Banks Recovering but Still Face Rough Times

Smaller banks are in healthier shape than big ones, but they need an economic recovery to grow their income.

By Renuka Rayasam, Associate Editor, The Kiplinger Letter

May 18, 2009

It's true, the banking sector is recovering. Investors are no longer pummeling share prices. Government stress tests revealed a badly damaged but still viable cadre of big banks, and those results shored up confidence. Some banks, notably Goldman Sachs, even plan to repay federal government rescue funds shortly. "One of the things that happened is that the tests provided a level of certainty," says Kevin Petrasic, a partner in the financial services group at Paul, Hastings, Janofsky & Walker LLP. "At the end of the day, we could see a rising tide that raises all ships because now everyone knows what the challenges are."

Still, there's a long, bumpy road ahead. Scores of banks remain doomed to fail. At least 60 more, mostly smalls, will fall this year. About three dozen have already succumbed in 2009. Across the Sun Belt and in hard-hit industrial states such as Ohio and Michigan, tanking home mortgages combined with rising joblessness spell more trouble. "As painful as it is for smaller banks to fail, it doesn't bring the whole system down," points out Matthew Anderson, partner at Foresight Analytics LLC.

Commercial real estate woes will take a toll. Cracks in these loans are just appearing as leases are allowed to lapse when tenants go belly-up or seek cheaper digs to survive the recession. Commercial mortgages account for 23% of assets on average for banks valued at less than $100 billion versus 7% for bigger institutions, according to Foresight.

And higher Federal Insurance Deposit Corporation (FDIC) assessments will sting, taking a bite out of banks' precious capital cushions. "Last year, we paid $8,000 for FDIC insurance," says Terry Jorde, CEO of CountryBank USA in North Dakota. "This year, we could pay up to $150,000, and that takes away from our ability to lend."

Big banks will have to sell their way out of trouble, shedding ancillary lines to salvage their core business. Bank of America plans to put First Republic Bank on the auction block, as well as Columbia Asset Management and Bank of America's stake in a Chinese bank. Regions Financial and Fifth Third Bank will slim down as well. "You'll see a scenario where the big banks will need to sell off more of their quality assets to raise capital," says Walter J. Mix III, managing director in the Los Angeles office of LECG, a global consulting firm.

Also a scramble for new profit centers to replace securitization markets, which contributed from 10% to 15% to revenue just a few years ago, but add only 3% to 5% now, says Chermaine Lee, analyst at Celent, a financial services consulting firm. In 2006, the total value of issues hit $2.3 trillion, according to Thomson Reuters. So far this year, the issuance of mortgage and asset backed securities has hit only a paltry $89 billion.

Some banks are finding rays of sunshine through the clouds, though. There are great growth opportunities for those strong enough to take advantage. Look for U.S. Bancorp, JP Morgan Chase, Wells Fargo, Goldman Sachs and others to snap up bargain priced units that generate deposits and fees. "We are coming to a point where winners and losers are being separated," says Nathan Stovall, senior industry editor at SNL Financial.

Among smaller banks, jittery customers are flooding those perceived as stable with deposits. And stronger banks are luring top-notch loan officers and commercial business from troubled rivals, including bigger banks. Louisiana's MidSouth Bank, for example, is aggressively marketing in an effort to pluck customers from Regions Financial, which needs to raise capital. "We are seeing tons of opportunities because big banks could never service customers," says MidSouth CEO Rusty Cloutier.

Sustained industry growth is a few years off and depends on the economy. Indeed, the availability of credit will return faster than demand for it. Already some more-aggressive banks are eager to lend but are finding few qualified and interested borrowers. "There has been a tremendous shift in people's attitude," says Cloutier. "But if you are healthy right now, we really want to do business with you." Most banks won't be able to grow their way out of the hole they're in until business spending picks up.

"The crisis is going to have a significant impact on the philosophy of banks in terms of what kinds of risks they are willing to take part in," says Rodney Nelsestuen, senior research director at TowerGroup Financial Strategies.

By 2011, we expect a healthier, but chastened and more conservative, bank industry.

For weekly updates on topics to improve your business decisionmaking, click here.