The Domino and Migration Theories
By Stephen M. Klein
February 25, 2010
Who Woulda Thought Dominoes Applied to Banking?
My partner Kumi Baruffi and I recently participated in Bank Director Magazine’s annual M&A Conference in Phoenix. At the conference, former Comptroller of the Currency, Robert Clarke, in his laid-back Texan manner, related the saga of the domino theory and the CAMELS rating.
What he, we and you all are seeing is examiners coming into banks and primarily focusing on one thing – ASSET QUALITY. It is unquestionably the driver of the whole CAMELS rating. Well, in many parts of the country, real estate values continue to deteriorate. So, when the examiners come in they downgrade ASSET quality. That typically results in mandated higher reserves and related provisions for loan losses, resulting in a downgraded EARNINGS rating. Arguably, this leads to a downgrade rating in CAPITAL and LIQUIDITY. And, of course, MANAGEMENT is downgraded since they oversaw all of this. Thus, the domino effect of a downgrade on Asset Quality is a single or double downgrade in the bank’s overall CAMELS rating.
What is the Cure?
Frankly, the best, and perhaps only immediate cure, is more capital. We are working with a host of banks on public and private equity raises. And the regulators have made it crystal clear that they want and expect COMMON EQUITY CAPITAL injected into banks. While raising capital, particularly if the bank is a “4” or “5” rated institution, can be a daunting task, some banks have been successful in raising equity, particularly the “2” rated and even the “3” rated banks. Obviously, MOUs and formal Agreements and Consent Orders do not help in banks’ capital raising efforts.
Our observation is that capital (i) improves many of your key ratios, (ii) allows the bank to more aggressively resolve its asset problems, and (iii) favorably impacts the attitude and approach of the examiners when they visit banks. In other words, CAPITAL IS A VERY GOOD THING!
The Migration Theory
Concurrent with the Domino Theory is the Migration Theory. What the regulators are seeing is a continuing deterioration in real estate values and asset quality in many parts of the country. The underlying fear that is driving CAMELS ratings and downgrades is that things will get worse before they get better, i.e. “migrate South.” Given the harsh tone of recent FDIC Inspector General Reports for failed banks, it is probably safe to say that few bank examiners or regulators are willing to give a bank the benefit of the doubt and subject themselves to after-the-fact criticism.
The scary thing is that with more failed banks comes more fire-sales of real estate in certain markets, further eroding values and bank capital, effectively resulting in a self-fulfilling prophecy. It appears that stopping this freefall is the key to stopping the hemorrhaging and beginning a true economic recovery for banks and the country.
What Steps Should Banks Be Taking?
Here are some practical tips we suggest Banks at least consider:
- Aggressively work your problem assets.
- Make capital raising a very high priority.
- Ensure you have a good and frequent (perhaps semi-annually) outside loan review.
- Communicate effectively and timely with all of your regulators – the “no surprise” rule is a good one.
- Involve and timely inform the Board on all material developments at the Bank.
- Utilize your professional advisors – lawyers, accountants, investment bankers, outside loan reviewers – properly, they can be valuable resources.
- Try to stay positive as we all work through these trying times.
Conclusion
We continue to see almost all banks struggling in varying degrees with the economy, asset quality, capital, liquidity and the regulators. Remaining focused, proactive and fully engaged is critical. The good news is that in a consolidating industry, there will be opportunities for those that successfully navigate these choppy waters.
