Christopher Menkin's  Instablog

--by Harish Mali and Kiah Lau Haslett SNL Financial

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The misalignment or absence of intelligent incentives means that consolidation in the credit union space remains proportionately muted as institutions play a dangerous game trying to ride out troubles rather than focusing on tactical acquisitions.

The nation's credit unions continue to grapple with squeezed net interest margins, low loan demand and amplified regulatory burdens. But consolidation activity remains concentrated among the most populated sector containing the smallest institutions - with assets of less than $500 million - and are motivated more by financial distress and avoiding failure than strategy and long-term planning, industry observers and would-be participants told SNL.

North Highlands, Calif.-based SAFE Credit Union would like to grow to between $3 billion and $5 billion in assets, the range at which it believes credit unions have the greatest economies of scale, said SAFE CEO Henry Wirz. But the $1.91 billion institution is having difficulty finding a healthy, similarly sized credit union that wants to partner with it.

He attributes that to the fact there is no incentive system spurring management to consider mergers until their institution falls into dire straits as membership departs and capital declines. He said bank deals are owner-driven in that investors exert pressure to explore strategic alternatives that maximize shareholder value, whereas credit union mergers are owner-driven by members leaving the institution and placing it in financial distress. Most of SAFE's deals have been the result of a regulator calling on the behalf of a credit union that has been pressured to seek a partner.

"The hurdle is to find the right kind of incentives for management and the board, and those are hard to come by because the people that control the credit union have to be willing to give up some control," he said. He later added: "What we have today is an irrational merger and consolidation process in credit unions. It's bad for the whole system the way we're doing it."

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Activity remains concentrated at the smallest credit unions, SNL data show. The mergers lack a strategic partnership component that has left credit unions with more than $500 million in assets frustrated and at a competitive disadvantage to their bank and thrift counterparts, said Peter Duffy, managing director at Sandler O'Neill. Credit union consolidation trends mimic broader operation trends in the industry, namely the bifurcation of institutions above and below $500 million in assets. Duffy said the proportionately smaller group of institutions with more than $500 million in assets has created the lion's share of return on average assets and booked most of the membership growth, despite the fact that they cannot merge and acquire institutions like banks and thrifts can.

"The larger credit unions we talk to are really desirous of adding mergers to their strategic plans as acquirers and are completely frustrated by the whole process because logic doesn't enter into it," he said.

Duffy faulted what he called a "systemic lack of accountability" in the credit union industry because there is no external pressure from shareholders, no slew of regulators and no cutthroat competitors who use acquisitions as a way to gain scale or market share. Average, weak and marginal credit unions continue to exist because their boards are not held accountable and are uninterested in pursuing opportunities that may offer members access to more services or better rates, he said.

"What you're not seeing in the credit union space is the strategic merger - mergers of larger, healthier institutions," he said. He later added, "I know there's a lot of discussion out there about all kind of pickup in merger activity, but the simple truth of the matter is they're mostly tiny."

Charles McQueen, president of McQueen Financial Advisors, said his credit union merger valuation business for the first quarter was double 2012's pace. He has worked with clients from Maine to California and said that most of the surviving credit unions in a potential merger have more than $100 million in assets, while the merged institutions tend to have between $20 million and $100 million, he said. Those thinking about merging have begun to see earnings run low and are trying to figure out who could partner with them while they still have capital. Very undercapitalized or failed credit union mergers are becoming more of a rarity for his business.

McQueen added he is seeing a rise in a different type of strategic merger: federally chartered credit unions merging with state-chartered credit unions. State charters generally have the potential for a more expansive field of membership, causing some federal credit unions to merge and then replace its federal charter with the state charter to grow their membership base, even if the federal institution was larger before the merger.

But in any merger, upper management teams of merged credit unions often struggle to find re-employment after consolidating, which means many of the credit unions McQueen deals with have executives who are close to retirement age or have other short-term opportunities.

Credit union consolidation is complicated by the desire of many institutions to keep an appropriate equity capital cushion. Dipping below a cushion of about 9% makes some boards nervous, Duffy said, as regulation continues to suggest capital requirements are going to increase; credit unions can only use retained earnings, whereas banks can raise equity or debt to increase capital cushions. Smaller credit unions facing decreased revenue outlooks but that are otherwise healthy may feel the pressure to find a larger partner as fee income remains under duress, lending demand continues to slacken and capital declines.

But the longer a troubled credit union remains independent, the more its capital is eroded and its value diminished. That could make it harder to find a partner willing to merge with it, forcing the NCUA to liquidate. Wirz said he fears an increase in liquidations would stress the insurance fund, as well as destroy the value of the credit union through a fire sale.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

By Andrew Wolcott and Lindsey White, SNL Financial

Community banks across the nation experienced an uptick in lending during the first quarter: New England saw the strongest growth, and commercial and industrial lending emerged as a bright spot in every part of the U.S.

Nationwide, SNL Financial found that banks under $10 billion in assets experienced nearly 2% median loan growth compared to the first quarter of 2012. The picture was somewhat less rosy compared to the fourth quarter of 2012, as banks under $10 billion saw a median linked-quarter drop in nearly every loan category except residential construction. But as Sterne Agee & Leach Inc. analyst Peyton Green noted, the first quarter tends to be seasonally slow.

Banks experienced median, year-over-year loan growth in every region of the U.S. except the Southeast. "The Southeast being more development oriented and more growth oriented coming into the downturn certainly could cause it to take a little longer to come out of the recession," Green said.

Green said that some small banks in the Southeast are bucking the lending trend. "The numbers may not have been great this year, but they're much better than they were a year ago," he said, pointing to names like Little Rock, Ark.-based Bank of the Ozarks Inc.; Tupelo, Miss.-based Renasant Corp.; and Nashville, Tenn.-based Pinnacle Financial Partners Inc. "All reported loan growth in the first quarter this year which was up [compared to] last year," he said.

The New England region experienced the strongest overall growth - nearly 6% - followed by the Southwest and then the Mid-Atlantic.

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Note: Geographical loan growth is based on company headquarters.

Every area of the U.S. saw C&I lending rise from year-ago levels. "The C&I recovery has been on for over a year," Green told SNL. "It was the first part of the commercial sector to go through the recession and the first part to heal."

Gray Medlin, managing director and head of the San Francisco office at Monroe Financial Partners, said the trend makes sense: Banks moved away from real estate loans after real estate got a bad name during the recession. But he does not believe the current emphasis on C&I lending is sustainable.

"The bread and butter of community banks always has been good real estate lending, because good real estate is good collateral: Dirt doesn't get up and walk away," Medlin said. Real estate took a serious hit during the recession, but in a normal environment, he said, local real estate loans are the best credits for community banks.

Medlin also expects that construction and development loans will make a comeback as the economy continues to improve. "Community banks, they're set up to do good construction and development lending with reliable, well-capitalized builders and developers, and they can make lots of money at it," he said.

"My prediction is, to get loan growth back, the community banks will have to begin shifting back towards real estate, and I think they should. It's a natural for them."

Medlin's predictions may already be coming true, at least in the commercial real estate category. Banks under $10 billion saw year-over-year CRE loan growth in every part of the U.S. but the Southeast.

Lending may be stagnant for community banks in the Southeast, but the same is not necessarily true for their larger counterparts. William Schwartz, senior vice president of the U.S. financial institutions group at DBRS, said he has recently spoken to some big-bank management teams in the Southeast who "all seem to be pretty pleased with what's going on." Even bankers in areas that were especially challenged during the recession, like Florida and Atlanta, are now more confident, he said.

Winston-Salem, N.C.-based BB&T Corp. certainly experienced strong year-over-year loan growth during the quarter, as did many of the nation's biggest banks. Capital One NA grew loans by a whopping 73.95%, thanks in part to acquisitions. In November 2012, ING Bank FSB was consolidated into the Capital One Financial Corp. unit. Capital One also acquired card and retail services from HSBC Holdings Plc in May 2012.

JPMorgan Chase Bank NA grew loans by 3.23% year over year, while Bank of America NA's loans increased by 4.51% and Wells Fargo Bank NA's grew by 5.25%.

Compared to its big-bank peers, Citibank NA saw some of the weakest year-over-year growth, as lending climbed by just 0.42%. Citi took the biggest hit in the residential construction category, where loans fell by nearly 68%.

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Perhaps unsurprisingly, it was the smallest banks that saw the smallest amount of loan growth during the first quarter. Those with less than $100 million in assets posted median loan growth of 0.77%, while those with between $1 billion and $10 billion grew loans by 5.67%.

Medlin said size matters when it comes to lending. "One of the first things you talk about when I meet a community banker is, how big is big enough to remain competitive, to remain relevant?" he said. "They're finding out that if they were bigger, if they had more capital, if their legal lending limit was bigger, they could compete for that good loan."

Observers agree that competition for lending remains tough - as Schwartz put it: "Everybody and his brother is competing for asset generation and asset growth."

Medlin made a similar point. "There is certainly a growth in loan demand but the competition for good credit is fierce," he said. "The bigger banks have come downstream and are bothering with smaller deals that historically they might not have. They can afford to offer really long terms and low fixed rates, and that's giving community bankers heartburn in a lot of cases."

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Western Equipment Finance Parent
Takes over Central Arizona Bank

Central Arizona Bank, Scottsdale, Arizona, was closed with Western State Bank, Devils Lake, North Dakota, to assume all of the deposits.

"Western Equipment Finance, a subsidiary of Western State Bank, began financing commercial equipment nationwide in 1990. The company is headquartered in Devils Lake and currently has over $165 million in equipment finance transactions outstanding."
www.westernbanks.com/about-us-our-history.htm

The bank is the 13th to fail this year and the second in Arizona: was Gold Canyon Bank, Gold Canyon, on April 5, 2013.

It is interesting as normally the FDIC closes banks the end of the week, not in the middle. It is also interesting that Western State Bank, Devils Lake, North Dakota, which has eight branches in North Dakota, but one in Chandler, Arizona, originally established January 01, 1899 which they grew from a loan production facility, then acquired and made a banking facility in 2009 (their web site states) and then Casa Grande, evidently from Centra Arizona Bank in 2012.

The bank had 9 full time employees as of December 31, 2012. Year-end 2010 they had 19 full time employees. In 2008 the bank changed its name from Valley First Community Bank to Central Arizona Bank, planning to open an office in Casa Grande in 2012 (which Western State Bank acquired in 2012)---and the net equity was up to $10.5 million in 2009---but in 2009 it dropped to $4.6, hitting the problems of many other Arizona banks as evidenced by the numbers below.

Tier 1 risk-based capital ratio .0287 3/31/2013

(in millions, unless otherwise noted)

Net Equity
2006 $7.7
2007 $8.1
2008 $10.5
2009 $4.6
2010 $1.7
2011 $922,000
2012 $716,000
3/31 $671,000

Profit
2006 $717,000
2007 $327,000
2008 -$1.0
2009 -$6.1
2010 -$5.6
2011 -$1.8
2012 -$1.4
3/31 -$52,000

Non-Current Loans
2006 0
2007 0
2008 $1.9
2009 $3.1
2010 $5.1
2011 $4.07
2012 $2.8

Charge Offs
2006 0
2007 0
2008 $940,000 ($608,000 commercial/industrial, $324,000
nonfarm/nonres.)
2009 $1.9 ( $993,000 construction/land,$489,000 nonfarm/nonresidential, $41,000 1-4 family_
2010 $3.0 ( $1.4 nonfarm/nonres.,$697,000 1-4 family, $611,000 commercial/industrial, $129,000 construction/land,$109,000 individuals)
2011 $1.3 ($669,000 1-4 family, $601,000 nonfarm/nonres.,$65,000 construction/land, $13,000 commercials
2012 $426,000 ( $295,000 nonfarm/nonres.,$189,000 commercial/ind., $29,000 individuals, -$90,000 construction/land) 3/31 $5,000 ($3,000 commercial/industrial, $2,000 construction/land)

Construction and Land, 1-4 family multiple residential, Multiple Family
Residential, Non-Farm Non-Residential loans.

3/31/2013
Tier 1 risk-based capital ratio .0287

As of March 31, 2013, Central Arizona Bank had approximately $31.6 million in total assets and $30.8 million in total deposits. In addition to assuming all of the deposits of the failed bank, Western State Bank agreed to purchase essentially all of the failed bank's assets.

The FDIC estimates that the cost to the Deposit Insurance Fund (DIF) will be $8.6 million
www.fdic.gov/news/news/press/2013/pr13040.html

List of Bank Failures:
http://www.fdic.gov/bank/individual/failed/banklist.html

Bank Beat:

http://www.leasingnews.org/Conscious-Top%20Stories/Bank_Beat.htm

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.