Stephen Clinton, President,Capital Market Securities, Inc.

04/2010

2009 in Review
Pressure on the banking industry continued in 2009 as the damaging impact of the collapse of the housing bubble and the recession caused many banks to continue to record massive losses. Bank pricing declined further in the early part of 2009, before recovering over the later part of 2009. For the year, bank pricing declined 18.5% (as measured by the Nasdaq Bank Index).

There were many in early 2009 who were concerned that our financial system was on the verge of falling apart and that we were on the precipice of a depression. The Federal Reserve took dramatic steps to strengthen the financial system. The new Obama administration and Congress passed a $787 billion stimulus program in early 2009 to infuse the economy with new cash. TARP infusions into banks and others continued in 2009. Bank regulators conducted highly-publicized stress tests of the major banks to estimate the capital they might need to keep from failing. Wall Street and private investors stepped in to provide the capital for the major banks failing to meet the net worth stress test levels. The chart to the left illustrates the dramatic decline in bank pricing from February 20, 2007 through the end of 2009 where bank investors saw a loss of approximately 50% in the value of their holdings. The chart also reflects the stabilization in bank pricing beginning in the middle of 2009.

First Quarter 2010
The general stock market, and the market for bank stocks in particular, enjoyed a good first quarter in 2010. The chart on the next page provides pricing information for general market indicies compared to the Nasdaq Bank Index.

Economic Review

Manufacturing – The U.S. manufacturing index in March registered its best reading since 2004. U.S. auto sales surged 24% in March, helped by a strengthening economy and hefty buyer incentives offered by most manufacturers.

Employment – U.S. employers created jobs at the fastest pace in three years in March. However, nearly one-third of the employment gains were the result of temporary hiring for the Census.

Consumer Spending – Consumer spending, which makes up 70% of demand in the U.S. economy, increased 0.3% in February.

Housing – Home prices in 20 U.S. cities rose in January, providing support for reports that the housing market is stabilizing. The Case-Shiller National Home Price Index climbed 0.3%, matching the increase recorded in December. Sales of existing homes fell 0.6% in February despite lucrative tax credits available to home buyers. Investories of existing homes were reported at a 8.6-month supply at the current sales pace.

Deficit – As of February, the federal government’s fiscal year-to-date deficit was up 10.5% from fiscal year 2009. In February, the government ran its largest ever monthly deficit – $221 billion. The costs of the government’s stimulus programs, along with shrinking revenues due to the weaker economy, has created the large deficits.

Interest Rates – The Fed, to soften the recession, has maintained a highly accommodative policy holding interest rates to historically low levels. Additionally, the Fed has ballooned its balance sheet through the purchase of government debt and mortgage-related securities. The Fed owned $2.0 trillion securities, compared to $497 billion at the beginning of 2009. The Fed ended its program of buying mortgage-backed securities in March, a program begun in 2008 designed to support the weak real estate markets. The program has been given credit for lowering mortgage rates by as much as a percentage point. Mortgage rates are expected to move upward as a result of the end of the Fed’s buying program.

The economy is on the mend. The recession is over, as shown by the January Commerce Department’s announcement that gross domestic product rose a seasonally adjusted 5.7% annual rate in the fourth quarter. Most economists are predicting a slow recovery. It has been estimated that American households lost as much as $14 trillion due to the financial downturn. This loss of wealth is anticipated to constrain consumer spending for the foreseeable future. High levels of unemployment will also keep 2010 economic growth in check.

Concerns for Bankers in 2010

Politics – It has been two years since Bear Stearns collapsed. In that time we have faced the worst financial crisis since the Depression. Millions have lost jobs, housing prices have plummeted, and investors have lost trillions. In response to the banking industry’s responsibility for the crisis, the Senate Banking Committee passed a sweeping financial regulation bill in March. The bill addresses the formation of a consumer protection watchdog, “too big to fail,” transparency and accountability for derivatives and other exotic instruments, streamlined banking regulation, and financial industry executive compensation. When legislation is enacted, the far reaching implications of the final bill will impact every banker.

Commercial Real Estate – Declining values on commercial real estate looms as the next risk to banking. It has been reported that $650 billion of commercial real estate loans are coming due over the next four years, with $150 billion maturing in 2010. It is estimated that 43% of the loans due in 2010 exceed the current value of the properties they secure. The decline in the value of commercial real estate makes restructuring many of these loans difficult.

Interest Rate Risk – The cost of bank funding has benefited significantly by the low interest rate environment. While the Fed is expected to remain accommodative for some time, it is inevitable that interest rates will increase. Banks that have not taken actions to properly structure their balance sheets may suffer in a rising rate environment.

FDIC Insurance Premiums – In total, 140 banks and thrifts failed in 2009, and 41 additional banks were closed in the first quarter of 2010. In 2009, the FDIC entered into 115 government-assisted transactions with a cost to the deposit insurance fund averaging 28% of the failed institutions’ assets. The FDIC has offered loss-share agreements about 70% of the time in purchase and assumption agreements to entice buyers of failed banks. The aggregate cost to resolve failed banks may require additional special assessments in addition to the three-year prepayment of FDIC premiums paid by banks in 2009 to strengthen the insolvent FDIC insurance fund.

Freddie Mac and Fannie Mae – The Obama administration remains unsure how to address the GSEs. Fannie Mae and Freddie Mac were taken over by the government and put into conservatorship in September 2008. The ultimate decision on the resolution of the GSEs could have a significant impact on bank mortgage lending activities and potentially present opportunities.

TARP – Over 700 financial institutions participated in TARP’s Capital Purchase Program. Total distributions to financial institutions participating in the CPP totaled approximately $300 billion. Approximately $150 billion has been repaid. SNL Securities has estimated that, for companies that have fully exited TARP including settlement or government sale of their warrants, the government earned an 8.5% annualized return. On the negative side, 74 TARP participants missed their February dividend payment. The Congressional Budget Office estimates that the cost of the entire TARP program will be $109 billion. The bulk of these losses are expected from non-banks including AIG's $36 billion, and the auto manufacturers' $34 billion. The general public perception of the bank “bail out” from TARP and the associated cost to U.S. taxpayers are misconceptions that must be addressed by bankers.

2009 Merger and Acquisition Activity
Consolidation of the banking industry, which slowed in 2008, slowed even further in 2009. In 2009, there were 122 merger transaction (exclusive of bank failures), compared to 159 deals in 2008. This lowered activity compares to the 288 deals announced in 2007. The median price to tangible book for transactions involving bank sellers was 117%, with a trailing twelve-month price to earnings multiple of 18.2. The price to book multiple is down approximately 27% from 2008.

Bank Market Pricing - March 2010
As of the end of March, the Dow Jones Industrial Index rose 4.1% in 2010, compared to the Nasdaq Composite Index’s rise of 5.7%. The banking sector improved even more, with the Nasdaq Banking Index posting an increase of 13.1%. Banks benefited by the general belief that the loan losses are coming to an end and that bank profitability for 2010 will significantly improve.

Stephen Clinton, President, Capital Market Securities, Inc.

12/2009

Market Update
The U.S. economy ended the recession with the third-quarter GNP growing 3.5%. The strength of the recovery remains of concern as government pro¬grams designed to stimulate the economy near their end. The following issues highlight certain areas of the economy that merit watching:

• Unemployment - The jobless rate reached 9.8% in September, its highest level in 26 years. Unemployment is expected to remain high for some time as employers are expected to be hesitant to hire new employees until further strengthening of the economy is evident.
• Interest Rates - Short-term interest rates remain at historical lows while long-term rates have increased approximately 150 basis points since year end. Banks have been the beneficiary of lower rates as net interest margins have widened.
• Commercial Real Estate - Economists, among others, continue to express con¬cern over declining commercial real estate values due to the struggling economy. Capmark, one of the largest real estate lenders, filed for bankruptcy protection in October. Capmark, formerly the commercial real estate lending division of GMAC, was principally a lender on office towers, strip malls, and hotels. Vacancy rates at malls and shopping centers have risen to multi-year highs.
• Home Sales - Home sales in September climbed to the highest level in two years. Purchases jumped 9.4%. Partial credit for the improvement was being given to the first time homebuyer's tax credit that was scheduled to expire. (In October, legisla¬tion was being discussed to extend and/or expand the homebuyer’s tax credit.)
• Federal Reserve - The Fed has ballooned its balance sheet to $2.1 trillion from $870 billion prior to when the credit crisis began. The Fed has purchased close to $1 trillion of mortgage-backed securities since the start of the year, driving down mortgage rates. As the Fed plans to exit from this buying activity and ultimately move to reduce its holdings of mortgage-backed securities, where mortgage rates go is uncertain.
• Oil Prices - Oil prices rose 9.1% in October, ending at $77.00. Oil inventories have moved to near the highest levels in decades as the recession has significantly reduced the demand for oil. Short-term interest rates ended October with the 3-month T-Bill ending at 0.05%, down from 0.11% as of December 31, 2008. The 10-year T-Note as of the same date was at 3.41%, compared to 2.25% at year end 2008. The yield curve has steepened as long-term rates have moved up more than longer-term rates.

As of October 30, the Dow Jones Industrial Index had risen 10.7% in 2009, com¬pared to the Nasdaq Composite Index’s improvement of 29.7%. The banking sector, conversely, declined, with the SNL Banking Index posting a decrease of 3.2%.

Merger and Acquisition Activity
Through October 31, 2009, there were 102 bank and thrift announced merger transactions. This level of activity is lower than in prior years. The median price to tangible book for transac¬tions involving bank sellers was 124% with a trailing twelve-month price to earnings multiple of 19.5. These multiples compare to 160% and 23.4 respectively for 2008. There have been 115 bank failures so far in 2009, the most since the savings and loan crisis in 1992.

Stephen Clinton, President of Capital Market Securities, Inc.

07/2008

It should come as no surprise to bankers that the credit crunch has taken its toll on financial institutions. Banks have been hit with loan losses, lower lending volumes, and higher loan loss provisions, leading to declining profitability for the industry. Market prices for banks have nose-dived as a result.

It was not too long ago that banks were flush with capital, and access to the capital market was welcomed. Banks routinely adopted share repurchase programs to lower their net worth ratios. Dividend payouts were regularly increased. Trust-preferred security offerings frequently provided banks with an alternative source of capital to fund growth. The capital market viewed the financial services industry in a favorable light.

Shareholders and regulators have become more focused on capital adequacy, as the credit crisis has worsened. We regularly hear about examiners demanding higher provisions for loan losses and strengthened capital positions. We have seen the prices of banks plummet, as rumors of the need for additional capital surface. In the second quarter, banks and thrifts raised over $90 billion in capital. Approximately 20% of the capital raised was common stock, preferred equity totaled 45%, senior debt totaled 23%, trust preferred securities was at 9%, and subordinated debt was at 3%.

The vast majority of the capital raised in the quarter was by major banks. Citigroup itself raised 23% of the total. Major banks have also announced reductions in dividends in another effort to preserve capital. Others have resorted to selling assets to generate capital or to shrink their asset base.

Community bankers must be prepared for the heightened focus on capital adequacy. Lower earnings will provide less capital than in prior years. Higher losses and a struggling economy will lead to higher loan loss reserve requirements. Access to the capital market will be more expensive and dilutive and, for some, unavailable.
We encourage community bankers to increase their attention on capital issues in their budgeting and strategic planning processes. With a higher scrutiny on capital by regulators and investors, issues surrounding profitability, growth, dividend policies, and capital contingency plans require increased focus. We are prepared to assist financial institutions evaluate these issues. For more information, please contact me at 1.800.376.8662 or click here to send an Email.

Stephen Clinton, President, Capital Market Securities, Inc

04/2008

Bank directors are charged with a variety of responsibilities. Shareholders expect the directorate to represent their best interests. Regulators demand that directors assume responsibility for the bank’s operation in a safe and sound manner and in compliance with a myriad of consumer protection regulations. The bank’s customers expect the directors to lead the bank in a manner where the bank operates as a good citizen, promoting the welfare of its community by providing for the market’s credit and investment needs. Employees want the directors to maintain their jobs and to promote a good working environment.

Should You Sell?

With responsibilities to such a diverse collection of parties, the role of a director can become very cloudy when the bank begins to consider whether the time is right to consider a sale. In a perfect world, the analysis should be straight forward. A bank is a corporation owned by its shareholders.
Therefore, the board of directors should compare the economic impact on the shareholders of a sale with the economic impact on the shareholders of remaining independent.

Typically, when considering a sale, the bank will employ a financial advisor to assist the board in evaluating a sale. The advisor will conduct an analysis of the financial prospects of the bank remaining independent and make an assessment of value implications to shareholders. Often, a range of values might be forecast using a variety of projection assumptions. Giving consideration to various risk factors, the advisor will compare the projected financial implications to an estimate of the sale value of the bank.

In my experience as an advisor to banks conducting such an analysis, rarely is the sale decision made based solely on what is the “best” financial alternative to the shareholder. Considering the variety of parties that directors represent, it is not surprising that other factors beyond the shareholders’ economic interest become involved in the decision matrix. The sale analysis typically evolves from a financial analysis to a judgment call.

The following examples detail instances that a bank decides to remain independent, even though the financial analysis indicated that shareholders would economically benefit from a sale:

• The board of directors is controlled by management. This may be the result of the recruiting process of directors where they feel an obligation to management for their positions, the level of ownership held by management, or due to other factors. Often, management may base their position regarding a sale on personal factors and on how a sale might impact them, the bank’s customers, and/or its employees, rather than from a shareholder fiduciary perspective.
• The board lacks a meaningful ownership position in the company. In this case, it is easier for directors to accept substandard bank performance or base their sale decision on other factors rather than shareholder best interest.
• Directors often “fall in love” with their prestigious positions and consider their personal position in the community derived from being affiliated with the bank. Two considerations typically surface: 1) directors don’t want to be the one to sell the local bank and 2) they don’t want to give up their status.

Young & Associates, Inc. is a bank consulting firm that is a strong advocate for community banking. We believe that community banks can operate successfully for the foreseeable future and strive to assure that we provide the support to help our clients remain independent. However, we also recognize that there are banks that should be seeking merger partners.

The profile of such bank sellers include the following:

• Banks experiencing regulatory problems where the resolution of the issues appears unlikely
• Banks who regularly fail to achieve average industry performance results
• Banks with weak management that are unwilling to upgrade management with proven leaders
• Banks that have achieved their corporate goals and lack the ambition or desire to reach for new goals
• Banks that are not competitive in today’s sophisticated financial marketplace and lack the resources to bring themselves up to a competitive level or are unwilling to make such a commitment

The Value of Strategic Planning

We believe that banks should regularly conduct strategic planning. The strategic planning process often includes an unbiased assessment of the sale analysis. Banks that believe in the strategic planning process and achieve their stated goals find the sale analysis typically leads to the conclusion that a sale is not in the shareholders’ best interest. Reaching a sale decision within this corporate philosophy becomes relatively simple for a director.

For banks that are not regularly assessing the decision concerning a sale, we encourage them to begin such a process. Board members should insist that this process be conducted as it provides evidence that the bank is focused on its fiduciary duty to shareholders. If the bank desires to avoid a sale and hopes not to be confronted with activist shareholders promoting a bank sale, the bank should become aware of the factors that require attention to justify continued independence. Thereafter, the directorate should monitor progress toward addressing such factors.

If you have questions about this article or would like to discuss our conducting an independent sale analysis for your bank, please contact me at 1.800.376.8662 or click here to send an Email.