By Frank Kalman

August 24, 2010

While the backlash of the financial crisis continues to weigh heavily on the nation’s banks, Illinois lenders are in the midst of a major consolidation of their own, with a lagging Chicago economy propelling the trend.

Since 2007, Illinois has seen 37 of its community banks succumb to failure, with Friday’s ShoreBank closure being the most recent. Illinois places third behind Florida and Georgia in bank failures over the past three years, according to the Federal Deposit Insurance Corp., the agency that steps in to protect depositors when a bank fails.

Heading into the second half of 2010, roughly 35 community banks in Illinois had Texas ratios (a measure of a bank’s charge offs and non-performing loans against its equity) of 100 percent or more, including ShoreBank, a key sign that a bank is struggling to stay solvent.

Furthermore, three of Chicago’s largest publically held bank holding companies (MB Financial Inc., Northern Trust Corp. and Privatebancorp Inc.) aren’t terribly optimistic moving forward, due to concerns about an underperforming area economy. Illinois’s unemployment rate was just over 10 percent in June, while the nation’s jobless rate stood at 9.5 percent.

“You’re not seeing the hiring that you’re used to seeing in this point in the recovery,” stressed Rob Wilson, president of Chicago-based HR outsourcing firm Employco USA Inc.  “It’s still not a great business environment.”

It’s become a vicious cycle of sorts, with businesses reluctant to borrow to expand and banks less than eager to lend to them. The result, industry observers say, will be more bank failures and bank consolidations in Chicago and the state as a whole.

Because Illinois was one of the last states to allow interstate banking, it’s loaded with community banks, with just over 600, according to the FDIC. That’s the most per capita in the country, estimated Jim McAveeney, a banking consultant in the financial services practice of KPMG LLP, an audit, tax and advisory firm.  California, for instance, reports to the FDIC that it has nearly half that number.

“The strong are going to get stronger,” McAveeney said.  “A lot of it is going to be at the expense of the weaker players.”

He classifies area banks in two categories: “dead” or “living dead,” according to McAveeney. The “living-dead” banks are well capitalized, still solvent, but too strapped to lend to businesses in the Chicago market.

The “dead” banks are those whose low capital levels got them into trouble, and either have been taken over or will be taken over by another banking institution through FDIC-arranged deals.

“So now the dead banks are doing nothing, the living dead are not able to lend because they’re still hoping and reserving and managing their existing assets to stay solvent.”

In its July 22 second-quarter earnings release, MB Financial caught analysts off guard by hiking its loan charge offs, a measure of losses from bad loans, to $67.2 million for the quarter, a 45 percent increase from first quarter charge offs of $46.5 million.  MB Financial also set aside more money to cover future losses from bad loans, a sign of the bank’s lack of confidence moving forward.

“We found little basis for optimism regarding credit quality,” wrote Anthony R. Davis, banking analyst for Stifel Nicolaus & Co., in a research note reacting to MB Financial’s earnings.  “Nor were we very encouraged by management’s outlook.  In fact, when pressed for guidance on future loss rates and provisions, management was extremely reluctant to comment.”

“We believe – as we have for a long time now – that the economy will remain weak and volatile for an extended period,” said MB Financial CEO Mitchell Feiger in the July 22 conference call.  “Furthermore, given the precarious state of our state’s finances and for other reasons, the state of Illinois and the Chicago area will probably underperform most of the rest of the country, economically,” he said. “Well into 2011 and likely into 2012.”

Perhaps part of the reason MB Financial reported heightened charge offs and provisions has to do with its aggressive acquisition of failed area banks.

The bank leads others in the state with six FDIC-assisted transactions since the start of the credit crisis — including its April 23 acquisition of Broadway Bank, the controversial lender previously owned by the family of Alexi Giannoulias, the Illinois state treasurer currently running for the U.S. Senate.

“One good outcome – at least for us – of the weak economy,” Feiger said, “is that…there will continue to be a high rate of bank failures.”

Joe Hemker, a banking attorney for Howard & Howard Attorneys, a firm that represents roughly 130 banks, the majority of them in Illinois, said much of the pressure local banks are feeling is a result of a cycle – similar to previous banking crises in the late 1980s and early 1990s.  He also was not surprised by MB Financial’s charge offs for the quarter.

“I don’t think that it’s unusual for a bank that has done as many transactions as they’ve done with the FDIC — which by its nature, is going to have added a lot of non-performing loans,” Hemker said.

But other analysts are more skeptical.

“It will take another quarter or so before we get a real clean picture of what is happening to [MB Financial],” wrote Paul Miller, banking analyst for FBR Capital Markets Inc., in an e-mail.

However Privatebancorp, holding company for Private Bank Trust & Co., reported charge offs and provisions in line with most analyst expectations, down to $49.8 million from $56.9 million in the first quarter 2010.  Yet Private’s CEO, Larry Richman, also found little room for optimism on the Chicago market during the company’s earnings call –  and 70 percent of Private’s business is focused in the area.

“The uneven nature of the economic recovery is leaving our clients cautious,” he said.  “We are seeing many businesses maintain high liquidity, causing new loan demand and existing line usage to remain low…as others have said,” Richman concluded, “we have a long climb up and this will take time.”

Even Northern Trust Corp., the $80 billion asset wealth management company that is less exposed to the local macro-environment due to its global reach and traditionally conservative nature, reported a slight climb in charge offs in its second quarter to $38 million from $30.6 million in the prior quarter.

Patrick Daugherty, a 30-year veteran attorney of Foley & Lardner LLP, said there are some signs the lending environment in Chicago is turning around, much of which has to do with the gradual return of cash-based lending, or lending using a company’s organic cash flow as collateral rather than physical assets.

“When the economy gets bad, there is more collateral-based or asset-based lending,” he said.  But the return of cash-based lending is not in full throttle yet; banks are waiting to see a trend in businesses ability to show sufficient lending capital on their books for longer than one or two fiscal quarters.

“The banks are basically saying to themselves, ‘that’s a good start, come back to us in six months,’” Daugherty said.

“The good banks,” McAveeney concluded, “have actually now had the regulators come in and layer some more stringent capital requirements.  So…the regulators have come in with all good intentions to protect the shareholders to say, ‘alright, guys, we want you to have more capital on your balance sheet so that should future events like this bad recession come about, you’re better capitalized to weather this storm.’”

This scenario, according to McAveeney, helps bank shareholder confidence and forces banks to be much more diligent in their loan underwriting and approval process.  Small businesses can’t get loans they would have gotten two or three years ago, he said.

This change in philosophy has forced banks to tighten their credit requirements, shrinking the population of businesses that are qualified to borrow.

“There are good businesses out there that banks would love to lend to,” McAveeney said, “but because of the uncertainly in the economy, a lot of them are not making capital investments that they would have traditionally made.”

Perhaps an even larger annoyance for the industry, however, is the local real estate market – a market that remains depressed, and should continue to weigh on banks’ balance sheets for the next several quarters.

MB Financial’s problem loans stem mostly from local real estate in the Chicago market.

Analysts describe construction real estate loans as the bank’s “nemesis,” accounting for an average of 52 percent of its net charge offs over the last four quarters leading up to its latest results.  Miller of FBR notes that new problems in the bank’s real estate loan portfolios caused net charge-offs to account for two-thirds of MB Financial’s second-quarter losses.

“Chicago just had a bigger housing bubble” compared with other cities in the Midwest, said Ernie Goss, MacAllister chair & professor of economics at Creighton University in Omaha, Neb.

Goss studies agriculture banks in the Midwest, a sector that he said is less exposed to the banking woes caused by the burst of the real estate bubble. “When you climb a mountain, you just got a longer way to fall.”

And residential foreclosure rates are still on the rise.

Newly released data by Woodstock Institute, a nonprofit research and policy organization focused on the Chicago economy, shows that new foreclosure filings on condominiums in the six-county region grew by two percentage points to 19 percent from 17 percent of all foreclosure filings in the first half of 2009 and 2010.  Many of these new condo foreclosures came from new activity in suburban Cook County.

Although there is no direct confirmation that the high volume of condo foreclosures in suburban Cook County is linked to MB Financial, analysts note that the bank’s “suburban exposure” in its real estate portfolio will “likely continue to weigh on” the bank’s losses.

Hemker of Howard & Howard said the Chicago market is simply behind others in the real estate recovery cycle.

“When I look at it in comparison with some of the other markets – large markets that we have clients in…they seem to be a little bit further along in terms of working through the problem loans,” Hemker said.  “Almost all the bankers you talk to say that they’re still early to middle way through the cycle.”

During the height of the housing boom, these smaller banks jammed their loan portfolios with real estate as a quick growth source.  Some, Hemker said, even extended to risky markets outside of Chicago like Florida and Las Vegas.

“Residential real estate development was really one of the only things they [small banks] could do to grow,” Hemker said.

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