The Texas Report – Q2 2011

by Curtis Carpenter

The performance and health of Texas banks improved during the second quarter of 2011 and continued to outpace banks in the nation, particularly those in large metropolitan areas. Meanwhile, merger activity in the state remains sluggish.

The early stages of a recovery are evident in Texas banking. Exhibits 1 and 2 chart the quarterly trend in nonperforming assets and provision expense as a percentage of average assets. While the level of nonperforming assets of Texas banks continued its
modest decline, the median level of provision expense in the second quarter continued its rapid decline to an annualized level of only 0.09% of assets. This implies that the earnings drag of nonperforming assets is lightening up as assets have been written down to the level needed to sell in the current market. South Texas and the DFW area clearly have more clean-up work to do but the state as a whole is well-positioned for a recovery in bank profits to begin taking hold.

One observation taken from the view of asset quality provided by the accompanying charts is that the credit cycle in Texas has peaked but the full recovery may have a long tail. Another take-away is that credit underwriting in Texas was strong in the years before the financial crisis and has been aided by a relatively strong state economy during the last three years. For the rest of the nation, the direction of the credit cycle is still in question given the steady rise of NPAs at banks in the large metropolitan areas. One caveat is that the improving trends are susceptible to any further weakening of the economy.

The continuing improvement in asset quality and the concomitant reduction in provisioning are reflected in the rising profitability in both the Texas and the national banking sectors. Led by the Non-Metro, El Paso and Austin banks, the median ROAA for Texas banks jumped to 0.79% in the second quarter, 32 basis points higher than the national metro median bank ROAA and 15 basis points higher than the national median. Also contributing to the Texas banks better performance are declining non-interest expenses. Non-interest expenses for the median bank in the nation have been essentially flat for the last year, likely reflecting the drag of losses on OREO sales and maintenance expenses of non-performing assets (see Exhibit 3).

Loan growth (or the lack of it) has been in the headlines as deleveraging in the private sector of the economy progresses. We decided to review the change in loans at Texas banks from the second quarter of 2009 through the second quarter of 2011. We aggregated total loans for each institution contained 2801 Via Fortuna n Suite 625 n Austin, TX 78746 (800) 279-2241 n www.SheshunoffIB.com The Texas Report Second Quarter 2011 in their quarterly regulatory reports. Loans for three institutions – Comerica, USAA, and Wells Fargo South Central, NA – were excluded from the analysis as significant portions of their loans are out of state. We calculated the percentage change in loans using the 2009 second quarter loan balance as a base and dividing the loan balance for each successive quarter by it.

The results in Exhibit 4 (Total Loans, above) show that loans in Texas as a whole remained above the 2009 second quarter benchmark in all quarters and were 103% of the base level in the 2011 second quarter. (The change in loans at the rest of the nation’s banks over the same period was about 1%.) Loan demand at Non-Metro, Austin and El Paso banks has been the source of strength over the last two years, contributing to the state’s resilience. Given its relatively high level of NPAs over the last two years, it is interesting to note that loans at DFW banks have also been strong. Loans at banks in Houston and San Antonio fell steadily until about the 2010 second quarter before stablizing. Banks in both MSAs reported higher levels of loans in the 2011 second quarter. Banks in South Texas have shed loans in each quarter for the last two years. Balances at these banks in the 2011 second quarter were 92% of the level in the 2009 second quarter. To some degree, the “stability” of loans over the last two years at both the state and national level is remarkable considering the large amount in dollar terms of loans that have been charged off, sold, or transferred to OREO in addition to the paydowns on performing loans.

Pricing for Texas’ publicly-traded banks in the second quarter shows that others are noticing the improving climate for Texas banks. Pricing rebounded sharply for the median Texas bank with the price to tangible book rising to 1.43x as of June 30, 2011 compared to 1.00x for the national median. Of note, this was the last quarter for Sterling Bancshares to report as its merger with Comerica closed on July 28. See Exhibit 5, previous page.

Texas is one of the leading states in merger volume and pricing, although in this weak market, the volume and pricing are not what Texans are used to seeing. Community banks or investor groups were the buyers in five of the Texas transactions so far this year. It’s difficult to draw much guidance from the pricing multiples with so few deals and with each having unique characteristics. Based on our experience in the market, a relatively clean bank in a decent market would fetch between 1.4x to 1.8x tangible book (assuming a capital level around 8%).

With the solid capital base and strong stock prices of the publicly traded banks in Texas, one would expect to see robust M&A volume. But the fact is that only one publicly traded bank in Texas has made an acquisition so far in 2011 and that was Comerica buying Sterling in January. One factor cited by executives at several leading publicly traded Texas banks is a lack of sellers in their target markets. On the other hand, given the strengthening financial condition of Texas banks, potential sellers aren’t under the pressure from regulators or shareholders that others around the nation may be feeling.

From our discussions with prospective buyers and sellers, we sense the M&A market is hostage to several short-term tensions. While regulatory pressure is driving some sellers to market, potential buyers are fearful of the regulatory consequences of fair value accounting and NPAs on capital. In some areas, there is an insufficient number of strong buyers with capital and management to handle the backlog of sellers, many of which are profitable with few asset quality problems. Although there is some convergence between buyers and sellers on the concept of a “fair” price, some buyers suffer from a low stock price or the seller’s reluctance to accept privately-held stock in a trade.

Certainly, greater clarity from regulators regarding “adequate” post-acquisition capital and the treatment of NPAs acquired is required to resolve the first dilemma. As to the second, only time and sustained efforts by potential buyers afflicted with problems can bring about a better balance. An informed understanding of value in today’s market and receptivity to alternative structures by both parties are essential to resolving the last issue.

What Opportunities Exist in Your Market?

Buyers and sellers are beginning to explore mutually beneficial transactions, a trend that is likely to accelerate throughout 2011. As the burden of regulatory costs becomes clear, many institutions realize the need for more economies of scale.

Call Curtis Carpenter or John Adams today to discuss how our recent transactions represent win-win situations and what can be done to create one for your institution. We would enjoy visitingwith you about current pricing trends as well as common obstacles in today’s negotiations.

Contact us at (800) 279-2241 or visit us online at www.SheshunoffIB.com.

Q2 2011 Texas Report

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