Tim: Okay. We’re on today with Chris Marinac of FIG Partners, a community bank specialist, research, and investment firm. Chris, thanks for spending a little time with us, and as we all know, the community banks have been pretty exciting since the election. What do you see as we go into the new year in the community bank space?
Chris Marinac: Well, I think the companies are very healthy, Tim, from a fundamental perspective. The capital is strong. They do have loan growth. The deposit growth, for the most part, has been solid. We think the liquidity at these companies is very good in many respects. These companies have more money to lend, in that we can see the cash and securities balances coming down, and loan balances go up. That’s gonna be positive for revenue and positive for margins. So I think it’s a pretty healthy time. And as I mentioned, credit is in very good shape, and I think that is always important, because credit tends to be what hurts the banking industry the most, and right now, we’re in a pretty good spot.
Tim: Okay. Do you see that credit possibly worsening in 2017? Bankers keep telling me that credit can’t possibly get any better, and then quarter after quarter, it keeps getting better. What can happen, economically, to change that?
CM: So the banks are a mirror of the communities they serve, Tim. So, if local economies were to deteriorate, then credit will get worse. I think the attitude among businesses is stable to improved, and that actually is gonna, I think, increase spending. And as businesses increase spending, potentially, change hiring plans, even if it’s modest, it should actually spill over into more loan demand, which actually would spill over into better credit. I think, on a selective basis, you’re always gonna have flare-ups that happen. There were individual situations where companies or borrowers have one-off incidents that occur. Sometimes, those get extrapolated. I think we had that happen with Opus Bank, of the past quarter or two, where some credit issues were extrapolated into a much bigger issue than probably exists, and that company, most likely, creates stability in the next quarter or two and proves that out.
CM: I think, in other instances, we’ve seen a lot of energy-related issues that are now going to get cleaned up in terms of the initial recognition has already been done. The problems that exist and the write-downs that are needed will occur, Q4 and the first half of ’17, and we’ll move on to another issue. And as long as energy prices stay where they are now, I think a lot of that has sort of been identified and should work its way through the system. So, the ongoing, incremental problems just aren’t out there. The level of past dues, the level of substandard loans for those banks who report that information, are very low. The charge-offs, most importantly, are very low. I think it will take time for that to develop that. If it does become more of a credit cycle developing, it occurs more in ’18 and ’19 than I think it occurs in ’17.
Tim: Okay. And I take it, you’re not seeing any bankers make a come 2006 brand or stupid loans at this point in the cycle, are you?
CM: Well, “stupid” is always a relative term, and so, compared to what we see today, we see, if anything, more examples of banks taking undue risk in terms of interest rates, where they’re fixing loans for five to eight years. Sometimes, they’re properly hedging those loans, perhaps with a federal home loan bank instrument, or other long-term CD, but typically, they’re not. And so that would be the only example of sorta stupid that I feel is out there. I think, credit in terms… We’ve seen those terms and structures sort of weaken and lessen over the last couple of years. It will just take another probably two years to fully develop into issues. But again, the good thing is that banks have earnings, they have capital, they can handle those issues, and we’re seeing that. Again, I use the Opus incident. Opus can handle the issue and address it and move on, and that’s a sign of health, it’s a sign of strength. Even though it’s unfortunate those things happen, they can handle it and move on.
Tim: Okay. Now, of course, the big question on everybody’s mind, and really the driver of this rally since the election, how does the regulatory environment change next year? What are your thoughts on that? Because I’ve heard everything from probably not gonna really change much at all ’til they’re just gonna rip Dodd-Frank up and throw it away. Where do you come in on that one?
CM: Well, regulatory change took a long time to be implemented, and I think it’ll take a long time to be broken down. I think that this will be a year where the regulations are known, that there’s no new rules that are put on, with maybe a couple of exceptions, which I’ll talk about. I think it’s gonna sort of be steady as she goes. I think the big picture question which has engaged investors who do look out longer than the next six to 12 months is that the direction of regulatory is towards reform. It is towards reducing Dodd-Frank, it’s towards perhaps rethinking how we treat the regulatory process. And that’ll be changed in, I think, 2018, 2019, there’ll be a lot more subtle than it is direct. I think looking for Dodd-Frank to be repealed or Glass-Steagall to change, that’s really unlikely. I think it’s more of an attitude shift that occurs over the time, and I think we don’t see much change on that in the next year. I think bank examinations are gonna be pretty much the same that they are now.
CM: In fact we’ve seen a slight increase, what I would say I call regulatory incidents where there’re banks who have been cited for not having as strong of a BSA, bank secrecy, or the AML, anti-money laundering, standards are strong as the Fed and FDIC want. A couple of companies have to correct those. They should be able to handle it with no issue, but it’s just an example that the regulators are still watching. I think regulation is gonna be a much more of a modest and slow change. But attitudes investors really is what’s changed, and I think the attitude is that the regulatory environment is going to get better. Even if it’s a 2019 event, it is getting better, and therefore they have a better ability to make a commitment to invest dollars in the space.
Tim: Now, an interesting thought, and this just popped into my mind this morning because I saw an article that a group of guys are actually starting a bank in Austin, Texas. They had previously started one in San Antonio. Does the changed perception of the regulatory environment perhaps see the return of De Novo banks?
CM: So there’s a new De Novo in Texas, as you mention. There’s a new De Novo in Atlanta, that we’re aware of. I believe there’s one or two on the West Coast that may come eventually. The regulators had already been becoming more open towards a handful of De Novos. Even if the election didn’t change the attitude of regulation, I think that these De Novos were going to happen. I think if anything the regulatory bodies had wanted to demonstrate that they’re at least willing to do a couple. I still think a couple is the operative word. I don’t think it’s gonna be a land shift. I think that the attitude towards new De Novo banks is definitely much different than it was in 2003-2006, that era where we had hundreds of new banks. I just don’t see it coming back to that.
CM: The capital might be there, but I think the structure of what regulators want, and the straitjacket that they put new banks under is going to make it more conducive for existing banks to re-capitalize or reset their business plans, and that becomes the de facto De Novo.
Tim: Okay. Now, how about your outlook for M&A activities? M&A has been very strong in the last few years with regulatory costs with the smaller banks being often cited as a reason. Does M&A slow down if there is some sort of regulatory reform, or is this more of a secular trend that’s just gonna keep going?
CM: I think it’s definitely a secular trend. I think M&A is here to stay. I think if anything, M&A accelerates because of higher prices. Currencies really drive M&A. What happens over time is that stock prices tend to have wider dispersion in terms of their valuations. That is beginning to develop, and I think it will continue to occur as 2017 unfolds, and what that means is that there’s a bigger spread on the price-to-tangible-book, and as that happens, the buyers distinguish themselves from the sellers, and more transactions can happen.
CM: There are still many boards of directors who I would say are tired by the environment. They certainly were scared by what went on during the financial crisis years, and they remember what it felt like. And when they’re given an opportunity to come out at a reasonable price, and particularly when they can take strong currencies from the buyer, I think there’s enough banks who will say yes and take that on. I think the decision was made a long time ago that they would like to sell. It was just a question of when they could get a reasonable price. This is still an ego game, and the egos don’t like when they have to take a low price, and something that is seen to be less than a real market bid. Now, that pricing has come back, I think egos can very much be massaged into feeling good about a particular M&A transaction, and that the pricing is much better.
CM So I still think the number of M&A deals will be higher at ’17 versus ’16 and ’15, and I think that there are gonna be some banks who decide not to sell because they feel a little bit less pressure from the regulations. But honestly, I think there’s enough boards who want to get a transaction done because the pricing is better, and that they can get a price that they can be happy with and feel good about. That’s where I think the ego comment is important ’cause I think this is an exercise in human behavior as much as it is finance.
Tim: Okay. That’s an excellent point. And I’ve talked about tired board syndrome for some time, and I think especially those with older boards and officers, I think they’ve wanted out for a long time, and I think you’re quite correct about the pricing environment making it a lot easier for them to do so. Now, regulatory cost has been cited as one of the big issues in the industry, but more and more it looks to me like a lot of banks are facing some serious technology spending challenges. Can you comment on that?
CM: It’s a great point, Tim. It’s interesting. I meant to mention, and I’ll mention it here, the concept of cyber security in the regulatory framework is awfully important. In fact, I would say that cyber might drive certain companies out of the business, A, because the regulators are as serious as a heart attack about banks and boards of directors being all in on cyber. That’s in spending, and it’s also just an attitude commitment that you have to be vigilant 24/7 on cyber security, and you have to be on guard, and if you’re not, that’s gonna create regulatory decimation where there’s gonna be chiefs of companies who just can’t take it, and they have to move on.
CM: So I feel like the cyber and the tech spending is still a real topic, and that if anything, companies might be investing savings that they’re getting on taxes… If we get tax reform, or frankly better spreads, which I think are going to happen, you might see companies taking the revenue from a better margin, and perhaps stronger net income because of taxes, and reinvesting some of those profits back into technology spending to not only make sure that they’re in line with the rest of the Jones’, but also that they’re ahead, that they can anticipate the problems. The cyber issues, large and small are still out there.
CM: And I hate to say this, but I believe it’s gonna be proven true that it’s gonna take an incident of public knowledge knowing that banks had issues and that they had to respond. It’s always worried me that only BBT and JP Morgan are the two most vocal banks about cyber. We haven’t seen enough banks being vocal about what they spend and how they do it. And I think unfortunately an incident’s gonna have to change that. I hope it doesn’t happen, but history suggests that that’s the type of thing that creates change in the industry. But again, I think there are plenty of boards who recognize that the regulators are not gonna let go of cyber, nor should they. And I think the new president is just as committed to cyber as anybody else out there.
Tim: Yeah. And the thing is, when you talk to the bankers and you talk to the cyber security guys, the guys on the other side of the equation, this technology is not cheap and it’s ongoing. Because every time you block one sort of attack, well the bad guys come up with another one and you gotta spend some money to tackle that one. It’s not a one time thing. It’s an ongoing thing. And I think a lot of bankers are daunted by it.
CM: Unfortunately, you’re 100% correct. This is the time of the year, the holiday season, where the cyber criminals are very active. The fact that you had Christmas on the weekend may have helped, but by the same token, it will be interesting to see what comes out. Last year, there were several banks who got targeted with debit card scams galore. And it was an unfortunate nuisance but it’s all wrapped up into the whole cyber security arena of discussion.
Tim: Yeah. You talked about the banks needing to disclose it more and it’s interesting that you said that because at our conference in Dallas last year, I found out that at these conferences you learn an enormous amount sitting at the bar. [chuckle] One fellow who was on the board of a not big bank, like 500 million, said that they average 10,000 attempts a day. Whether it be phishing or trying to commit fraud or just crack through the firewalls, 10,000 attacks a day at this small little bank. And I think this is much more widespread than people realize.
CM: No, it is. And I think that the email fraud is rampant as well. There’s not a CEO or CFO who hasn’t told me that they get emails all the time requesting to wire funds. It’s almost becoming comical, that their internal people know that we have to follow up with a phone call in multiple ways to get money wired internally to pay vendors just doesn’t come because a CEO asks via email to wire some money, X dollars. That unfortunately continues to be a good example of incidents that are occurring in the industry.
Tim: Okay. Now, as long as we’re on technology, the FinTech threat, how real is it? Are they really gonna make banks obsolete?
CM: Oh, I don’t think so. I think we see banks who are continued to be focused on branches because it’s the center point of how to do business. A branch is not just a place to go in and get a cup of coffee and a donut and to make a deposit. It’s really a way that you know a bank is in your neighborhood. And I think we’re gonna see banks in 2017 on a select basis really use the branch for a very strong purpose, which is as a marketing tool in the area. Having it be a first class facility, in a first class street corner, but using that as the epicenter for their own calling effort. Where they’re going out and calling on people individually so that that personal relationship, one on one, still occurs. And it’s not necessarily at the branch but it originates from the branch. And that employee at the bank has a cubby hole or an office there that they use that as a springboard to go drive the community and have cups of coffee and lunches and meet with people in their office and close business and solve problems.
CM: That sort of door-to-door service is where we’re going. And I think that’s where the industry is gonna take a mixture of the really good tools that are available for mobile and check truncation and then deliver that with the face to face service so that customers can tell the bank what they need, what they’re looking for, and the bank can come back and respond. I think the branch is alive and well. I think that the number of branches certainly is changing, the focus of branches is changing. But it’s gonna be a blend of technology and physical infrastructure that gets it done. Every bank in the country is finding ways of doing more with less that will continue to play out in 2017. But to our earlier point in technology, companies are spending money, they have to. And recently a CFO tell me pretty directly that, “I’ll spend a dollar all day to make two or three dollars in revenue,” and I think that’s where we’re heading. Most investors and analysts are probably tired of hearing the term operating leverage, which is really getting revenues growing faster than expenses.
CM: But it’s true, operating leverage is real important that it happens in a positive way at banks. And I think that’s gonna become one of those terms we hear often, just like we hear ROA and price to book and return equity and margin. We’re also gonna hear about operating leverage and whether a bank does or doesn’t do that over time.
Tim: How likely is it that… ‘Cause I think the way the whole FinTech scenario plays out is I think the banks end up acquiring a lot of these technologies outright. Is that a realistic view?
CM: I think so, and if you think about it, the banks have more currency now. The fact they have stocks that they can use to do small equity deals, absolutely. And I think in many respects the marketplace would embrace that. It’s a way of getting thin comments aways and being sharper. I think you’re also gonna see alliances come. I encourage investors to take a look at what Fifth Third is doing. They announced a alliance in September where the company out of Atlanta called GreenSky that does home improvement lending and not only are they buying loans from GreenSky but they’re also licensing their technology and the technology is very sharp, it’s very regulatory friendly, but it allows Fifth Third to kinda rethink their own internal processes and that’s gonna help them not only save money but also create more revenue over time. That’s a real good example where FinTech and the banking industry overlap and I think it can actually be very helpful for each other.
Tim: Yeah. I think that the FinTech lenders in particular have to look to sell their license to the bank because the technology maybe wonderful, but at heart, they’re non-depository lender and first time there’s a liquidity crisis they’re in trouble.
CM: Absolutely, and I think I’ve talked about this before. Deposits are the life blood of the banking industry and the banking industry does extend into the FinTech and those lenders and most of those lenders do not have a good cost of funds. They have a high cost of funds and that’s where the banks win. The banks who have a cost of funds between 20 and 30 and 40 basis points, they can deliver a meaningful spread, and again that’s where the ticket is. We’ve seen companies try to go the securitization route. That certainly works. We’ve seen companies get partnerships with banks. We’ve seen success at GreenSky, as I mentioned, and SoFi is another good example. But at the end of the day banks and their low cost of funds is really what’s gonna win out and that’s where I think the partnership with the online lenders is going. I just that some of them had admitted it and some have not.
Tim: Okay, good point. Alright, now, let’s move to loan classifications and categories because the regulators earlier this year, they expressed some concerns about commercial real estate concentrations and there is a fear that it will go from a gentle suggestion to a regulation talking the 100, 300 rule. Can you comment a little bit on that?
CM: Sure. It’s a fair point and I think that it’s a fair expectation. Like a lot of things, the regulators can only hint at things so long and there comes a point where they have to make it more of an official rule. And while we may not necessarily get an official ruling, it’s gonna become more direct. The interesting thing to me is that the technical rule takes all four categories of real estate which are gonna be construction, multi-family, owner occupied and the non-owner occupied and lump them together for the concentration ratio. For the most part, the owner occupied real estate, Tim, has been excluded from the conversation, but in the Fed and FDIC guidelines, they really include it. They have the ability just like the traffic cop to create a letter of the law expectation that this is the letter of the law and we expect you to abide by it and if you’re above that level, we wanna know why. I think that there is going to be more, and they already have been, changes made as banks diversify away from commercial real estate and it’s both good and bad.
CM: It’s bad because there are some really good lenders in real estate who know how to make very good money from the concentration despite their concentration and they’ve had really good credit scores, but I think they’re gonna naturally back down. But it’s also positive and that it forces banks to find a way to be not only creative, but I think also focused on other categories. C&I lending is something that some banks are good at and other banks are not, but we could see that purchased. I think more banks are purchasing loans from each other to try to get themselves some diversity. I think you’re gonna see banks focus on the consumer area and not necessarily trying to match car loans or match the online lenders, but really trying to find where they can have niches. We’ve seen BBT be successful for years in the lending on recreation vehicles and they’ve done that quite well. They’ll take a higher loss rate, but they also have a really nice spread so that it works out in their favor net net. I think more banks are gonna adopt that model.
CM: We’ll probably see more banks buying paper in the consumer area to get some exposure there. All because they wanna at least send the signal to the regulators that they’re listening and making progress. The other point I’d make is that the concentration is not just a statistical exercise. It’s really more of a focus of the bank and are they paying attention. There are banks who have and will continue to have high concentration in real estate but it’s really how they manage it, they manage it well. If you look at an Eagle Bank, for example, EGBN, their concentration numbers may come down over time, but they’re still gonna have a concentration. It’s what they do. They manage it very well and I think that they have a good regulatory relationship and they’re able to work within the guidelines even though their statistic may look high, they have had a really good track record for a long long time. And in a lot of respects, they are model citizen and shows that it can be done. A lot of it is focus, but I do think your general point’s accurate that we are gonna see more banks having to limit their commercial real estate.
CM: There is a lot of companies that I think have to improve their internal processes in terms of how they track real estate and that’s really what the regulators want. They want to see banks getting deeper on their own book of business so they know where the issues are and they can respond when there are problems because that was the big lesson learned from the financial crisis, is that banks had too much real estate and too much construction and they didn’t know how to respond or what to do and that I think is… We’re definitely educating a better financial system and a better financial institutions industry as a result of this sort of regulatory guideline that continues to be talked about louder.
Tim: Are there any loan categories that you’re a little concerned about at this point where you’re seeing that, “Oh, that might be a problem down the road?”
CM: So multi-family has grown a lot. It’s been the biggest growth category. I think that multi-family is something to watch. At the end of the day, multi-family’s a function of supply and demand. If the supply and demand are in balance, multi-family will be fine. We think that there has been a lot of attention paid to multi-family the past six months, and that banks have already made changes and pulled back and changed behavior. That’s very positive already. It gets back to the job growth and the economic activity. If the economic activity is positive, it’s going to sop-up the supply. I feel like multi-family, while it is asterisk in terms of being something to watch, I don’t feel that the problems are gonna be that high. And I think there’s a lot of companies, perhaps in the New York area, who get cited for having a concentration of multi-family, but generally those loans are performing very well. We’re seeing some signs at the high-end. It’s slipping a little bit, but for the most part, a lot of your rent controlled buildings in the big urban areas like New York continue to perform really well.
Tim: Okay. It doesn’t really like it’s… Goin’ back to the commercial side of it, it doesn’t look like there’s any cracks in the market. It may not appreciate as much as it had over the last five years, but it doesn’t look like it’s going to go down a bunch, which basically means it’s an okay time to be a lender in that sector, doesn’t it?
CM: I think it does, and I think, to me the attitude is that companies have to build reserves. And so one of the things that could happen if the corporate tax rate gets cut is that you can see companies actually investing those dollars back into reserves. And that would be a really healthy thing. The reserve argument for years has always been that the SEC and the accounting firms do not wanna see banks using the reserves as a cookie jar where they set ’em aside without any rationality and they pull ’em out when they need it. But the reality is, reserves and equity go hand in hand, and it’s a really healthy thing. I think the regulators are mistaken sometimes for not having more reserves. I think banks are gonna get better at putting reserves aside and really documenting it. What we’re hearing companies do is getting more creative about how they document putting those loans and loan-loss reserves up.
CM: So the challenge for the industry is loan-loss rates, are very low. You have a lot of companies who have charge-off rates below 20 basis points, so if they have a 1% reserve, they effectively have five years of coverage. And five years of coverage is pretty doggone strong. But 20 basis points can easily become 40, and that’s the point that I think banks are gonna hang their hat on is that we may have a low loss rate in ’17 but we can’t guarantee that in the future. And I think forecasting higher loses, there’s nothing wrong with being conservative. So we do have a new, accounting standards that’s gonna go into place in 2020, called CECL, which is gonna be kind of expecting losses. Instead of going historical, it’s gonna be more forecasting, and I think you gonna see banks get creative to be pretty cautious and pretty conservative in expecting the future. It’s a way for them to justify high reserves.
Tim: Okay. Now when we talked last December, doing a little year-ahead look, you had suggested that bank book-values you thought in ’16 would grow probably right around 7%, and I think you came in pretty close to the actual number. How does that look for 2017?
CM: Okay. So fourth quarter’s gonna be a reset because fourth quarter gonna have to mark-to-market on having interest rates go up as much as they have. We’ve seen 70 basis points, approximately the 10-year increase from the end of September to where we are here in late December. That, unfortunately, is gonna create a negative mark-to-market for the available for sale securities. But I think most banks will probably only will probably only see book-value go down. I think net-net about 1%, maybe less. That’s because earnings will still be very good for the quarter. So for example, banks may take a 2% hit on the book-value from the mark-to-market, but they may make one-and-a-half or so back in terms of their profits for the quarter. So that’s really gonna be the net change, less than a percent. So I feel like we will see a little bit of that noise, quarter-to-quarter, in ’17, Tim, but I think a 6% growth rate is still a pretty good number to have, because I think the industry will have a good year, and even if interest rates go up and we have a little bit of mark-to-market negativity, it’ll still be a positive on net net.
Tim: Okay. Any final thoughts on the community bank space for investors as we go into 2017?
CM: So we’ve seen a lot of stocks go from 90% a book to now 120 and 130 a book and some that gone from 120 to 150. Historically, this group has more to run. That doesn’t mean we don’t see profit-taking because I think that would be healthy in the first part of the year, but I think there’s room for a price to book to expand. And again, as we just talked about, book-value should rise for the year. So, if we can see the price to book expand, and we could see the book-value itself per-share expand, it’s not a bad thing for the industry. The challenge is we’ve seen 25% plus returns in banks in the last two months, and that always is lovely while it lasts, but we have to be realistic that this an industry that probably… If we can get a 9% to 10%, or a 10% to 12% return each year, that’s pretty solid, and will be my expectation for this year after the big move we’ve had.