For the past two years, taxpayers and bank customers alike have been buoyed by one hope: that banks would emerge from the crisis much as a survivor might emerge from a plane crash — not only thankful but essentially reborn, eager to chart an entirely new course.
But although markets are liquid again, a boatload of Troubled Asset Relief Program (TARP) capital has been repaid, and federal regulators are beginning to piece together legal reforms, questions as to what banks have learned and how they might change remain very much open.
For answers, we went straight to the source: CFOs in the financial services world, at institutions that are healthy and buoyant as well as at firms that may be only a few rough waves away from capsizing. They described how they are working hard to correct past mistakes by centralizing the underwriting function, building quality capital, moderating real estate–secured lending (or getting rid of it entirely), and carefully matching assets and liabilities. It's Banking 101, but many banks strayed from the core curriculum in the boom lending years.
What these stories also reveal is that it is still too early to tell how banks will do when the doctor (federal regulators) takes them off the respirator. Profits are up, but loan portfolios are still bleeding. The long horizon is also fuzzy: Will banking be better off if institutions shrink and become more like utilities? Evidence supports the case for smaller banks, but the case is far more ambiguous for restricting bank activities to basic lending and deposit collection. Certainly the banking industry will need to look far different from the way it looked two years ago, if only to avoid a calamitous repeat of its recent history. CFOs will play a central role in helping banks steer clear of future crises.
Wells Fargo: "We Never Drifted"
Wells Fargo knows a thing or two about how to survive a crisis; after all, it had to endure the California Panic of 1855, when the company's mission was to carry gold and freight between the mining regions of the West and the financial centers of the East. Thanks in part to a wagon-load of TARP funding, it appears ready to emerge from this most recent crisis, having reported revenue of $88.7 billion for 2009 and net income of $12.3 billion.
CFO Howard Atkins is a survivor as well, having outlasted the finance chiefs at the nation's other largest banks. Atkins attributes both his and the bank's success to the fact that Wells Fargo stuck to its business model and stayed out of activities that entangled other large banks. It was also helped by the capital position it enjoyed as the crisis began two years ago. Early last decade, many banks issued hybrid securities — instruments that combine elements of debt and equity — to buy back their common stock. "We never really thought that was a smart thing to do," Atkins says. "It may have helped earnings per share in the near term, but it weakened the banks' capital structures." The Basel Committee on Banking Supervision has come around to that view and plans to phase out the acceptance of hybrids in banks' Tier 1 capital calculations and make retained earnings and common equity more prominent.
Wells Fargo hardly stayed above the fray, however, largely due to its all-stock acquisition of Wachovia Corp. for $12.5 billion. The move caused many experts to scratch their heads, given Wachovia's high-risk loan book. But Atkins is unwavering in claiming it was the right decision. Despite Wachovia's weaknesses (which were compounded by its acquisition of a large California mortgage lender right before the housing market peaked), "we looked through its problems and found an affluent customer base that represented a huge cross-selling opportunity," Atkins says.
Fixing the Hole
Nonetheless, as it struggled to absorb the acquisition, Wells Fargo saw its Tier 1 capital ratio fall 75 basis points, to 7.9%. After stress tests conducted by the Federal Reserve last May, Wells was told to raise $13.7 billion, despite already having received $25 billion through the TARP program. The bank launched a series of massive follow-on stock offerings, raising $33.5 billion in 13 months. "We got it done in a short period of time with a lot of pressure in the marketplace," Atkins said. As a result, the bank was able to repay its TARP infusion, with interest. "TARP served its purpose, and we returned a billion and a half dollars to the taxpayer," Atkins says.
Atkins is glad to have thrown off the TARP, in part because he can now turn to other matters, such as how a rise in interest rates will affect Wells Fargo's investment portfolio. To match its assets to liabilities, Wells typically buys long-duration mortgage-backed securities, but term interest rates are still at historic lows. "Even though we have a growing base of deposits, we are intentionally underinvesting to avoid the risk that rates go up and we have to take a loss," Atkins says.
The bank may face new regulatory pressure as well: it boasts a 10.8% deposit market share nationally (about the highest in the United States) and above the 10% limit created by the Riegle-Neal Interstate Banking and Branch Efficiency Act of 1994. If regulators decide to address the "too big" aspect of "too big to fail," Wells Fargo will definitely appear on their radar screen.
However, in a community-banking climate in which there are fewer competitors and credit pricing is more rational, Wells Fargo's customer focus will serve it well, says Atkins. "A lot of banks got into trouble when they drifted away from focusing on doing the right thing for customers," he says. "We never drifted."
First Horizon: Shrink Positive
Meanwhile, in Memphis, B.J. Losch, former CFO of Wachovia's general bank, was joining First Horizon National, a bank that needed to quickly rein in past excesses.
The bank typified the wild ride of the mid-2000s. In its 2006 annual report, the bank's management lauded its national mortgage business, which originated tens of billions of dollars' worth of loans yearly and could generate "new banking customers and prospects irrespective of economic or business cycles." That proved to be a bit of an overstatement, of course, and soon the subprime crisis forced the bank, which had become a top-20 originator of mortgages and a lender to homebuilders as far away as Maryland, to ditch its retail and wholesale mortgage banking offices outside Tennessee.
In late 2008, the bank accepted $866 million in TARP funds; three months later, Losch signed on as CFO. His mission: shrink the business (its balance sheet is down 32%), keep the bank well capitalized and liquid, and overcome the severe deterioration and outsized losses in its portfolios. "We shifted the emphasis from growth to returns and profitability," he says. "We had to shrink; we had no choice. We had to reduce our exposures and come back to the core we were good at."
But profitability has had to wait. First Horizon's efforts at stabilization have focused on being one of the first banks to come out of the cycle, a strategy that has entailed aggressive loss recognition. The bank now writes down large commercial loans (more than $1 million) to net realizable value. "Not only have we written down loans when they were nonperforming, but in many cases we've taken delinquent loans or loans that were still paying and have written them down," Losch says. "It causes much bigger losses much faster, but we think it's the most prudent thing to do."
The bank has a new emphasis on transparency, providing granular information to investors, customers, and rating agencies, both in print and in person. Losch visits investors often, and the bank divulges in its earnings supplements metrics such as the lien position and loan-to-value characteristics of First Horizon's home-equity portfolio.
The bank also took a hard look at its risk-management practices. Basic credit-risk evaluation got a makeover, and the practice of originating consumer loans was rebuilt. First Horizon used to have roughly 200 people in its Tennessee footprint with consumer-loan decision authority; underwriting, risk management, and pricing often differed across markets. Now the bank has centralized underwriting, and this has resulted in better quality control and pricing standardization, expense efficiencies, and faster turnaround times to the customer.
Losch also found time to address something often ignored in the crisis: employee morale. He created an employee council for the finance department focused on such issues as employee engagement, internal communication, recognition, and professional development. "Finance people see all the tough numbers and have to live with that every day," says Losch. "You can't ignore the things that make people want to come to work daily." Loyalty surveys indicate that the council has made a positive impact.
Has First Horizon fully recovered? Not quite. While nonperforming assets, charge-offs, and provision expenses have lessened, the company still posted a $71 million loss last quarter, and foreclosure and loss-mitigation costs continue to suppress earnings. Fortunately, the bank is getting a boost from its fixed-income trading and distribution business, which presents little balance-sheet risk. And core deposits rose 4% last quarter.
Meanwhile, the company is talking with regulators about the timing and method for repaying the TARP money, and also trying to gauge the potentially higher costs of increased banking regulation. Even as he grapples with those challenges, Losch says he is now able to spend more time analyzing drivers of performance — net interest margin, fee income, and customer relationships, for example — instead of being solely focused on fighting fires.
UMB Financial: No TARP Needed
As it watches other banks grapple with when and how to repay TARP funds, UMB Financial can breathe easy: it never accepted the federal infusion, and it made sure its customers knew that. When TARP was announced, the bank issued a press release detailing why it was declining the capital.
Not that UMB came through the crisis unscathed. Regulatory expenses rose sixfold in 2009, nonperforming loans almost tripled, and loan-loss provisions climbed 80%.
But over the past two years, the Kansas City, Missouri-based financial services firm, which handles everything from commercial banking to mutual-fund servicing to wire transfers, has grown its commercial-and-industrial loan book, kept charge-offs as a percentage of total loans at 0.37%, and shored up its risk management, all while staying profitable. It resisted the siren song of easy profits by not directly booking mortgage loans or buying toxic assets. "We just surpassed $1 billion in equity for the first time," says CFO Michael Hagedorn, "and we did that in arguably the worst economy since the Great Depression — while acquiring companies, buying back our stock, and increasing the dividend."
When the crisis broke, Hagedorn's first worry was counterparty risk. "Many of us questioned whether the things we believed about financial institutions were, in fact, true — were they as healthy as we thought they were?" For example, UMB settles its international securities trades with a major commercial bank. Would it be forced to find another provider? (An analysis determined it wouldn't.)
Credit risk was another concern. Would loan defaults skyrocket? In both cases, the bank's small size and old-fashioned, hands-on approach to business served it well. Assessing counterparty risk, for example, is not an activity that can be dictated from on high. "You have to dig down in your organization and find out exactly what's going on," Hagedorn says. "We told our people to go out and involve employees at all levels to make sure they understand risks in the business."
Similarly, credit risk was helped by the fact that every large, complex product goes through a loan-review group staffed by analysts and lenders with industry and business-cycle expertise. Hagedorn calls the approach fundamentally different from the "quant shops" — the large banks that put commercial credits through a credit-scoring system that determines approvals.
Far more straightforward was the bank's rejection of TARP money. The senior executive team evaluated the proposal from every angle. "Ultimately, the decision came down to principles," Hagedorn says. "We didn't think it was good public policy for any [commercial outfit] to take taxpayer dollars. And, frankly, we didn't need it."
UMB feels vindicated, in part, because of how TARP funding ultimately came to be perceived. Initially pitched by the Treasury Department as a way to send a signal of strength to the market, and as a source of funding by which stronger banks might acquire weaker ones, it has in fact proven to be the opposite. Accepting the money was widely seen as a sign of weakness, and Hagedorn says that despite plenty of effort, UMB found few potential Federal Deposit Insurance Corp.–assisted deals worth pursuing.
E-Trade: Back to Brokerage
Talk about the challenges of a new job: Bruce Nolop joined E-Trade Financial as the online brokerage and banking firm's CFO on September 12, 2008 — three days before Lehman Brothers declared bankruptcy.
Nolop, previously finance chief at Pitney Bowes, knew there were problems with the mortgage-loan investments of the company's bank, stemming from its 2001 acquisition of LoansDirect.com, but he thought E-Trade's brokerage business had enough upside potential to counteract them.
Unfortunately, after Lehman's fall, E-Trade saw its mortgage portfolio slammed by a wave of defaults and delinquencies that its internal models failed to predict. "What I thought had been a crisis past was a crisis present," says Nolop. The mortgage losses were huge — ultimately larger than the company's precrisis equity.
As Nolop worked with then-CEO Donald Layton (who has since retired) to steer the company through a recapitalization and a return to its core online-trading business, they tried to convince banking regulators that their financial plans were sound. E-Trade hoped that those same regulators would offer some assurance of their own, in the form of TARP funds. "When TARP came out in late 2008," Nolop says, "we thought, 'Hallelujah, here is a source of inexpensive capital that can really help us get through this year.'"
The firm dutifully applied for assistance, submitting financial projections and capital plans. When the Office of Thrift Supervision called on a Friday evening asking for a new plan to be sent to Treasury by Monday morning, "we spent all weekend negotiating the terms and coming up with the new financial model," says Nolop.
After all that work, however, the silence from Treasury was deafening. "We were never turned down, but we were never accepted," Nolop says. "To this day we have never had any formal communication from the government saying that we would not get TARP, or an explanation of why."
So E-Trade embarked on what it called a "self-help" program. The firm recapitalized in the third quarter, completing a deal with shareholders to exchange $1.7 billion of its corporate debt for debentures that could be converted into stock. The debt exchange spawned a $968 million third-quarter pretax, noncash loss, but it also cut E-Trade's annual corporate interest payments from about $360 million to about $160 million and pushed out all maturities until 2013.
The company also raised $765 million in common stock, including a $147 million at-the-market offering (an offering of stock directly into the market at other than fixed prices). Nolop says that management knew the stock offerings would be enormously dilutive to existing shareholders, but it felt that if they were done right and put the problem behind the company, the value of the stock should start rising from that point forward. "The cost of dilution was offset by the reduction in the risk of bankruptcy," he says.
As of mid-February, however, E-Trade's stock hadn't rallied. But the company's fortunes have gotten a boost from an influx of new customers who want more control over their investments, and it can now offer more security for deposit customers thanks to the FDIC's new $250,000 deposit insurance cap.
"E-Trade itself is a cash machine," Nolop says. The company is now focused on wooing even more customers to its core business, and investing its own cash as wisely as possible. As for a return to profitability, the company offers no prediction. Indeed, its loan losses are still larger than the profit generated from the basic brokerage business, although its provision for loan losses has decreased markedly of late. "We're still going to have significant loan losses through 2010," says Nolop. "We are past the crisis, but we're not past the problem."
Vincent Ryan is senior editor for capital markets, Marie Leone is senior editor for accounting, and David M. Katz is New York bureau chief at CFO.
NexBank: Timing Is Everything
By the third quarter of 2008, the subprime-mortgage debacle had precipitated one of the most devastating financial crises in U.S. history, as a host of questionable if not insane business practices took a collective toll on every sector of the economy.
What's a community bank to do? Why, get into the residential-mortgage market, of course. "Everybody we talked to, including our board, questioned the decision," says Michael Rossi, CFO of Dallas-based NexBank. "But we saw it as an opportunity because we knew the mortgage business would come back."
Rossi knew a thing or two about the mortgage business — and about timing. He parlayed the profits from a restaurant chain he co-founded into a mortgage company, and left that business in 2005 as he "started to see the writing on the wall." He reported for duty at NexBank three days later.
Today, NexBank originates about 300 mortgages a month, which Rossi admits is "not a huge part of our total assets, because the mortgages that we originate are sold to large aggregators that securitize them." And, in a sense, real estate still poses a headache for NexBank, primarily due to regulators' calls for more-stringent limits on its commercial real estate exposure. Fortunately, NexBank derives a significant income stream from its fee-based agency services business, a line of business that involves little or no credit risk.
As for a true return to normalcy, Rossi says it is just a matter of time. "Lenders and borrowers will just have to get sick of feeling bad," he says. "Once that happens, you'll start to see new deals." — Marie Leone