March 9, 2009

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Banking and Finance

March 9, 2009

The economy has everyone from Wall Street to Main Street on edge these days. Local financial experts are advising to stay calm and think long term when making financial decisions. Our experts also discussed the pros and cons of the Troubled Asset Relief Program (TARP), media portrayals of the economic situation and financial opportunities that still exist. We’d like to give a special thank you to Hal Heaton, BYU professor, for moderating the discussion, and to Holland and Hart for hosting the event. Participants: Jim Anderson, Bank of Utah Kelly Matthews, Wells Fargo Damon Miller, U.S. Bank Jim Smith, Bank of the West Matt Krull, J.P. Morgan Jeff Thredgold, Zions Bank Hal Heaton, BYU Ed Leary, Department of Financial Institutions John Beckstead, Holland & Hart Frank Pignanelli, Utah Association of Financial Services Sheila Camarella, Key Bank Howard Headlee, Utah Bankers Association Curtis Taylor, Heber Valley Bank Robyn Martinez, J.P. Morgan In general, what do you think about the current economic situation? Are we headed toward a depression? MATTHEWS: The implications of this [economic] situation have gone far beyond what anyone could have ever imagined as recently as a year ago. And, there is any number of ways we can attempt to try to figure out what went wrong and whether we are on the correct path or not to correct it. Did we learn enough from the Great Depression or by watching Japan’s situation when they got caught in a deflationary credit crunch? Did we learn enough to avoid that kind of situation or is it possible that we are going to continue to face something like Japan did? I don’t believe that is the case. We are doing everything that the policymakers can think of. Whether it’s exactly the right thing and how soon it will work, we don’t know. Personal confidence has been seriously disrupted. The amount of inappropriate lending and, therefore, excessive debt up and down the entire economic spectrum was extreme and, of course, it’s very hard to wave a magic wand and change that excess debt and excess leverage. But, we’re doing most everything that we can think to do. Under the best circumstances, we’re probably going to have a full year of economic difficulty. Hopefully, there are some seeds of improvement available out there at some point and we will begin to work our way through this situation by the end of this year. THREDGOLD: We’re going through a whole dismantling and dismembering of this financial house of cards constructed over the last five to 10 years with housing as its base. The actions that the Treasury, the FDIC and the Fed is doing—nobody wants to be doing that stuff. The numbers that are involved in terms of spending or the explosion in the fed’s balance sheet—none of it is the first choice of anybody. It’s done really, honestly, by necessity. And, it’s the lesser of two evils. The greater evil is for the Treasury or the Fed to have sat back and done nothing and watched this whole credit issue just take us even farther and farther down the tube. There will be horrific deficits for the next few years, but potentially it’s the lesser of two evils versus what the other alternative might have been. KRULL: I think Kelly [Matthews] and Jeff [Thredgold] have made some great points, and the thing that I’d like to emphasize is the speed at which our government has implemented its fiscal and monetary policies. It took Japan roughly eight years to make the moves that we were able to make in interest rates as well as fiscal policy in 18 months. The speed at which the federal government has acted, in addition to what works policy is implemented via the Obama campaign, are going to have a much better outcome for our economy looking forward in the next 12 to 18 months than would have been had we reacted more slowly. THREDGOLD: We’re going to be reading about this [economic] stuff in the history books over the next 20 years. But, is this the biggest threat since the Great Depression? I think one of the things that will develop is the idea that on the weekend of September 18 when Ben Bernanke and Treasury Secretary Paulson essentially announced that the sky is falling and publicly and emotionally said we need the $700 billion—that may have been a mistake. If you look at the employment data that came out in the last year, but especially in the last four months, we’ve lost employment 12 months in a row. In January through August we were running about a loss of 60,000 jobs, 80,000 jobs, 90, 100 and so on. When you look at the last four months, averaging almost 500,000 jobs a month, Wall Street knew there was a problem. The financial community knew there was a problem. But, the consumer didn’t necessarily know that the problem was as severe and pervasive as it was. And that weekend and the next week of House votes and Senate votes to pass this $700 billion program scared the heck out of everybody and led to the economy notching down again and raised the anxiety level perhaps even higher than it needed to be. HEADLEE: As it relates to Utah, I think Jim [Thredgold’s] perspective captures the situation pretty well. First of all, it’s important to note that the word “bank” is being thrown around with reckless abandon. The institutions I hear referred to as banks on the national media are not banks, and so a lot of the public is being poorly educated on what a bank really is. So, when people criticize and use the word “bank” far too liberally, it’s a real disservice to the public because a lot of people don’t realize that they can still walk into their local bank and get a loan. HEATON: Creating that fear is dysfunctional in that if people believe that the economy is headed south, they stop buying. If they stop buying, producers stop producing. They lay off. The layoffs scare consumers more and it creates this downward cycle so they spend even less. How has the current economic stress affected your institution? ANDERSON: [Bank of Utah] is a pretty small fish in this pond, but we’ve always had strong underwriting in our lending and will continue to do so. We don’t find our borrowers or prospective borrowers coming with as much glimmer and gleam in their eyes as they used to, so they are much more practical. And, it’s relatively the same process as we go forward with our borrowers in this economy because they are nervous too, and they are not going to take chances that they used to take. So, we think there is some pretty good business to be done, and if we keep our head on straight, we’ll be just fine. MILLER: Utah certainly is not immune this time from the downturn. We are seeing residential building permits hitting lows that probably have not been seen since just after World War II. So, there is a dramatic shift of what is going on in Utah, and that drives so much fundamental business. However, we [U.S. Bank] are finding plenty of good business to do. And all of our advertising nationally says, “U.S. Bank, open for business.” But, of course, it is a very cautious period. THREDGOLD: It’s alarming how hard Utah has been hit in the last six to eight to 12 months. Utah essentially led the nation in 2006 and 2007 in percentage growth in employment adding roughly 40,000 jobs a year. We’ve gone from that to being in a recession. In the most recent 12 month period, we are down almost 12,000 jobs versus a year ago. Economy.com is projecting a 2.7 percent loss in employment in 2009, which would correspond to about a 30,000 decline in net employment in 2009. So anybody who thinks Utah is an isolated community not impacted by what goes on outside of our borders, it’s just not the case. As bad as we’ve been hit, Idaho has been hit hard. Idaho’s unemployment rate a year ago was 2.7 and right now it is 6.6. The whole region has been hit hard. The sexy places to buy real estate the last five or six years—Arizona, Nevada, California, Florida—they are all in deep recession. But now the pain is in roughly 40 states that are in recession right now, and Utah right now is one of them. CAMARELLA: What’s positive about the economic situation is it has opened the doors for a lot of communication, whether it is the consumer or in our arena. Whether you are a large bank or a community bank, the challenge right now is communication with your clients. I think that we will come out of this with better informed, better educated consumers, but it is going to be painful. And, while, yes, you can walk into any one of our institutions and still apply for a loan, there are a lot of people that a year ago could get any loan they wanted who are now finding that they cannot get all of the loans that they want because of their credit scores. A year or two ago, when we used to sit down with a small- or mid-sized business owner and really try to explain the importance of good, quality financial statements, many thought they were a couple pieces of paper that were totally unnecessary. They expected us to give them the money and let them run their business. Now when we sit down and have those relationship reviews and really go through what the financial condition of their company is and what it’s going to take to help them stay in business and grow, we’re having much more open dialogue. So as painful as this economy is, I welcome it in terms of where I see relationship between banks and their customers. Overall, those who survive are going to come out of this strong. And those who, unfortunately, lived on the edge may not survive. What unique steps are you taking to communicate with and educate your clients? CAMARELLA: There is a lot of fear and a lot of times business clients will not tell you what they are afraid of. They almost don’t want to “flaunt” their ignorance. They are afraid to ask questions because the bankers may think, “Wow, how are you going to be around in a year?” So, it is our challenge to get out to the business clients that we serve and really help them say, “Look, what is keeping you up at night? What is the pain?” MARTINEZ: From a wealth management perspective, we definitely are advising our clients differently. Our world has definitely changed. I’m a banker and I used to lead with credit, but we are not doing that right now. We are assessing the entire relationship to make decisions or to decide loans based on whether individuals have investments with us and whether they have deposit accounts with us. That has changed drastically in the past year. KRULL: When you look at a client’s balance sheet these days, you are seeing a lot less leverage. Lending is decreasing significantly. From an investment management perspective, this is providing opportunities for some of our clients. As many know, there has been a discrepancy in municipal bond prices due to the need in liquidity from some institutional managers. We’re providing opportunities to our clients via the municipal market. We also feel that some highly rated debt from institutions is providing good opportunities for our clients. A lot of this debt is being underpriced and sort of the baby out with the bathwater kind of a concept. So, there are a number of opportunities being presented to our clients and changes in clients’ balance sheets from a wealth management perspective. How has regulation evolved considering the economic climate? LEARY: [The Utah Department of Financial Institutions] is spending much longer in most examinations. There’s a greater focus concentration on asset quality and the methodology for determining the allowance account for loan and lease losses (ALLL). Also, we are spending a tremendous amount of time on the models or the methodology for internal controls. At times like this, weaknesses manifest themselves. As a result, regulators are taking more supervisory actions than they historically have. About a year ago, problem banks were down in the 60s and 70s nationally. The last number I saw was up more than 200, and that number is expected to continue to grow throughout the remainder of 2009. So, that’s definitely not good news from a regulatory perspective. But, even in these times, I would still represent that a majority of banks, as Chairman Behr continues to say, are still profitable, still doing well and still serving the needs of their customers. From the bankers’ perspective, regulators are definitely more conservative in their calls than they have been and probably today’s conditions warrant a different view on a number of things. Where you could have had a little bit of trust or faith in credit, now the examiners are questioning those credits extensively and probably not grading them as well as they once we were. And that’s indicative of the time and the repayment schedules and what we are seeing. How have credit standards changed? SMITH: Is the economy an indictment of our current lending policies or our previous lending policies? A few years ago there was a lot of pressure to do a lot of loans and we all got into some bad habits, and even then [Bank of the West] was much more conservative than some of the non-banks. I know our bank has people who come to us and say, “Man, you are not doing the same loans you did nine months ago.” That is correct. And if you remember, nine months ago we were being severely criticized for these loose credit standards. So now we’ve tightened the credit standards more to where they should be. Overall, though, [Bank of the West] has been very conservative all through this and now it is paying off. Our fundamentals are still very basically strong. We are back to where we should have been all along. BECKSTEAD: The impact of that correction is severe, whether we are going back to where we should be—which I think most agree we are—it’s going to be a painful process getting it corrected. It will not be smooth sailing to get to where we need to be. SMITH: I hope it’s not falling off a cliff, but going down a relatively steep incline to bringing us down to where we probably should be. We’re seeing a down, but not a dramatic down. It is starting to bottom out. Borrowers are coming to us much more intelligent than they were a year ago, and they realize the challenges that they face. You know, it’s not just the bank putting their money at risk. It’s me putting my money at risk. Residential real estate has been hit hard. Is commercial real estate the economy’s next big victim? CAMARELLA: I am concerned in terms of some of the smaller retail developments that we have seen, both here in Utah and nationally, and the effect of those as some of the smaller businesses. If small businesses were not well capitalized enough going in and they decide, “I can’t hang on any longer,” that will have a domino effect. However, this is an opportunity for all of us to learn from this situation and move forward. The economic situation has provided tremendous opportunity to take the next generation of commercial lenders and get back to truly the strong fundamentals of what makes commercial lending strong and viable. BECKSTEAD: Loans are still being made, and there is a lot of business to be booked, but it’s being done in a different way that has a ripple effect that I don’t think we are all appreciating. I had a conversation about a month ago with a fellow who has a real estate development company. He is a national player who develops big shopping centers and hotels and resorts. He said that he used to be able to borrow $50 to $100 million with zero to 10 percent down. Now, he has to have 30 to 50 percent down. Before, he could easily borrow $15 million and build a big shopping center. Now, because of the amount of equity he has to put up, he can only borrow $5 million. So, instead of building a big mall complex, he’s building a grocery store. There are ripple effects of that. His move now hits the construction industry, so there is less work there. That, then, ripples through so many things. While there is business being done, it’s a cutback and a reduction in many respects from what we have seen in the past. MILLER: There are groups that are putting together pools of funds to go out and take advantage of commercial real estate, specifically because there are precipitous declines in values of commercial real estate. It doesn’t change hands nearly as often, so it doesn’t get the visibility that the residential markets do, but there certainly are some opportunities there. What about retail? How hard is it being hit? THREDGOLD: Approximately 181,000 [retail stores] closed last year across the country and we’re going to expect something comparable if not even more than that next year. If you look at the whole area of retail spending and all the strip malls and all the development that takes place in a very easy lending environment, and when you take away the availability of easy credit and take a consumer who is going to tone it down the next five years and save more than spend in many cases—there is probably 10 to 15 percent of existing retail space we simply don’t need and that will probably fall by the wayside and the loans supporting those businesses will become problem loans. MATTHEWS: I agree, but if you compare [retail stores closing] to what happened in the residential real estate situation and what led to all of this securitization and the Wall Street debacle from those mortgage-backed securities, to me, it’s a totally different world. We’ve been through commercial real estate problems and we have to get through this one. But, it’s not even in the same world as what led to this situation from the residential mortgage situation. What do you think of the Troubled Asset Relief Program (TARP)? How has taking or not taking TARP funds affected your institution? HEADLEE: The TARP program has been a political nightmare. For example, the first $350 billion of the TARP is being labeled a “bailout.” There is no bailout. The vast majority of the money has gone in the form of capital purchase. These are investments that are made in healthy banks. They will be paid back with interest over time. By labeling it a bailout, what the national media has done is desensitized the public to what is happening now. We are now discussing a fundamental change in what Congress is doing with this money. We are moving from an investment to expenditure. But, because the first investment was portrayed as a bailout, give away expenditure, the public is desensitized to the fact that we are discussing a fundamental difference now under this administration where a lot of that money is going to be spent. So, it’s not a bailout—it’s an investment. It’s going to be paid back with interest over time. And if you wonder where the money went, there are Websites that list every institution and how much [TARP money] they got. Now, what started as a fairly decent economic proposal to stabilize and support the banks’ balance sheets is turning into a train wreck, frankly. And I warned everybody who took the TARP money that Congress is going to start meddling and start adding strings and they are going to start telling you how to do your business. That is where we are going to have a real economic problem. MILLER: [U.S. Bank] took $6.7 billion in TARP money. We were the last of the 20 major banks to take that money. And there was an awful lot of subtle peer pressure within the industry to make sure that the top 20 banks that were in healthy condition or at least reasonably healthy all took the money. And so we did. We really didn’t need the money, but we took it and now we have to pay it back at 5 percent interest. THREDGOLD: The top nine [banks] had no choice [to take the TARP money] TAYLOR: The community banks had a choice, and I think there has been a concern among the community banks that if a bank applies there could be a stigma. And, if the bank doesn’t apply there could be a stigma. So which way should a bank go? That confusion is exacerbated by the fact that the rules were changing day by day. So, even as the deadlines approach for applying for the TARP money, the rules were changing and term sheets were ambiguous and so forth. Most community banks, such as ours [Heber Valley Bank], thought, “We better hold our place in line. We better file the application and be in the queue and then as the rules are solidified and maybe some of the definition is forthcoming on the economic environment, the real decisions can be made.” But community banks have had a choice. It’s important to note, however, that any bank, large or small, would rather not have the government sitting at their table and assisting them with decisions. And we all have been around long enough to know that there will be strings coming with [the TARP money]. What we don’t know is how bad the environment is going to get, and all of us have been saying, “Maybe we’re willing to pay an insurance premium to have that in our pocket as a reserve.” THREDGOLD: Assuming we move toward some level of economic growth again in a couple of years and somewhat return to financial normalcy versus where we are now, I think one of the big surprises to the Congress will be how fast banks pay this money back. It’s a 5 percent rate for five years. It jumps to 9 percent after five years, so there is already an incentive to pay it off. And, the taxpayers will make money from this deal. When they bailed out Chrysler 29 years ago, the taxpayer ultimately made money. In terms of the government having warrants on stocks, when you return to a more normal economic environment, the government makes money on the stocks. And, that will have the effect of reducing deficits down the road. HEADLEE: One piece of information that is critical for people to understand is that we are not lending the TARP monies. That is not how banks work. That is our capital and by raising our level of capital, we can then go out into the marketplace and leverage it up 10 times by collecting more deposits, which then are lent out. So, the multiplier here is phenomenal. Together, we can stimulate our economy if people will bring their deposits home to Utah institutions, so we can put those monies to work in our local economy. CAMARELLA: But, there are also reports that banks are using that to go out and acquire additional banks and build their banks. So, the taxpayer is being leveraged so banks can take this bailout money and grow their institutions, which is really irritating to hear. ANDERSON: We have not been very excited to sign up for government money. We have not been able to figure out how you make an economical transaction out of it. It’s expensive money. Our bank would have to expand the size of the bank significantly to make that an economical situation for us. And in the economic environment we are in, that is very difficult to do. So, we’re not very excited about jumping in bed with the government. How have Utah’s industrial banks been affected by all of this? PIGNANELLI: A number of our great industrial banks felt pressure to take the TARP money—just as the top 20 banks [felt pressure]. But, in order to take the TARP money, industrial banks had to change their way of doing business, since they cannot be a state chartered industrial bank. So, Utah lost several of the larger industrial banks through this, either because they have taken the TARP money or they had to restructure because of other elements, and that is a shame. It’s a shame for the Utah economy because industrial banks have done a lot to promote jobs here, but also because of CRE programs. There is a larger concern than just industrial banks and the diversity of banking services. There is going to be discussions in Congress of whether you can mix commerce and banking together. And I can’t think of a better way to get capital into the banking system than to mix commerce and banking. But overregulation is an issue—there is a threat of over-regulation in Congress. But, there will be industrial banks left here in Utah. In fact, we are still receiving calls from people interested in forming an industrial bank. And maybe what will happen is Congress will take that industrial bank model and say this is one way to get capital into the marketplace and use industrial banks as a model for doing that. HEADLEE: My concern is that we will move toward a less diverse financial services industry when the diversity of the American financial services industry has been what I think has made America great—the small banks, the big banks, the different types of banks serving different needs of different people. The industrial banks are part of that diversity, whether other banks want to recognize that or not, we cannot say, “We like diversity, but only our kind of diversity.” So, when you embrace diversity and you accept it as an important part of the American economy, you have to embrace all of the diversity and the industrial bank industry is part of that. LEARY: My whole career as a regulator has been an endorsement of diversity of financial services products and the manner in which they are delivered. I believe in a fundamental safety and soundness that the federal deposit insurance or federal insurance conveys to those institutions. But, the whole industrial bank experience is that you establish the fundamentals. Are there concerns with the manner in which they can do business? That was the first thing: to identify risk and threats and try to prescribe prudential standards that counter some of those. We put in place here in Utah some standards we thought countered perceived threats and risks with commercial parents having a bank within their family of companies. PIGNANELLI: You can have innovative financing whether through industrial banks or the other banking systems. But, you can have innovative financing and also have firm, but fair, supervision and regulation. What was happening in some of these other entities was manipulations of the system, not innovation. A lot of people made investments based upon very sound principles that these things are triple A rated, etc. So, when they start looking into it, the people that purchased these and that sold these based upon these ratings, you wonder if there any type of lack of scrutiny on their part. If the word comes out that we cannot have innovation, then you will see a super regulator at the top. And that is my concern, because at risk after the industrial banks are going to be the community banks, because we just need to consolidate into five or six major institutions across the country, and that is a concern that we need to have because a lot of the innovations have come about through community banks or these other innovative banks. Our mantra in Congress is safe, innovative ways to provide Americans accessible credit. If you could say one thing to banking services’ users, whether to individuals, small businesses, developers or others, what would it be? What should they know about Utah banks, especially considering today’s economy? CAMARELLA: Capital is king. De-pending on what stage you are in the business’ life cycle, it’s truly maximizing the capital that they have available and preserving. It takes good, solid business sense in terms of running tighter ships in those businesses and then preserving those profits within the company to continue that company’s growth. TAYLOR: The real estate industry and housing has been a huge part of the financial picture in the west, and especially for community banks. And those folks need to understand that asset based lending was successful for so long. Repayment of which depends upon the sale of the asset being improved or developed is not as reliable as it used to be. And, the banks and their regulators are expecting those borrowers to have other sources of repayment, some sort of back up plan, because things are not selling. And that is a big paradigm change for folks in the real estate industry. SMITH: We [Bank of the West] are doing a lot of lending. We are not out of the lending business and we are not out of the deposit gathering business. And, the bank is not the enemy. Sometimes people look at us and think, “Man, they said no.” Sometimes “no” is absolutely the right answer. They come back to us and say, “Gee, you don’t do the same innovative old loans you used to do.” Those innovative loans are really not new. It’s just that we used to call them “bad” loans back in the day. KRULL: From a private wealth perspective, we advise our clients to use leverage wisely, take advantage of the lowering interest rate environment that we are going to be in here over the upcoming months. And also from an investment market’s perspective, take a look at some of the anomalies that are out there right now because it’s providing great opportunities for long-term investments.
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