Shell shocked - Atlanta banks look to 2008

Drew Ermenc

March 1, 2008

Mortgage delinquencies are up. Home values in Atlanta are eroding. And lines of credit backed by these falling housing prices are in jeopardy, putting banks that lent money against these lower valued homes holding the bag. And it may get worse. In late January, The Wall Street Journal reported Atlanta ranked fourth out of the top 28 real estate markets with a 5.21 percentage of mortgage loans past 30 days due. The national average is 3.98 percent. And Georgia bankruptcy filings have increased an astounding 24 percent in 2007 from the year before, giving our state an embarrassing distinction: the second highest percentage of filings nationwide.

Some of Atlanta's local banks, particularly community institutions, are in for a tough fight in 2008. "It's the broadest and deepest problems in the banking industry since I've been bankgraphic

around, and it's different problems for different-sized banks," says Nat Padget, a 30-year veteran of the local banking industry. "I can't imagine there's a banker out there who doesn't agree the industry is very stressed right now."

"A bank's challenges don't change very much from year to year; so much can be exacerbated by a poor economy," says Lauch McKinnon, president and CEO of RockBridge Commercial Bank. McKinnon, who has been in the banking business for four decades, says, "the biggest challenge banks continually have is loan portfolio quality. A declining economy creates greater portfolio challenges than when the economy is stronger."

Padget points out the sub-prime pangs just may be the tip of the iceberg for the "big three," the trio of the largest U.S. banks for total assets under management: Bank of America, JP Morgan Chase and Citigroup, respectively. "The top three certainly have been in the news because of the investments in sub-prime portfolios and those securities secured by sub-prime mortgages," he says. "That's something that doesn't affect small banks nearly as much in a direct sense."

The fourth-quarter financials for some of these top banks show how powerful the downturn has hurt these Goliaths. Wachovia, the fourth-largest bank, saw earnings plunge 98 percent, mainly due to $1.5 billion set aside to cover bad loans. Bank of America reported it was barely profitable last quarter, as the nation's No. 1 institution wrote off $5.3 billion for similar reasons. And SunTrust, the Atlanta-based regional bank with top-market share in Georgia, announced a 99 percent drop in earnings.

Padget doesn't see the pain going away anytime soon. "You will also see with these large banks that these very large consumer credit portfolios will start to deteriorate, and that will be in the areas of credit card and equity lines they hold on their books," he says. "[Some of] these institutions have been pretty aggressive on the consumer credit side in the last five years."

Despite the gloom, Atlanta banking execs aren't as stressed as their nationwide banking brethren, citing the bustling local market as an advantage. "One of the strengths for us in Atlanta is the market's diversity," says Kendall Alley, president of Wachovia's Atlanta region. "Even though the housing issues and the construction associated with that will have a slowing effect on one piece, we have a tremendously diverse economy in this market. There's still population growth [and] retail sales growth that give us opportunities to work the market in 2008."

Jenner Wood, chairman, president and CEO of SunTrust Bank's Central Group, which includes Georgia, also is comfortable. "Atlanta is still experiencing good job growth," he says. "People are still moving to Atlanta. It's still a very healthy city to invest in."

Despite The Home Depot layoffs and the potential Delta Air Lines merger that might facilitate additional downsizing, Atlanta has strong employment growth compared to other large metropolitans, ranking fourth in a January Forbes list of the top 10 cities for jobs in 2008. "The companies out of here continue to do well: Coke, Delta ... Atlanta is a market that hopefully will not take it as tough as other markets and will rebound very quickly," Alley says. "You hope one single thing can't impact [the local economy] enough to damage it. I have worked in cities where specific industries were the main driver and when those industries had challenges, it was a tough place to be."

Trickling down

Home equity loans, in particular, are poised to be another unfortunate reminder of the lending mistakes made over the past several years. Many of these loans often were leveraged on the property's value, and now that these homes' values have been reduced in many markets, in delinquency situations, the mortgage company – not the home equity lender – has first right to recoup from foreclosures.

According to BusinessWeek, home equity lending is an $850 billion market, and $14.7 billion of those loans already have been considered delinquent through the end of September last year. "It's part-in-parcel with the mortgage problems because, as residential values have gone down, equity line lenders have no equity on the equity line," Padget says. "If you have a problem with a borrower, the chances of foreclosing and coming out whole are reduced dramatically. You may find out the value of someone's home has fallen below that of the first mortgage. You're facing a straight loss."

Wood also raises concerns with the lowering home values, but feels confident in his lending procedures. "What I'm worried about in 2008 is price erosion, and it's getting harder to find good home equity loans," he says. "As far as our portfolio, it's healthy, and a lot of our portfolio is home equity lines of credit. But going forward, price erosion in residential home prices make it harder to get good growth in getting good home equity loans. You have a $100,000 home that's now worth $80,000; that's $20,000 we can't lend against."

With different pain points, Padget believes Atlanta's community banks will steer clear of the home-equity-lending tsunami, in part because of the methods used by larger banks to attract new clientele. "A lot of the [home equity lines] were done by the very large banks just by using zip codes and what valuations have done historically," he says. Often with these big banks, you "have no relationship with your bank and all your bank knows about you is what's on your application. Most community banks were offering lines of credit underwritten on a relationship basis, and they will not be hurt as much as the big banks as a wholesale product that were, quite frankly, sold through mailers."

Touchmark National Bank, which opened its doors on Jan. 28, 2008, virtually has a blank slate on which to begin. Bill Short, who spent more than 30 years with Wachovia and now heads up the Norcross-based bank, says this year "was a good time to open a bank because we don't have any bad loans on our books. We've raised more than $30 million in capital, and we're in a good position to market ourselves. Not everyone is struggling right now, and there are many fine businesses with which to work.

"The biggest thing we all need to be concerned about is not just the housing problem, but the people who are struggling because they've lost their jobs or were stretched too far. This will bleed over into credit card debt. Right now our focus is to make sure we're underwriting the credits appropriately. We're focusing on small businesses and professional groups, and will have a robust offering for consumers as well."

"The two biggest challenges this year [for community banks] are continually maintaining their loan portfolio's quality, and responding effectively to margin compression," says McKinnon, adding, profitability will be a challenge "because of margin compression.

"The Fed has been aggressively reducing interest rates, and our bank's loan portfolios are based off the prime rate, which adjusts in concert with the Fed's target rates. As a result, our loan portfolio yields shrink faster than we can adjust our funding sources."

Alley doesn't believe Wachovia's portfolio is a concern, citing a conservative strategy while other competitors dealt with higher-risk products. "It's how we're underwritten, who we are doing business with, the operations in place and the way we've done our business," he says. "[Home equity lines] won't have a significant impact on how we do our business. We do have a significant home equity loan position as a company, but we feel comfortable.

"We've done it with prudent underwriting and risk management approaches and just like everything else right now, everything is a little softer than it was, but our non-performing assets and past due payments continue to be better than most of the industry and that is directly correlated to how we've underwritten the risk and assumed the right loan-to-value. "And we didn't loan 125 percent of the equity in their home that is or isn't there," he adds, slyly.

History repeats

The confidence of these banking executives isn't so much hubris as experience; both Alley and Wood have witnessed crisis-type downturns in the local market during their banking careers. "[Running] from mid '89 to '92, there was a pretty significant real estate correction that was more commercially driven than it was residential, so the parameters were the same, but were in different parts of the universe," Alley says. "The inventory was absorbed fairly quickly through consumer demand and the people who needed them and we got back to normal. It was considered to be a softening, and specific markets did well and specific markets did not. From an office building standpoint in Atlanta today, we can continue to lease space because the vacancy rates still are in pretty good shape."

Wood recalls a time eerily similar to today's market troubles. "I started banking in 1975 and the '74, '75, '76 cycle, there was a serious downturn in real estate valuations in Atlanta and Georgia, to the extent in 1975, Trust Company [of Georgia, a SunTrust predecessor], broke even for the year, not unlike SunTrust announcing they broke even for fourth-quarter earnings," he says. "The difference is this one seems to be centered in the residential real estate market. The one in the '70s was [revolved around] all aspects of
real estate: industrial, commercial, residential, raw land.

"Atlanta banks came out of this cycle by the early '80s and the Atlanta and Georgia financial institutions will come out of this, too."

Padget predicts an 18-month window of trouble for the Atlanta financial sector, and sees slow growth, in particular for the banks that didn't diversify their portfolios. "While we will come out of this, it will look a lot worse here for a shorter period of time than other areas," he says. "The real estate recession will be V-shaped, not U-shaped, but during this period of time, which could be 18 months, it will be very painful for local banks. Two years from now, it will be better. Quite frankly, the 7,500 charters out there today will be reduced greatly in the next two years."

As the former founder and president of Chattahoochee National Bank, Padget opened his community bank in the mid-1990s to tap into unprecedented growth along Georgia 400, focusing his core clientele on business banking. He's spent a lot of time with community banks, and is concerned about the smaller local banks in what may be a saturated market.

"Everyone is waiting for the market to turn because no one appears to be buying homes in metro Atlanta, or not at the rate we've seen in the past," Padget says.

"The inventory of homes out there will get eaten up fairly quickly as the Fed has moved rates to be more attractive," Alley says. "We are continually trying to help people get into homes, and then that inventory will be absorbed quickly. There will be new inventory demand and new inventory product and the economy will get moving again."

Shifting revenue sources

Banks that relied on residential housing markets to carry profits are strategizing how to find revenue in other segments, and many are turning to commercial lending divisions.

"We have strength carrying over from 2007 in pure commercial lending, in the small business arena which [are] companies with sales of $1 million to $5 million, and from diversified commercial segments [$5 million to $100 million]," Wood says. "We have a good strength in commercial lending. We're in a renewed strategy in middle-market commercial clients, where we're trying to service commercial clients that have from $100 million to $700 million in revenues."

Wood says SunTrust is investing resources to target these markets to make up for its mortgage divisions. "Clearly, it will be a lot slower in the residential construction side of the business because of what they are experiencing now," he adds. "This will probably continue throughout this year, and it will be a little slower on the consumer home equity business for the same reasons."

Wachovia is committed to the same commercial lending strategy. "We've focused on commercial and industrial business for a long time and that has always been a growth momentum opportunity for Atlanta and the Southeast. We don't really see that slowing down," he says. "Industries not related to housing show good progress and growth and obviously it's all macro-economic issues and are contingent on consumer spending.

"We don't anticipate this market getting hit as hard as other markets. The consumer markets – on the wholesale side – will continue to be good; medium, middle market will be a great growth opportunity because at times like these they have an opportunity for expansion and need capital to make that happen."

Padget isn't sure commercial lending will be a market segment on which to depend. "The first evidence of problems in the commercial real estate side will be in the small retail shopping centers, because they typically follow the residential developments," he says. "You see some nice looking retail centers with no clientele right now. They have been sitting for some period of time."

But Alley sees other avenues for growth, pointing out another economic negative – the incredibly shrinking dollar –actually may play a role in helping banks find additional revenues. "With the dollar weakening, a lot of our customers are beginning to export where their products may not have been price competitive before. So that's a new market to help support that opportunity," he says.

And now is a good time to invest in international trade. According to the U.S. Department of Commerce, Atlanta companies were responsible for exporting $11.4 billion worth of goods in 2006. While numbers weren't available for 2007 at press time, they are expected to increase considerably.

"We are focused on insuring that we are providing services to show we are an international company with trade capability all over the world," Alley says. Referencing its diverse portfolio and conservative approach to lending, Padget likes what he sees in Wachovia. "They are the best positioned to come out of this. They sold their credit card portfolio to Chase a couple of years ago. They've had a pretty conservative viewpoint of the world in the last five years. They haven't grown as quickly, and they've gotten some criticism for that, but in the long run, they are going to come out the true winners of the superbanks."

As for Alley, his cup continues to be half full. "There are certain pockets that are taking a little beating, but the diversity of our market, particularly the retail sales growth momentum that is here, gives us great chance for continued construction expansion," he says. "I'm sitting here in Atlantic Station right now and I'm looking across the universe and there's plenty of cranes in the air building stuff. That implies to me the market is still strong."