at this juncture most would agree that capital is king — and nationwide we have seen a dramatic slowdown — and just typical capital management things that in times past were great, i.e., share repurchases and dividends and so forth — but certainly as we look at Southern California, this area has been very hard hit. And there's going to be a plethora of banks that need capital in one way, shape or form. What are your favorite methods? And what are you seeing out there, whether it's a convertible preferred or a secondary or a backstopped rights offering? How or when do you see a pickup?
Chris: Well, certainly I think a pickup is undoubtedly going to happen. James mentioned the East West transaction, which was a noncumulative perpetual preferred. Temecula Valley Bancorp Inc. back in February had a public trust preferred that paid 9.45%, so that was a fairly high coupon to get that deal done. I suspect that just like we're seeing at the large banks whether it be Wachovia Corp., Colonial BancGroup Inc. and First Horizon National Corp. today announcing straight common stock offerings that increase pure tangible capital is going to be the best method. This may not be the most preferred method from a dilution perspective, but I think it's going to be what gets companies recapitalized. At the end of the day, I think folks have an opportunity to buy stock close to book value or even at a discount to book depending on the individual situation that these will prove to be the most attractive securities. You know when you have a noncumulative of preferred you know there's not really a true dividend there, it's just simply, it becomes a place marker. So I think ultimately the yield instruments, if you're willing to cough up the yield that's one thing but I think at the end of the day I think the common equity is probably going to be the most likely, most often used once we get through all these phrases.
Laurie: Yep, I absolutely agree. James do you want to weigh in on what you like better, a convertible preferred, preferred or backstop rights offering?
James: I think it depends on what the company's capacity and what their tangible equity to asset ratio is to start with. …I think in East West's case they could have simply gone with… something a little less equity, if you will, a little bit more debt oriented. But their view was that that was a more solid structure in order to build upon, and I thought that that was the right decision that they made. I wanted to add one thought. … As I talked to several investors over the last two to three weeks as we've seen earnings numbers come out and we've seen other companies that seem to be in a situation where they need to raise capital — the investors are looking at what the write-offs will need to be off the construction portfolios, that's primarily what they're looking at and then figuring out what the book value is on an adjusted basis and then they're willing to pay really not much more than that [adjusted tangible book value] for the, for a rights offering. So that seems to be where the price sensitivity is around deals right now, is book value. But on an adjusted basis for losses.
Laurie: That's a great point. So as you look at your coverage list here in California, who are the ideal candidates for potentially a large write-off or in need of capital via a rights offering?
James: The one that comes to mind is UCBH. [They are] relatively thin on their tangible equity-to-asset ratio but they already have something in place, a mechanism in place to raise capital, actually at a premium to tangible book value. That mechanism is China Minsheng Bank over in China, which has already purchased 5% of the company and is, we think it will be sometime in the next six months, probably in the next three months there would be an infusion again by China Minsheng Bank in to UCBH for another 5% of the common shares, probably at a price, based on the trailing 90-day average, but that would probably be somewhere near the $8, maybe $9 a share level. So that sort of keeps [UCBH] in the clear in the near term but otherwise that would have been a candidate because of the low tangible equity to asset ratio.
Laurie: Right, right. Chris, any candidates you want to throw out there that are in need of capital?
Chris: One of the ways to answer that, Laurie, is that certain companies on paper should have enough capital to get by… for now. But to James' point a few minutes ago, we do not yet fully know what official marks the rest of the industry will take. I see companies that really haven't really announced poor credit yet and when they do, there are hits that will come out. It's well-documented about the situation with Vineyard National Bancorp, but there's also uncertainty about Temecula Valley. As these companies could recognize more issues throughout the cycle, will their tangible capital base be sufficient? But, there are other banks whose capital may look sufficient today but all bets are off if we go through another couple of quarters with more issues coming to light. This is especially true if CRE problems surface. I don't wish that bad scenario on these companies, but certainly that is a scenario.
Laurie: Agreed. From a credit perspective, if we look at where we were this past quarter, which California banks were hardest hit in your coverage list?
Chris: There's a few examples that we noticed, such as 1st Centennial Bancorp, who certainly had a pretty large increase in NPAs last quarter. We also cover First Community and there was well-documented deterioration there, although some of that was self-inflicted by the decision to sell the loans. John has not commented on this, but I would say that there were decisions First Community has made that were quite proactive on recognizing issues early. I think in FCBP's case they probably could have sat on the loans they had for a least a quarter or probably two quarters and not recognized the loan issues due to the rules. They chose to recognize early, and I think that will benefit them over time. Also, Jeff had made the point about playing games with reporting credit issues. We see the better management teams showing that in their actions, they will take their medicine today and make the move now versus waiting another three or six months.
Laurie: Right.
Chris: Last, on the flip side, you know there are companies who did well. You could look at a CVB Financial Corp. in Ontario who actually had a very good quarter and frankly has not had the issues that others have had. They are a business bank, so they don't tend to have the same portfolio of residential garbage that a lot of others do. So it is possible to dodge the bullet with their portfolio at this point in the cycle.
Laurie: OK. And James, what about from your prospective? When you run down your coverage list? Who in California was the hardest hit? And maybe where are the safe haven investments right now?
James: If I can turn the question a little bit — because as I thought about your question — I thought, "Well, everybody was very hard hit in California, except for a couple." And I think one of the concerns that we had, and we actually reflect this in our rating on CATY, which is an ethnic Chinese-focused bank based in Los Angeles. What we found is throughout the last six months, every company has a different stand on how proactive they are on managing their portfolio, particularly on the construction loans, reappraising their assets and then, and adjusting NPAs for that. We have some companies that have reappraised 100% of their construction portfolio, especially, particularly the residential loans.
We have other companies that have reappraised, and this is the case of UCBH, they have reappraised 100% of their construction portfolio in the Inland Empire, Central Valley, other areas like that that are deemed to be very distressed. And then there are other companies that aren't reappraising their portfolio proactively at all. There are the normal reappraisals as the loans approach their maturity date and they need to ask for an extension, so there's another appraisal that comes at that point but there's not a proactive approach to reappraising residential construction. As I understand it, residential construction lending is very open to a lot of interpretation and I think there are some companies that are very proactive and others that are not.
In CATY's situation, the company actually had a decline in the nonperforming asset ratio; it sits at about 1% today down from 1.25% in the prior quarter and then reserves are only at 97 basis points. That's an anomaly but I think it's a function of the way that some companies are choosing to recognize the problem early as opposed to delay[ing] the problem.
Laurie: Right. I think proactivity is going to be the key. Jeff, as you are out there giving advice to management teams in this market, what are the one or two things you'd want to share?
Jeff: Well, I think it's the same thing that we've touched on here several times, which is I think that you're not served, and you're not serving your shareholders at the end of the day by continuing to not recognize your problems and deal with them. And if you're in a market such as California where the market has materially changed, then your board needs to understand that you're not necessarily a bad manager if you have to address your problems, that the market is the market, and that good managers address those problems and do it early. So I would say cleaning up your balance sheet whether it be by sales or participations or whatever it may be and raising capital even if it's painful, clean up your mess and take advantage of some of these situations. It is a true statement that wallowing in all of these problems will not allow you to grow and prosper.
Laurie: Great, thanks. And John, why don't we close with you. What advice would you give to management teams bogged down by deteriorating credit or a need of capital? Or what general advice would you give?
John: I think it's all about confidence. When the market, your investors, your customers, your employees lose confidence in your organization you're in serious trouble and that clearly was highlighted in the Bear Stearns situation. I have always believed, going back to the first bank that I managed through a turnaround in 1982, that when you have a problem you need to be brutally honest in identifying the depth of the problem, you need to quickly put together a plan that will deal with the problem, with a sufficient margin of error to allow for contingency, and then you need to be absolutely honest with people and consistent with your plan. Once investors lose that sense of confidence either in your integrity or your ability to understand the problem, you're finished. So my advice is to be absolutely honest with yourself about the depth of the problem, put together a thoughtful plan and communicate it effectively to all of your constituencies.
Laurie: Great points. Gentlemen, thank you very much.
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