Darkness before dawn

Economic forces that mauled major banks still stalk those that aren’t too big to fail.
By Frank Maley

As the U.S. financial system staggered to the brink of collapse last September, Buddy Greenwood watched events unfold with growing concern. As CEO of Weststar Financial Services Inc., he runs its sole subsidiary, Bank of Asheville. This BofA little resembles the behemoth a two-hour drive away in Charlotte. It occupies the bottom floor of a three-story building on the outskirts of an eccentric mountain metropolis, not a preening 60-story tower in the heart of what was then the nation’s second-largest financial hub. Bank of Asheville would have to see its $203 million in assets grow 8,993 times to match Bank of America Corp.’s. When his iconic New York brokerage stared death in the face, Merrill Lynch’s leader didn’t pick up the phone and call Greenwood; he called the other BofA — much to its shareholders’ eventual chagrin.

Though far from the epicenter of the temblor, Greenwood could feel the landscape shifting. “You’re concerned about the ripple effect, because you know it’s going to impact your customers and it will have some residual effect on the bank.” Bank of Asheville has had to restructure loan-payment schedules to accommodate slowing customer cash flows during the recession, but its deposits, like those at many other community banks around the state, have increased as customers of shakier, sometimes larger, banks sought refuge from the upheaval.

The vast majority of North Carolina banks, including Bank of Asheville, appear poised to survive the downturn, but many Tar Heel bankers still live in fear of what tomorrow will bring. While Bank of America grabs attention with big deals gone awry, worrisome capital levels and leadership shifts, smaller institutions struggle in its shadow with woes of their own. Most have been pinched by bad loans and difficulty finding the money to cover them. And the longer the economy stays in the tank, the worse their position is likely to get.

Many of the big banks are laying off workers, but capital infusions from the federal Troubled Asset Relief Program make them unlikely to fail. “Smaller banks have a much tougher row to hoe,” N.C. Commissioner of Banks Joseph Smith says. “If you’re not too big to fail, if you’re not systemically significant, you’d better keep your nose clean because you don’t get that kind of support in a downturn.”

Smith likes to crack jokes — some of them funny — but about that he’s dead serious. He shut down Wilmington-based Cape Fear Bank Corp. in April, and three others formally have been warned to change the way they do business — just as Cape Fear had been. The admonitions aren’t necessarily preludes to failure, but they’re signs of banks heading in that direction. When the downward spiral will stop is anybody’s guess. The savings-and-loan crisis of the late ’80s and early ’90s took down 10 North Carolina thrifts in five years. Smith says this crisis won’t produce that many casualties, but he doesn’t guarantee that Cape Fear will be the last Tar Heel bank to fail. Some still standing have even scarier numbers.

Tom Hood had his eye on the Wilmington market a long time. In many ways, it’s a smaller version of Charleston, S.C., where Hood is CEO of First Financial Holdings Inc. Both have ports, historic neighborhoods downtown and an extensive second-home market because of nearby beaches and waterways. First Financial crossed the state line in 2001, opening a branch in Sunset Beach, where its northward expansion stalled for eight years.

When panic hit the financial markets last fall, it struggled, too, losing $6.5 million, 58 cents a share, in the last quarter of 2008, largely because of a steep rise in its loan-loss provision. But it rebounded the first three months of 2009 with a profit of 19 cents a share. Cape Fear already had problems, and the broader crisis made them worse. Losses hit $1.18 a share in the third quarter, and the bank was still dealing with fallout from a bitter battle with dissident shareholders led by Maurice Koury, a real-estate developer and president of Burlington-based Carolina Hosiery Mills Inc.

In July, Koury had pitched a plan to replace the bank’s board and accused management, especially CEO Cameron Coburn, of unfocused and ineffective leadership. He complained that the bank had been outperformed by peers since it was formed in 1998, that its expenses had increased 83% in two years — primarily because of branch expansion and excessive executive compensation — and that troubled loans were rising. Earlier efforts by Koury to buy the bank and to nominate board members had been rebuffed. “Any objective review of the matter would have to conclude that management and the Board HAVE NOT created any meaningful value with your money in the ten years you have trusted it to them,” he wrote to fellow shareholders.

Management, for its part, suggested that Koury might be practicing greenmail, threatening to take over the company in hopes it would pay a premium for his shares to get rid of him. It said Koury had tried greenmail once before at Kenly-based KS Bancorp Inc. and had no plan for improving shareholder value other than selling Cape Fear. “Mr. Koury, a man with no prior banking experience, is trying to characterize Cape Fear as a bank in trouble — which it is not. Cape Fear, like all other financial institutions, is facing a difficult economic environment.”

In August, both sides agreed on an eight-member board — four holdovers and four Koury allies. Neither Coburn nor Koury returned calls seeking comment, but a competitor agrees with Koury that the bank never developed a sharply focused strategy. “Cape Fear struggled with its identity and its culture as to what they really wanted to be, says Larry Barbour, CEO of Raleigh-based North State Bancorp. “I never could determine what they really stood for as a bank, as far as what segments of the market they knew they could excel in.” A bank that size — just below $500 million in assets — needs a strong niche, something that gives it a home-court advantage against heftier rivals. “Otherwise, you simply try to dot the landscape with branches that will compete alongside the Wachovias and Bank of Americas of the world, and that’s not very wise.”

Cape Fear focused on loans to small businesses, First Financial’s Hood says, and suffered from a general decline in the local economy. The proxy fight also hurt its chances by distracting management as the economic storm clouds gathered and burst. Finding capital grew increasingly difficult — even for companies that hadn’t recently been forced to reconstitute their boards to quell a shareholder rebellion. “The timing was just terrible,” Hood adds.

Coburn resigned in September. About a month later, federal bank examiners took issue with Cape Fear’s performance. In November, the board replaced Coburn with Ralph Strayhorn, chief executive of Greensboro-based SterlingSouth Bank & Trust Co. until its sale to Thomasville-based BNC Bancorp in 2006. In December, Cape Fear landed on the Federal Deposit Insurance Corp.’s list of problem banks. In late February, state and federal regulators issued a cease-and-desist order requiring it to raise more capital and analyze its management and staff. Less than seven weeks later, Smith failed Cape Fear, turning it over to the FDIC, which closed the bank April 10 and sold most of its assets and liabilities to First Financial. Its offices opened the following Monday as branches of First Federal Savings and Loan, First Financial’s main subsidiary.

Exactly what clinched Cape Fear’s closing — what made it this recession’s first North Carolina bank victim — isn’t clear. Its performance was by no means stellar, but by most measures it wasn’t the worst in the state. Smith says it’s too soon to talk about details, but regulators look closely at five factors known collectively as CAMEL — capital, asset quality, management, earnings and liquidity. Management is more a qualitative measure than the others, and Cape Fear clearly had a history of management problems. “If you look at some other franchises in the state, their numbers look really bad, but they’re still in business,” says Tony Plath, an associate professor of finance at UNC Charlotte. “There’s a reason for that. The government — i.e., the bank commissioner and the FDIC — has greater confidence in those banks’ ability to manage their way through the crisis.”

Though Cape Fear’s failure is regrettable, Smith says, the resolution was successful. All branches reopened under the management of a healthy institution. Depositors and creditworthy borrowers didn’t lose anything. And First Federal has an incentive to work out any problems with Cape Fear’s loans. “The resolution was done with what I believe will be the least cost to the insurance fund, which is paid for by the banks, and also with the least damage to the Wilmington real-estate market.”

But not all bank failures are resolved so neatly, and two other banks in Business North Carolina’s Financial 100 have received cease-and-desist orders — Wilmington-based Cooperative Bankshares Inc. and Asheville-based Blue Ridge Savings Bank Inc. Both appear to have bigger problems than Cape Fear did. The Texas ratio — so named because it was developed to analyze struggling Texas banks in the ’80s — measures how likely a bank is to be dragged down by bad loans. On Dec. 31, Cape Fear’s stood at just 44.9%. Cooperative and Blue Ridge had Texas ratios above 100%, the level at which banks are considered at severe risk of failure. Cooperative’s was a whopping 127%. “After Cape Fear went, I figured that the next Friday Cooperative would be under the control of the FDIC,” Plath says. “You’ve got to figure they’re on life support. Blue Ridge, same thing.”

Asheboro-based FNB United Corp. had the third-highest Texas ratio, 82%, but it subsequently received a $51.5 million infusion from the feds in February. “I’m not worried about FNB because they’ve got plenty of TARP money,” Plath says. “In the absence of TARP money, they would be in trouble.” Fourth-place Bank of Granite Corp., once hailed by investment guru Warren Buffett as the best bank in America, has fallen on hard times in recent years. Last September, regulators warned it to raise capital under a memorandum of understanding, a move less drastic than a cease-and-desist order. Then came a disappointing first quarter, losing 27 cents a share. Its regulatory goal is to be well-capitalized, but it finished the quarter merely adequate.

As Cape Fear shows, regulators don’t follow just the numbers, so a high Texas ratio does not always predict which banks will fall or in what order. But “it does a pretty good job of ranking the banks according to the riskiness of their loan portfolios and the heartburn that’s experienced by CEOs,” Plath says. Most Tar Heel banks had acceptably low Texas ratios — Bank of Asheville’s 2% was among the lowest — but those could rise as the recession lingers. Federal Reserve Chairman Ben Bernanke told Congress in May that the housing market appears to be bottoming out after a three-year slump and that economic activity should pick up by the end of the year. But he didn’t rule out a relapse in financial markets and said the U.S. unemployment rate likely will continue rising into next year.

“The recession continues to worsen, which means credit quality continues to weaken, which means the need for increased provision expense continues,” Plath says. “You’ve got to maintain operating income. That’s your fortification against the continuing rise in provision expense that you need as your loan quality deteriorates with a deepening recession.” But most banks will struggle to generate revenue and earnings through 2009, says Harry Davis, professor of finance at Appalachian State University. “Lending is tough because there’s not anybody wanting to borrow money. Banks have been criticized for not making loans, but who would they make them to?”

Smith says it’s unlikely the state will experience the carnage of the S&L crisis. Since then, regulators have beefed up requirements and tightened oversight, meaning banks entered this downturn “with a significantly higher level of capital than they had before the S&L crisis began.” It might be little consolation, but North Carolina is faring better than some other states. As of May 1, Georgia led the nation with six failed banks this year — 10 going back to the start of the crisis in September.

The way forward will be difficult in North Carolina, Smith says. Some banks will need to be recapitalized or merged with healthier ones. “I think at the end of it all, we’ll have a stronger, more resilient system.” Until then, “there’s going to be some pain for a while.”

Even for the more-secure banks. In early May, though Bank of Asheville has plenty of capital and stayed profitable through the crisis, its stock price is down 22% since mid-October. “We’ve been thrown in the bucket with everyone else,” Greenwood laments. Then he quickly glimpses the silver lining for would-be investors. “We’re trading at $6.25, and the book value is around $7.70. So we’re a good buy.”