With narrowing margins and a growing regulatory burden, there are plenty of reasons for community banks to throw in the towel and sell to competitors, but there's one overriding reason: To make money for their shareholders.
The banking industry survivors are still building capital, as they await regulators' final set of rules to implement the Basel III rules. This is the powder for an expected wave of industry consolidation, which has been held back by relatively low stock valuations.
Many small and regional banks' boards of directors facing limited returns on their investments have, or will have, numerous reasons to sell:
Lingering Credit Problems Threatening Capital
In his firm's Bank M&A Weekly report on Monday, KBW analyst Timur Braziler said that while "the overall health of the banking industry continues to improve ... there remain 350 banks that have a Texas ratio of greater than 100 percent with total assets of $191.6 billion."
The Texas ratio is a bank's ratio of Tier 1 capital and loan loss reserves to its nonperforming loans, and considering the drop in collateral values over the past five years, a ratio of more than 100 percent offers quite an incentive for many banks to look for stronger acquirers.
V. Gerard Comizio — the chair of the Global Banking practice of Paul Hastings, based in the firm's Washington office — says that community banks that need additional capital will find it very difficult to remain independent. "Only the biggest of the community and regional banks will have access to private equity and the capital markets," he said.
Dodd-Frank
The Consumer Financial Protection Bureau was formed under the Dodd-Frank Wall Street Reform and Consumer Protection Act, and according to Comizio, "there was a misperception on the part of community banks that they would not be regulated by the CFPB if they had less than $10 billion in total assets. In some ways, they will face an even worse regulatory burden than the larger institutions, because the CFPB's requirements will be enforced by the community banks' everyday regulators, which really have something on the line."
Because the consumer protection aspects of Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency supervision are now under the umbrella of the CFPB, Comizio said it is likely that "you are going to see the primary regulators of the smaller institutions be pretty vigilant in enforcing CFPB regulations."
Lenders large and small will also be affected by the "skin in the game" rules under Dodd-Frank, which send banks "back to the future," according to Comizio, in requiring lenders to retain a significant piece of the risk when they securitize residential mortgage loans or sell commercial loans into syndication or participations.
"You can imagine that to the extent that largest banks are feeling the regulatory requirements," Comizio said, but "the smaller institutions are feeling them even more, since they do not have the scale to deal with them.
Another major factor, especially for savings and loan associations, is their transition from being regulated by the Office of Thrift Supervision, which was folded into the OCC in October 2011. "There are pretty tough examinations for the first cycle or two, as the regulators turn over every stone they can," Comizio said.
Thrift holding companies are also "subject to a much more hands-on regulation under the Federal Reserve's rules and under Dodd-Frank, as the OTS tended to focus much more on the thrift subsidiary itself," according to Comizio.
A Hostile Rate Environment
With the Federal Reserve keeping its short-term federal funds target rate in a range of between zero and 0.25 percent since late 2008, most banks have already seen most of the benefits of lower funding costs. Meanwhile, the Fed is doing everything it can to keep long-term rates at their historically low levels, which leaves most banks with narrowing net interest margins as loans reprice. Banks are also looking to keep the maturity of their securities investments short, so they can take advantage of better opportunities when rates eventually rise again.
Goldman Sachs analyst Kris Dawsey on Wednesday wrote that "based on our economic forecasts the Fed may purchase up to $2 trillion in Treasury securities and MBS under QE3, before the first fed funds rate hike in early 2016."
The Federal Reserve Open Market Committee itself has said that it "anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015."
This means that banks will continue to feel the margin squeeze for years, and in order to grow earnings — and support higher stock prices — banks have to ride the mortgage loan refinance wave, grow their commercial loan portfolios, and cut expenses. For many of the largest industry players, the continued release of excess loan loss reserves has been padding earnings.
Wells Fargo, for example, saw its third-quarter net interest margin narrow by 25 basis points from the second quarter, to 3.66 percent, leading its net interest income to decline to $10.7 billion from $11.0 billion the previous quarter.
Meanwhile, Wells Fargo's earnings rose to 27 percent sequentially to $4.9 billion in the fourth quarter, as it released $935 million in loan loss reserves. The company also saw an increase in gains from trading activities, while its third-quarter mortgage banking revenue totaled $2.8 billion, declining slightly from $2.9 billion the previous quarter, but increasing 53 percent from a year earlier.
Compliance Expenses
Challenges to banks large and small include an increasing compliance reporting burden, with the Consumer Financial Protection Bureau expected to issue rules requiring more detailed sets of data, without taking away any of the existing, often arduous rules.
Examples of costly ongoing compliance headaches for community banks include the Community Reinvestment Act (CRA) and the Home Mortgage Disclosure Act (HMDA). CRA is meant to keep banks from "redlining" geographic areas for lending, in order to prevent discrimination, as well as encourage banks to reach out to all communities in their geographic footprint. Donations in a "predominantly minority neighborhood" or "to any minority depository institution or women's depository institution," can help an institution meet its CRA requirement.
HMDA requires banks to report to regulators a large set of data for every residential mortgage loan applicant, including gender, income level, race, ethnicity, interest rates and spreads to prevailing industry rates, and location, along with information on the credit decision, especially if the loan application was denied. Sounds simple, right? It's not. There's a reason that the Federal Financial Institutions Examination Council calls its 120-page HMDA reporting guide "Getting It Right!" The exclamation point is theirs.
CRA and HMDA were passed with some good intentions, but it can be quite difficult for banks to report the data correctly, requiring extensive staff training each year. Dodd-Frank modified HMDA to increase the scope of data that banks are required to report, and the Consumer Financial Protection Bureau not only "will require banks to compile and report additional HMDA data and HMDA-like small business loan data," it "has broad authority to require reports or 'other information' from any bank at any time," according to the American Bankers Association.
ABA senior vice president Richard Riese said that the CFPB's new HMDA and CRA reporting requirements "will not get ahead" of the Bureau's current focus on mortgage rules and disclosures, and that "there is better than a 50/50 chance that the additional data won't be collected until 2016 [for the year 2015], because the amount of additional requirements is so extensive, especially on the small business side."
Riese expects the CFPB to propose regulations for HMDA and CRA reporting in 2013, but finalizing the rules will take additional time, following public comment periods, because "you never really understand all the consequences until you see final language and begin to implement."
Buy-Rated Bank Takeout Targets
KBW maintains a "consolidation list" of publicly traded banks that they think might be selling for various reasons. Five of the names on last Monday's list are "buy"-rated, and none of these are threatened by high Texas ratios. Here they are, in ascending order by upside potential, based on KBW's price targets:
5. Boston Private
Shares of Boston Private Financial Holdings closed at $9.23 Friday, returning 17 percent year-to-date, following a 22-percent return during 2011.
The shares trade for 1.7 times their reported Sept. 30 tangible book value of $5.49, and for 12 times the consensus 2013 earnings estimate of 75 cents a share, among analysts polled by Thomson Reuters. The consensus 2014 EPS estimate is 80 cents.
Boston Private had $6.3 billion in total assets as of Sept. 30. The company reported third-quarter earnings of $16.5 million, or 19 cents a share, improving from $14.2 million, or 17 cents a share, in the second quarter, and $11.7 million or 14 cents a share, during the third quarter of 2011. The sequential earnings reflected a decline in provisioning for expected loan losses. The third-quarter provision was a negative $4 million, compared to additions to reserves of $1.7 million in the second quarter, and $4.5 million a year earlier.
Net interest income declined 1 percent sequentially but rose 3 percent year-over-year, to $46.4 million in the third quarter. The third-quarter net interest margin was 3.11 percent, narrowing from 3.35 percent in the second quarter, and from 3.25 percent a year earlier, however, Boston Private said that the margin "in the third quarter was negatively impacted by a short term deposit that inflated Average Assets," while in the second quarter, the margin was inflated because of "pre-payment penalties and the recovery of nonaccrual interest income."
CEO Clayton Deutsch said that Boston Private had "implemented a senior executive restructuring that will enable us to save in excess of $5 million per year of senior executive costs."
Following Boston Private's earnings announcement, KBW analyst Christopher McGratty raised his price target for the shares by 50 cents to $10.50, saying "we got what we been hoping for on the expense side — an incremental $10 million of reductions which should be realized over the course of 2013." The analyst estimates the company will earn 81 cents a share in 2013, followed by 2014 EPS of 86 cents.
After spending last "Wednesday in Baltimore with CEO Clay Deutsch," McGratty said "while there's no hiding from the fact that margins are likely to remain under pressure, we also believe BPFH is nearing a stage of capital deployment which, to this point, may not yet be on investors' radars."
Boston Private is currently paying a nominal quarterly dividend of a penny a share. McGratty expects the company to raise the dividend to a nickel early next year, and wrote on Wednesday that "taking it a step further, even with an additional hike in the dividend in 2014 to $0.07/qtr we are left in a position where BPFH ends 2014 with [a tangible common equity ratio of 8.4 percent], giving them about 100bps of capital flexibility, by our estimation."
Investors could then see the company deploy excess capital through acquisitions or "a share buyback perhaps as soon as 2014."
With analysts' estimates showing only a slight increase in earnings from 2013 to 2014, the return of a meaningful dividend might not be enough to stem pressure on Boston Privates board of directors to throw in the towel, sell the company, and cash out.
4. Oritani Financial
Shares of Oritani Financial of the Township of Washington, N.J., closed at $14.60 Friday, returning 22 percent year-to-date, following an 8-percent return during 2011.
The shares trade just below their reported Sept. book value of $15.05, and for 17 times the consensus Fiscal 2013 EPS estimate of 84 cents. The consensus Fiscal 2014 EPS estimate is 86 cents.
Based on quarterly payout of 15 cents, the shares have a divided yield of 4.11 percent.
Oritani Financial had $2.8 billion in total assets as of Sept. 30.
The company on Nov. 20 announced a 40-cent special dividend to shareholders of record as of Nov. 30, payable on Dec. 14.
Many companies are paying special dividends or even moving up the payment dates of their fourth-quarter dividends, in anticipation of the possible expiration of the 15-percent federal income tax rate limitation on qualified dividend income. Under the current rules, if an investor's adjusted gross income keeps him or her under in the 15 percent tax bracket, the investor actually pays no federal taxes on the dividend income, so nearly all investors could see a massive new haircut to their dividend income, unless President Obama and leaders of Congress come up with a compromise to avert the "fiscal cliff."
Oritani CEO Kevin Lynch said that "the likelihood of increased tax rates on dividends in 2013 makes a special dividend at this time particularly appealing," and that "the amount of the special dividend is loosely based on the difference between our earnings per share and our dividends per share since we completed our second step transaction" to full stock ownership in June 2010. Following second-step conversions, thrifts are generally unable to agree to a takeout deal for three years.
Oritani's fiscal year ends on June 30. Following the special dividend announcement, KBW analyst Brian Kleinhanzl wrote in a research report that "the special dividend, when added to our existing capital return assumptions, equals 150 percent of our 2013 earnings estimate. That is certainly a hefty payout ratio, however, the company was very solidly capitalized, reporting a ratio of Tier 1 capital to average assets of 19.0 percent, as of Sept. 30.
The company reported that it had repurchased 11,159,700 since June 2011 through Sept. 30, at an average price of $13.00. Oritani had roughly 1.8 million remaining in authorized shares for repurchase, as of Sept. 30.
The company has had, by far, the strongest earnings among the five names from KBW's Consolidation List discussed here, with an operating return on average assets (ROA) of 1.24 percent for the 12-month period ended Sept. 30, according to Thomson Reuters Bank Insight, however, Oritani's return on average tangible common equity for the same period was a relatively low 6.81 percent, reflecting the excess capital.
Kleinhanzl said on Oct. 25 after Oritani reported its fiscal second-quarter results that the company had continued to achieve "strong loan growth," and that "ORIT should be a core holding for investors seeking growth plus capital returns through dividends and buybacks." The analyst's price target for the shares is $17.00, and estimates the company will earn 84 cents for fiscal 2013, followed by EPS of 88 cents in fiscal 2014.
3. OmniAmerican Bancorp
Shares of OmniAmerican Bancorp of Fort Worth, Texas, closed at $22.74 Friday, returning 45 percent year-to-date, following a 16-percent return in 2011.
The shares trade for 1.3 times tangible book value, according to Thomson Financial Bank Insight, and for 27 times the consensus 2013 EPS estimate of 85 cents. The consensus 2014 EPS estimate is $1.10.
OmniAmerican converted to full stock ownership in January 2010, so the company's board of directors will be able to consider selling the company early next year.
The company had $1.3 billion in total assets as of Sept. 30, and reported third-quarter net income of $2.3 million, or 22 cents a share, increasing from $1.4 million, or 14 cents a share, in the second quarter, and $1.0 million, or 10 cents a share, in the third quarter of 2011. The earnings improvement reflected an increase in gains on loan sales to $941,000 in the third quarter from $501,000 the previous quarter, and $380,000 a year earlier. The company also reported 762,000 in gains on the sale of securities during the third quarter.
A bright spot for the third-quarter was that the net interest margin expanded to 3.30 percent during the third quarter, from 3.15 percent in the second quarter, although the margin had narrowed from 3.40 percent a year earlier.
KBW analyst Brady Gailey wrote on Oct. 26 that "OABC reported a strong quarter with 15 bpts of NIM expansion, propped higher by shrinkage in the bond book and paydowns of higher cost borrowings," and said that with the company not buying back any shares during the third quarter, he continued "to believe OABC could be worth around $28/shr in a sale."
Gailey estimates that operating independently, OmniAmerican Bancorp will earn 85 cents a share in 2013, with earnings growing to $1.10 a share in 2014.
The analyst said that "a sale of the company is likely in the near term," and that "we believe OABC's Dallas/Ft Worth geography will be attractive to many."
2. Sierra Bancorp
Shares of Sierra Bancorp of Porterville, Calif., closed at $10.51, returning 22 percent year-to-date, following a 16-percent decline during 2011.
The shares trade for 0.9 times their reported Sept. 30 tangible book value of $11.98, and for 14 times the consensus 2013 EPS estimate of 74 cents. The consensus 2014 EPS estimate is 92 cents. Based on a quarterly payout of six cents, the shares have a dividend yield of 2.28 percent .
Sierra Bancorp had $1.4 billion in total assets as of Sept. 30. The company reported third-quarter earnings of $1.6 million, or 12 cents a share, declining from $2.6 million, or 18 cents a share, in the second quarter, and $2.5 million, or 18 cents a share, in the third quarter of 2011. During the third quarter, the company's provision for loan loss reserves increased to $4.7 million, from $3.2 million the previous quarter, and $3.0 million a year earlier.
CEO James Holly said in the company's Oct. 22 earnings announcement that the elevated provision for loan loss reserves reflected "continued efforts to push problem assets toward resolution, as announced in our first quarter earnings release and as evidenced, in part, by a significant level of charge-offs against specific reserves established for losses on nonperforming loans." The company reported that its nonperforming assets declined to $48.7 million as of Sept. 30, declining from $51.1 million the previous quarter, and $71.5 million a year earlier. Nonperforming loans made up 3.41 percent of total loans as of Sept. 30, improving from 4.49 percent in June, and 7.41 percent in September 2011.
Sierra Bancorp's average loans increased 7 percent sequentially to $814.0 million in the third quarter, but the company cautioned that "loan growth this year has been concentrated in a component of commercial loans known as mortgage warehouse lines, and growth in those balances is highly dependent on refinancing activity."
The company also warned that it "could continue to experience a relatively high provision for loan losses and elevated charge-off levels as it continues to work on reducing impaired assets."
KBW analyst Jacquelynne Chimera said on Oct. 22 said that Sierra Bancorp had "attractive branch network and deposit franchise," with "the no. 1 market share position in the Visalia-Porterville MSA," and said "we continue to believe the company would garner an attractive multiple of book in a sale if it were to choose to find a strategic partner." Chimera's price target for Sierra Bancorp is $13.
The analyst estimates that Sierra Bancorp will earn 75 cents a share in 2013, increasing to EPS of 85 cents in 2014.
1. First Defiance Financial
Shares of First Defiance Financial of Defiance, Ohio, closed at $17.01 Friday, returning 18 percent year-to-date, after a 23-percent return during 2011.
The shares trade for 0.9 times their reported Sept. 30 tangible book value of $19.29, and for 10 times the consensus 2013 EPS estimate $1.73. The consensus 2014 EPS estimate is $1.64. Based on a quarterly payout of a nickel, the shares have a dividend yield of 1.18 percent.
First Defiance Financial had $2.1 billion in total assets as of Sept. 30. The company reported third-quarter net income applicable to common shares of $5.4 million, or 54 cents a share, increasing from $3.2 million, or 32 cents a share, in the second quarter, and $3.6 million, or 36 cents a share, in the third quarter of 2011. The main factor in the earnings improvement was a decline in the provision for loan losses to $705,000 in the third quarter, from $4.1 million the previous quarter, and $3.1 million, a year earlier.
The company's third-quarter ROA was 1.06 percent and its return on average tangible common equity was 11.70 percent, according to Thomson Reuters Bank insight.
First Defiance continues to operate under a memorandum of understanding (MOU) with the Federal Reserve, requiring regulatory approval before the company pays dividends on common shares.
KBW analyst John Barber said on Nov. 15 that "we believe FDEF has positive momentum following strong Q3 results and that its valuation should increase as earnings visibility improves," and that "the shares remain attractive given its above-peer profitability metrics."
Barber's estimates that First Defiance will earn $2 a share in 2013, and his price target for the shares is $22.00. The analyst said that "removal of its outstanding MOU and capital return to shareholders also remain near-term catalysts."
—By TheStreet.com's Philip van Doorn
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