Earlier this month, I was interviewed by financial journalist Nathan Stovall on the state of banks and loans in Texas. Stovall's article in SNL Financial's Banks & Thrifts section focuses on the Texas economy and how banks are preparing with regard to commercial real estate loans. My comments can be found in the article pasted below (half way through the article). SNL Financial is a global company that collects, standardizes and disseminates all relevant corporate, financial, market and M&A data — plus news and analysis — for the banking, financial services, insurance, real estate, energy and media/communications industries.
Will Texas remain the Lone Star?
April 16, 2009 5:47 PM ET
By Nathan Stovall
With the Texas economy beginning to soften, first-quarter bank earnings will clearly show that the Lone Star State is not immune to the downturn, but it should still outperform the rest of the country.
The Texas economy has proved to be a positive outlier, and lenders' credit quality in the state has outperformed banks in the rest of the U.S. The Texas economy's GDP expanded by 4.2% in 2008, more than double the pace of the U.S. economy. The state comptroller's office estimates that GDP in the state will increase 1.8% throughout fiscal 2009, well above the expectation for the U.S. economy, an 0.9% contraction.
Sterne Agee & Leach Inc. analyst Brett Rabatin has questioned whether GDP projections for the Texas economy could be too optimistic, highlighting the fact that a March commentary from the Federal Reserve Bank of Dallas indicated a "more pronounced drop-off in recent weeks" amid waning consumer demand, a declining real estate market and tumultuous financial markets. Rabatin noted in an April 13 report that Texas is beginning to feel the impact of falling energy prices, which equated to roughly 10% of the state's GDP in 2007. The analyst further said that the index of Texas Leading Indicators, a metric produced by the Federal Reserve Bank of Dallas combining eight measures that can anticipate changes in the Texas business cycle by over a three- to nine-month period, experienced a more meaningful year-over-year decline in January than in any other point during the previous two recessions. It fell by 15%.
"The key question for the state is the extent to which overcapacity in the economy was developed during the recent energy and economic boom. We do not believe the situation in Texas will be nearly as bad as the 1980s; however, the situation is likely to continue softening before improving," Rabatin wrote in the report.
Bankers and attorneys in Texas tell a similar story of the state's economic softening. John Blaylock, an associate director at Austin, Texas-based Sheshunoff Investment Banking, said his banking clients started to feel the downturn in January.
"And it's going to stay this way, and it's going to get worse. There's no way we're insulated from the national economy. We can't pretend that we are," Blaylock told SNL.
The downturn in Texas began at least a year after some other parts of the country, said Peter Weinstock, partner in Hunton Williams' Dallas office. He said Texas did not sustain job losses until the fourth quarter of 2008. Unemployment in the Lone Star State still remains low, at 6.5% as of February, but the figure rose notably from the early part of 2008, when it stood at only 4.5%, according to the Bureau of Labor Statistics.
"The problems, they're happening," Weinstock told SNL. "I think the downturn here came later. It's likely to be softer, and the bankers saw it coming and have been conservative in anticipation of it."
Like other areas of the nation, the greatest stress in the loan portfolios of Texas-based banks has occurred in residential real estate-related loans. Keith Mullen, co-chair of the financial services industry group at Winstead PC, said single-family mortgages and loans to home builders have produced the most delinquencies, foreclosures and workout situations. Texas-based banks have not really taken hits on commercial real estate loans yet, but Mullen said tenants are beginning to notify their landlords of their plans not to use expansion space or open a store.
"People are not exercising expansion rights. They are not moving into new space. They're sending notices back saying, 'We're not going to do it. We need to renegotiate the rent.' And that's starting to then hurt the banks as they are looking at construction loans that they are trying to see become stabilized with a projected rent-hold strength – those are now in jeopardy," Mullen told SNL.
Banks are not sitting on their hands and waiting for losses to mount up. Mullen, who is based in Winstead's Dallas office, said banks are "bleeding the cash out of the borrowers," as they work to get developers to put more cash in projects. However, he said the savvy builders are not "having any part in that."
As another loss-mitigation strategy, Mullen said banks are looking to sell loans. Some analysts believed that Texas-based banks would have an easier time off-loading such assets since the state did not experience as much of a real estate boom and, as result, home prices have held up. In fact, home prices in Texas experienced the fourth-largest year-over-year appreciation in the U.S. in 2008. Home price appreciation in the Austin, Houston and Dallas metro areas all finished in the top 35 MSAs in the U.S. in 2008.
Given the relative strength in the Texas real estate market, Morgan Keegan analyst Robert Patten noted in a report in February that Texas banks could dispose of real estate assets with only 10% to 15% markdowns, compared with the 50% to 60% markdowns in other geographic regions. Unfortunately, that prediction has not held true, Mullen said. He noted that "vulture investors" are seeking to buy into projects at severe discounts, creating a large disconnect between the bid and the ask. Since banks cannot off-load projects, Mullen said, some have extended loans, or in other cases, the borrower has taken its business elsewhere and refinanced with a community bank.
"The fear is, now the community banks are full up on their real estate investment mix and they can't take anymore," Mullen said, noting that regulators will not let institutions expand that business.
In fact, Dory Wiley, president and CEO of Dallas-based Commerce Street Capital LLC, said at his company's annual bank conference April 3 that regulators are being more stringent when examining banks with higher concentrations of real estate lending. If a bank grew its real estate lending business quickly, Wiley said, regulators will give it a 3 CAMELS rating, even if a bank's credit quality is pristine and it previously had a great rating.
To keep regulators happy and prepare for the future, Texas-based banks are looking to shore up capital. Weinstock said capital is clearly more limited, but banks are out in the market raising funds. Raising capital certainly comes at a higher cost to banks. As Wiley noted at the conference, banks' days of "driving the terms on capital are over. It's on investors' side." He added, "If you're clean, you can raise capital, but it's still going to be expensive."
Blaylock said investors are taking a much more careful look at institutions' markets and their business plans before handing over funds, but most of the banks in Texas could raise capital if they tried.
That is the case because Texas is simply in better shape than most parts of the U.S. Not only did the real estate markets in Texas experience less of a real estate boom, bankers in the state have learned lessons from the last downturn. This time around, Weinstock pointed out that Texas banks did not capitalize interest in loans or make no-document loans. Mullen also said the Texas economy is more diversified now than it was in the 1980s, when it was primarily oil-based.
Sterne Agee's Rabatin also noted that most of the banks in the state already have adequate capital levels to survive the next few years, and he expects that those institutions should remain profitable.
Competition has waned notably in the state, according to SunTrust Robinson Humphrey Inc. analyst Jennifer Demba, and that will certainly help Texas-based banks remain profitable. Demba said in a recent report summarizing meetings with Texas banks that credit spreads have improved substantially, and the hiring market in the state is much more favorable than in recent years.
Demba expects credit losses in Texas to be lower than in many other markets with faster population growth. She added that Cullen/Frost Bankers Inc. and Prosperity Bancshares Inc. will remain safer banks from a credit standpoint.
Rabatin does not expect Prosperity to report material net charge-offs in the first quarter either and put First Financial Bankshares Inc. in the same boat. The analyst said he likes the potential of the commercial and industrial business model of Sterling Bancshares Inc. and Texas Capital Bancshares Inc. but is concerned that those institutions will report higher net charge-offs in the first half of 2009.
Still, Rabatin said the relative strength of the Texas economy should continue to give the state an advantage over other areas of the country, though he cautioned that does not provide banks in the state with immunity.
"Economic trends will continue to soften, and banks are likely to have higher credit losses. However, we believe those fearful of an early 1980s retread for the Texas banking system are over-concerned," Rabatin wrote in a report.
