Under Siege

Washington bankers have added a grim ritual to their weekly
schedule: checking the Federal Deposit Insurance Corp.s website on late Friday
afternoons to see if any of their neighboring institutions have been taken over
and sold by regulators.

A total of seven times in 2009 and 2010eight if you count
the 2008 takeover of Washington Mutual, which technically was on a Thursdaya
Washington bank was on the weekly list (see chart at right; click for a larger view).

Thats not a huge number compared with states like Georgia,
where more than 30 banks have failed, or California, which has logged more than
20 bank failures.

But its a dramatic change from the days not so long ago
when the portfolio of problem loans at many Washington banks was almost too
small to measure, and the economic climate was healthy enough to generate new
banks almost as rapidly as fast-food joints.

Today, many of those same banks have eye-popping,
double-digit percentages for nonperforming assets (loans generating neither
interest nor principal payments, and in delinquency or default). Virtually
every part of banks portfoliosresidential real estate (prime and subprime),
construction and development, commercial real estate, consumer and credit
cardhas felt the strain of the recession. More than 20 banks in Washington are
operating under some sort of cease-and-desist order or written agreement with
federal and state regulators that prohibits unsafe and unsound practices, and
requires the banks to clean up their balance sheets.

The Seattle-Bellevue-Everett region earned the dubious
distinction of being first in the nation for the proportion of delinquent
commercial real estate loans (Tacoma was third), according to Foresight
Analytics. That picture has special meaning for banks in this state.

Unfortunately, in our market here, [with] many of the
community banks here, their portfolio is very heavily weighted toward
commercial real estate, says Rick Wirthlin, president for KeyBanks
Seattle-Cascades district. Thats what has been their downfall, frankly. Not
poor management but the fact they had a lot of exposure in commercial real
estate.

And its not over yet. More bank failuresand more anxious
Fridayscan be expected.

This is going to be a tough year, says Scott Jarvis,
director of the states Department of Financial Institutions. The pressure is
on.

But some day it will be over. The economy will eventually
recover, the banks whose balance sheets are beyond repair will have been closed
and sold off, and the survivors will resume lending.

When that day comes, Washingtons banking industry is likely
to look and operate in significantly different ways from how it did five or 10
years ago. Between what Congress has in store for us and the regulators have
in store for us and just the condition of the industry, things are going to be
very different once we get through this crisis, says Megan Clubb, president
and chief executive of Baker Boyer Bank in Walla Walla.

How so, exactly? For example:

The Washington banking market will have some new faces:
JPMorgan Chases purchase of WaMu introduced a major new player to the states
banking scene, one with much more focus on commercial banking (see chart at right; click for a larger view).

Other banks have an eye on Washington. One is Roseburg, Ore.s
Umpqua Bank, which has already bought three failed Washington banks, Seattles
Evergreen, Tacomas Rainier Pacific and Bank of Clark County. Umpqua had some
presence in the state, but as Jeff Rulis, banking analyst with D.A. Davidson
& Co. notes, Thats a drop in
the bucket [compared with] what theyre going to do up there. Thats clearly a
market theyre interested in.

Adds Dave Straus, president of Fortune Bank in Seattle,
Well have more multistate banks than we do even now. From a risk standpoint,
youre spreading your risk if youre in a larger area. In the long run, we have
a very attractive area here, so were going to attract more capital, so well
attract more banks.

The strong will get stronger: Theres going to be a
bifurcation between the haves and the have-nots, says Wirthlin. Those banks
that have been through the stress tests, that have raised capital or stayed out
of trouble in the first place, will have an opportunity to snare market share
from weaker banks.

The strong will include banks that kept the loan mix
relatively balanced, adds Rulis, and didnt go head over heels on development
loans during the boom times. That restraint might have cost them some earnings
compared to their competitors. Now, however, those more conservative
institutions are the ones with the capital to buy banks the regulators have
taken over.

Were reshaping who the ultimate leaders are, Rulis
explains. In the midsize regional category, for example, Washington Federal and
Columbia Banking System have both added to their network through acquisitions.

The major national banks arent sitting by idly, either.
KeyBank opened four new branches last year, and has four more planned this year
and seven or eight in 2011. We think its a great time to be doing it,
Wirthlin says, since real estate prices are down and landlords are more willing
to deal on leases.

Wells Fargo, meanwhile, is also looking at additional
locations, has added bankers on a regular basis and is building its business
in British Columbia, says John Rindlaub, president of the banks Pacific
Northwest region.

The new bank formation trend is kaputfor now: For two
decades, Washington could count on a steady stream of bank startups, often
formed by executives and investors who had begun and then sold the previous
round of new banks.

No more. There will be interest but for a while, there
wont be regulatory willingness to allow many small banks to start up, Straus
says. Youll have to have a very, very seasoned management team and a lot of
capital and a really good reason why there needs to be another bank.

Clubb agrees. The regulators are requiring, and have been
for the last five years or so, much higher levels of capital to start a bank;
theyre requiring in the management team a level of expertise and experience …
[and] that the president of the newly formed bank actually have been in that
position before. Its not like a junior team can break off from an organization
and start a new bank.

Just in terms of the whole profitability of a startup
operation and the expectations of the regulators [for new banks] to be
successful, I think the barriers to entry are going to be higher going
forward.

The irony is that now would be a great time to start a
community bank, Jarvis says. Youve got an absolutely clean balance sheet.
Youve got the pick of the applicants. Its going to be a while before the next
wave comes in, but Im confident were going to have additional waves.

But until we do, the net effect of acquisitions and no
startups, Straus says, is that theres going to be considerably fewer banks in
this state either through consolidation or failure. The good news is theres
capital flowing into the industry that is going to allow the stronger banks to
absorb the weaker ones. Youre going to have fewer banks but healthier ones
when we get through all this. I dont know that thats all going to be
completed in 2010. It could take a couple of years. While I dont like to see
any banks fail, its something we have to get through in order to have a
healthy financial system.

Creditespecially for small and midsize businessescould be
harder to come by: The banking crisis has moved on from the big national
players to community banks, and thats worrisome to Baker Boyers Clubb.

Megan Clubb, CEO of Baker Boyer Bank in Walla Walla, says community banks will be well-positioned for the coming economic recovery, even while the regulatory environment remains uncertain.

The importance of community banks for small business and
economic recovery is still being overlooked, she says. As community banks
numbers are reduced and consolidations and mergers occur … the bigger banks are
gobbling up some of the community banks. I really think that the regulators
need to get a clear strategy on how theyre going to replace the supply of
loans [from community banks]. … The lending capacity thats being lost needs to
be replaced, and the big banks are making it pretty clear that its not a market
they are considering in the way they structure their system. Those banks
operating under more intense regulatory scrutinyand for Washington that means
many of its community banksare not as able to support their clients, she
adds.

Ive got to believe in the near term [credit is] going to
remain pretty tight, says D.A. Davidsons Rulis. With interest rates as low as
they are, banks may be reluctant to do much lending when better rates of return
are available elsewhere.

Community banks will go that next layer of risk down that
larger banks are not willing to do, says Brad Williamson, director of
Washingtons Division of Banks, adding that rates and terms wont be as
favorable to borrowers as they have been.

Thats not necessarily a bad thing, in terms of the banking
systems overall health, he adds. Credit has been amazingly available and
cheap for the last five to seven years.
… Banks have not been pricing for risk for 10 years. Theyve been
pricing to stay in the game. Its going to be a lenders market in terms of
price and terms. Banks should price for risk.

Consensus is not universal on this point. Weve been
absolutely wide open for business the last couple of years, says Wells Fargos
Rindlaub. Although credit may be harder to find if you dont have a good
story, for healthier companies, the story is much the same as it is with
banks: The strong will get stronger. For the companies that ran themselves
conservatively during the good times, now they have liquidity, they have a good
bank and they have capacity, so they can look at taking market share because
they can be more aggressive. They can look at acquisitions.

For businesses that can demonstrate an ability to pay,
banks have always been willing to lend, even through this cycle, adds Fortune
Banks Straus. One area of expansion hes seeing: companies taking advantage of
low real estate prices to buy the buildings they occupy.

Borrowers should expect more scrutiny, more paperwork and
more collateral: Even those who can get credit are going to find things are
not like two years ago when there was no verifying of income when you got a
mortgage, Wirthlin says.

Notes Rindlaub, It probably is more difficult today, in
that a number of institutions tightened up their standards. Perhaps before they
would not have required a guarantee from the owner; today, theyre requiring a
guarantee. Before, they would have required one covenant. Now, theyre
requiring three covenants.

Again, thats not necessarily a bad thing. Explains Straus,
Banks have been just a little more traditional in the way they analyze credit
because theyve been getting back to the basics, to understanding the cash flow
of the borrowers and understanding what their first source of repayment is and
what their second source of repayment is. We got into an atmosphere where you
could almost not make a mistake. That wasnt a healthy atmosphere. He cites a
banking-industry adage that has been proven to be all too true lately: Bad
loans are made in good times.

Regulators may get
new powers to back up what theyre advising banks to do: One of the problems in
banking regulation that the current crisis has unveiled, DFIs Jarvis says, is
that it tends to look backward. Our powers kick in when the trouble has hit
the fan, he says.

Regulators can warn banks about potentially troublesome
trends, but those warnings dont carry the force of law.

Such was the case, he says, with the concentration of
lending in construction and development loans that now has so many community
banks in trouble.

That was a sector that, as long as it kept growing,
returned wonderful returns to these guys, Jarvis says. But as we all know
from our personal investments, diversification is smart and some folks didnt
diversify. When times are good, regulators are not in a position to go in and
order people not to make money. We warn them about concentrations. We warn them
about other issues. We try to stay on top of managements capabilities and
checks and balances. But the reality is when its a healthy world out there,
the last thing a regulators in a position to do is to say stop making
money.

Whatever form legislative changes to bank regulation take,
theyre likely to address the issue of how do we have more forward-looking
enforcement tools, Williamson adds. I would expect hard rules rather than
guidance, either in the way of statutes or tougher rules interpreting current
legislation.

Clubb says a changing regulatory climate is already having
an effect. If you talk to any of my lenders right now or the head of my
compliance area, the amount of material coming across their desks prescribing
changes to their processes is huge. I think the energies and efforts need to be
focused on the nonregulated banks right now that got us into this trouble as opposed
to adding layers of regulation and complexity, which really bogs down
opportunities for community banks to provide loans so really needed right now.

One other regulatory change Williamson figures is likely:
Banks will be required to accumulate more capital. There is no replacement for
tangible capital, he says. That, in turn, could add to a tightening of credit
availability.

Whatever the form of change for banking, most agree that it
will take time for the industry to recover fully. Clubb says shes struck by
the anger she hears directed at the industry. Weve got to build trust again,
she says. We can only do that by giving good advice.

Wirthlin sees some signs of mending, both in the economy
generally and in banking particularly, but he quickly cautions thats not the
same thing as proclaiming the latest banking crisis to be over and done.

There is a clear distinction between
recovery and recovered, he says. Were not close to being recovered. Were
slowly recovering.

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