Bank News: February 2009

Community Banks For Sale

By: Bill Poquette

Merger activity on the public company level has slowed to a crawl in recent months, characterized mainly by a few high-profile rescue operations — the acquisitions of Wachovia Corp. by Wells Fargo & Co., Washington Mutual Bank by JPMorgan Chase & Co., and National City Corp. by PNC Financial Services Group Inc.

Conversely, Dean Johnson and Bob Wray of The Capital Corp. L.L.C. in the Kansas City suburb of Lenexa, Kan., who arrange sales of privately owned community banks, are as busy as they have ever been.

The reasons are several, say Johnson and Wray, who have operated their firm since 2001 when they bought it from the former Commercial Guaranty Bancshares Inc. in Overland Park, Kan. Wray was general counsel for Commercial Guaranty until it was acquired by St. Louis-based Enterprise Financial Services Inc. and Johnson, a former correspondent banker and Kansas bank president, was on the staff of the company’s First Commercial Bank N.A.

Six months or a year ago, non-public community banks were selling first of all because of the age of the CEO, the age of ownership and health issues in that group, says Johnson. But then the souring economy intervened, bringing with it classified assets and capital issues, not just for the big guys but for community banks as well.

Increasingly, the firm’s business is being fueled by banks with problems, some not of their own making but some self-induced. In the second category are lax underwriting standards and reaching for earnings with loan participations, out-of-territory lending and over-concentration in commercial real estate.

While Johnson and Wray have previously ranked regulatory burden and associated costs high on the list of factors motivating sellers, in the last few months they have seen a disturbing tendency by regulators to pressure some ownership groups to get out of banking altogether. They are working on a half-dozen deals currently where they say the pressure is being felt, although they haven’t been ordered to sell the bank. Last year, however, they handled a case where regulators told the owners their strategic plan needed to be “sell the bank.”

As Johnson tells it, the owners submitted one strategic plan that was turned down, then they hired a consultant who wrote two more strategic plans that were rejected as well. Exasperated by the rejections and expense involved, the owner requested a meeting where the regulators would explain what they wanted. The regulators couldn’t have been more clear: “We want you to have one sentence that says you will sell the bank.”

Pressure is being applied in a number of ways, Johnson and Wray point out. They are seeing banks penalized currently for things the regulators didn’t have issues with six months ago, and CAMELS ratings plunging from 2 to 4 in that short period.

They don’t see these types of problems going away any time soon, and in the last few months this situation has evolved into the No. 1 reason people are at least discussing the possibility of a sale, says Wray. Unfortunately, banks with problems like rising classified assets and pressure for more capital will have substantially less value than they did a year ago and some buyers will be reluctant to take on these problems.

Wray and Johnson are still arranging bank sales arising from the previously more common age issues and related factors, however.

Wray explains that many owners are in their 70s; their children have left town and don’t want to come back to run the bank. “In the old days the president could buy the bank, but today they can’t borrow enough money to do that,” he says. “The owners don’t really have an in-house option to transfer the bank so a lot of them are going to sell.”

Expanding on why it’s difficult to transfer ownership to non-owner management, Wray recalls a time when many current owners didn’t need to have any money to make a purchase. “Banks didn’t bring a ton of premium,” he says. “A lot of the deals were at book value or slightly above and regulators would allow 100 percent financing – either borrowed money or the seller carrying the note for 10, 15 or 20 years.”

Today’s pricing and regulatory restrictions make deals more costly and complicated. Financing is available at rates pegged to LIBOR or prime, they point out, but the problem is the amount that can be borrowed. And the availability of seller financing today is limited.

A related issue is the difficulty in attracting skilled employees to the rural locations served by many smaller community banks. “The skill level for running a bank has gone up, especially with technology and regulatory burden,” Wray points out. “If you’re in a small town an hour away from a trade center it’s very difficult to attract a compliance or IT person or a senior lender. In addition, regulators are putting more pressure on banks to have certain skill levels in some fairly small banks,” he says.

Another reason for what Wray calls a “big push” in the last half of 2008 was the expectation that the capital gains rate will rise with a new administration and Congress, perhaps retroactive to the first of the new year.

In addition, many banks have been Sub S corporations for 10 years now and can be sold without being subject to the built-in gains tax.

Yet another reason for some of the recent sales is that owners are realizing that prices have probably peaked. Although they remain “surprisingly strong,” by Johnson’s estimation, the expectation is they will go lower so there is some “panic” selling. One factor that will drive prices lower, Johnson believes, is the substantially higher FDIC insurance premiums ahead, which will put pressure on earnings and hence prices.

If there is no shortage of banks for sale, for whatever reasons, neither is there a shortage of buyers. “We’ve probably shown potential transactions in the last year to 100 different prospective buyers in Colorado, Kansas, Missouri, Nebraska and Oklahoma,” Wray says. The vast majority on their list of buyers are bankers or other banks.

“We’re working with several buyers who have sold their banks recently and are looking to come back,” he adds.

While there are still plenty of buyers, the pool has shrunk some, they acknowledge. “There are definitely buyers that have to sit on the sideline today,” says Wray, “especially in the Kansas City market, for example, where they have their own issues. They might have been a buyer a year or so ago but they aren’t a buyer today.” Rural banks, on the other hand, are doing very well. They don’t have construction loan issues, he points out, most of them are over-capitalized and they are looking to expand.

Adds Johnson, “Some of the buyers have withdrawn because they don’t want to take the risk in today’s environment. And they are keeping their powder dry because they know the banks are going to get cheaper.” And some are poised to buy failed banks on the cheap from the FDIC. As Wray points out, once a bank gets to the point where it looks like it will fail, buyers back away and wait for it to be closed.

Other buyers are showing willingness to pay market price or higher for a clean bank, rather than one with problems at a lower price, Johnson explains. “We’re having to consider escrows or other ways to handle classified assets that make for a good clean bank,” says Wray. Other options may include the seller keeping the classified assets or involving a third party, which he expects to see more of.

Pressed for other reasons why their phones keep ringing, Wray suggests they may be having more calls because the deals are more complicated than in the past, primarily due to problem assets. In the past their competition was “the guy who wanted to sell his own bank.” But it’s more difficult to get financing and more consulting is involved, Wray explains. “We’re spending more time talking to boards of directors as opposed to just owners,” he says. “Just in the last year or so it’s gotten even more complicated with the due diligence issues, regulatory issues and financing issues, so that’s part of the reason our numbers are going up as well.”

Maybe it won’t always be for the reasons they would prefer, but given the growing number of sellers and many willing buyers, Johnson and Wray shouldn’t have trouble keeping busy for some time to come.

Bill Poquette is editor-in-chief of BankNews.