Orange County banks continue to post profits in a robust local economy despite rising interest rates, a growing federal deficit and signs of some slowing in the mortgage lending market.
A key factor for banks in deposit-rich OC: interest rates.
Banks have been increasing the rate of interest they pay on certificates of deposit, which are used as one way to attract deposits to lend to borrowers.
Earlier this month, the Federal Reserve raised its benchmark short-term interest rate 25 basis points for the 12th time since June 2004. The Fed also indicated that more hikes are coming to battle a pickup in inflation.
The central bank’s federal funds rate of 4% is the highest since June 2001 and up from 1% before the Fed starting raising rates.
Higher rates have several effects on banks. Executives say that higher rates mean it costs more for them to attract deposits via higher rates on CDs. And while banks raise rates they charge on loans for everything from construction to investing in new equipment, higher rates could stifle demand for loans and increase delinquencies.
But local banking executives say for the most part that OC’s strong economy should help them weather the effect of rising rates. Variable rate lending also should help offset rate increases, they say.
Meanwhile, there’s plenty of disagreement among executives about a possible housing downturn and the possibility of a local recession.
The Business Journal contacted several banking executives to gauge their outlook on rising rates, a housing correction and the direction of OC’s economy.
Following are their edited responses.
How are rising interest rates im-pacting your bank?
Chief executive
CalWest Bancorp, parent of South County Bank
Rancho Santa Margarita
In a rising rate environment it is almost impossible not to experience some increase in the bank’s overall cost of funds. However, we focus on relationships, which minimize the rising rate impact because our focus is on the lower cost of funds core deposits.
President, chief operating officer
Pacific Coast National Bank
San Clemente
Changing rates are a fact of life for financial institutions. By actively monitoring the rates and product mix within a bank’s deposit and loan portfolios, the net interest margin can be preserved. From our customers’ point of view, higher interest rates add to cost pressures for most companies and adversely impact corporate profitability. From the bank’s point of view, higher rates reduce loan demand, increase delinquencies and require the bank to work harder for good quality earning assets.
Outside the affordability factor, borrowers become concerned about buying real estate in an unstable economy. A large part of our loan portfolio,commercial real estate loans,can be significantly impacted as real estate values fluctuate.
Pacific Coast National Bank monitors market rates on a regular basis. We also are limiting our exposure to long-term fixed rate loans. As a commercial business bank, we obviously prefer competitive variable rate loan products to protect against rising rates. We also actively seek borrowers requiring SBA loans for business acquisitions, equipment purchases or owner occupied real estate acquisitions. Like most community banks, we go the extra mile in knowing our borrowers. We do not have “credit scored” credit products like the large institutions. We know our loan customers very well before approving the request. Our pricing is flexible, and encourages banking relationships over single transactions.
Chief executive
MetroPacific Bank
Irvine
The Fed increases rates to keep a robust economy from overheating or fight increasing inflation. We are counteracting rising interest rates by shifting away from fixed rate loan products to adjustable products tied to the prime rate or Libor. Bank borrowings at MetroPacific continue to be strong. Our credit analysis of borrowers continues to focus on the traditional “C’s of Credit”: capacity, collateral, character, capital and conditions. Increasing core deposits and longer maturities on certificates of deposit to match loan maturities provide a comfort level in a rising interest rate environment.
Chairman, chief executive
CommerceWest Bank
Irvine
A majority of our loans are variable rates because we’re primarily a business bank that offers lines of credit, term loans, working capital loans, SBA loans, among others. By being focused as a business bank, we are able to control our costs better because the consumer banking side has more exposure,look at the rising cost of CDs and low, fixed cost of auto loans and other consumer loans.
Chairman, chief executive
Carpenter & Co.
Irvine
Most Orange County banks are asset sensitive, meaning their variable loan rates re-price upward in a rising rate market. To date, the loan rates have risen faster than the overall deposit rates and delinquencies have remained at historic lows.
Chairman, chief executive
Orange County Business Bank
Newport Beach
We strategically structured our balance sheet to hold adjustable rate loans while focusing on serving the day-to-day banking needs of business owners and their families. Translation: Rising interest rates do not have a negative effect on Orange County Business Bank. The key to ensuring safety from rapid rises in rates is to avoid speculation on interest rates, which is inherent in fixed rate lending, coupled with dependency on CDs as a source of funding loans.
Chief executive
Pacific Mercantile Bank
Costa Mesa
A rising interest rate environment allows smaller banks a larger spread from their cost of funds and is usually beneficial. The bank operates an asset liability model in order to assess interest rate risk on a regular basis.
Chief executive
Uniti Bank
Buena Park
I am worried that rising interest rates will bump up deposit rates and put strong pressure on the bank’s profitability. The bank may also charge a higher rate for loans. But due to strong competition among lending institutions, increase in loan rates can’t keep up with increase in deposit rates. Many bankers are also worried that if interest rates go up too high, the default rate on loans will grow.
Is there a housing bubble? Does your bank have exposure to the housing market?
Yott of South County Bank
I keep hearing about the “bubble” and then I hear from all the so-called market experts, who show tremendous faith in the Orange County region and don’t see a bubble in the near future. From all appearances it looks like OC has another year of slight growth in appreciation in real estate values. South County Bank accommodates our customer base for mortgage loans through a strategic alliance we have with a quality mortgage provider. So, in effect, our bank has no exposure to this type of lending.
Hahn of Pacific Coast National
A “housing bubble” is a scary topic, especially for those who lived through them in the mid-1980s and ’90s. It is inevitable that rising real estate values will slow with rising rates. Borrowers just won’t be able to afford the payments. The good news is that the Orange County economy is still doing well. Employment and population continue to grow at a healthy rate here. High housing prices and cost of living in the county, however, will continue to give inland communities a competitive advantage in job creation over the next several years.
Currently Pacific Coast National Bank isn’t offering residential real estate loans. We leave the market to the experts in the mortgage banking arena. We do have financial partners in the mortgage lending industry to which we refer our customers. The management team and board of directors strongly believe our focus should be on providing the highest level of service to small to medium size businesses and professionals.
Hildt of MetroPacific
Waiting for Orange County’s housing “bubble” to burst could be a long wait. The local economy is so well diversified that a complete collapse in real estate values seems unlikely. The economy is healthy, unemployment is favorable and the county has experienced nearly a decade of continuous growth. Prices are still going up, interest rates remain down and buyers are surprisingly plentiful. The main risk is some of these “creative” interest only and negative amortization loans, which could come back to bite borrowers and some lenders in the future. At MetroPacific we mitigate residential interest rate risk by pre-selling all of our residential loans on a non-recourse basis into the secondary market.
Tjan of CommerceWest
We see the potential for some correction in the housing market. It has been too hot for too long. I don’t know if the correction will just be a flattening of the growth in the next few years or if we see a minor decline in the value of homes. There are already signs and I am confident to say something will change in the future with housing. We protect ourselves by not doing residential loans.
Carpenter of Carpenter & Co.
The commercial banks in OC do not have loan exposure to single-family housing. The housing bubble will most affect the institutions with home equity lines, first mortgages and those that lend to the builders and contractors. Most banks are withdrawing from the speculative housing market.
Gough of Orange County Business Bank
No one knows for sure where the valuations of housing are headed. What’s important for banks is to carefully grow the balance sheet with quality cash-flowing business loans backed with not only strong collateral, but more importantly, strong borrowers. As values rise and fall, strong borrowers will take advantage of opportunities, but will be able to handle any burps (unanticipated challenges) as they occur in everyone’s life. As a business bank, we have not focused on the residential mortgage market.
Dellerba of Pacific Mercantile
The housing market has been frothy for some time and we may be in a conundrum of rapidly increasing valuations. Whenever values on any commodity move upward or downward in a very short time period, it usually requires an over-adjustment correction. Since interest rates have been climbing during the past 12 Federal Reserve meetings, this will eventually cause a degradation of the market on its own. Mortgages are very interest-rate sensitive and value is lost when available buyers become non-existent due to higher costs. The interest-only mortgage loans do have a purpose, although recently they have been highly abused.
Im of Uniti Bank
I have seen that housing prices almost doubled in the past three years in Orange County. The housing market seems to have reached a high plateau. But I don’t believe that it will collapse in a similar way as it did in the last decade. Our bank will not be directly hit by an adverse change in the housing market since we don’t make direct housing mortgage loans. But I am cautiously watching out for a possible indirect effect.
Any signs of a national recession? What’s the impact of the federal deficit? Do you expect to see a lending slowdown?
Yott of South County Bank
I believe California has its own set of problems with the state budget calling for more spending than we have revenue to support. You and I can’t spend more than our checkbook has in it. The state continues to borrow to pay for the revenue shortfall, and that can’t be looked at as fiscally healthy. I always look at the potential unemployment fallout and I look to that picture getting worse. Manufacturing jobs continue to shrink and construction will begin to slow due to the rising rate environment. Add to that the impact that the energy stress is causing our economy and you have to conclude we must be struggling to a certain extent.
The more the consumer base retreats from spending the less likely our manufacturing sector will grow. I don’t know if I would classify all this as a full-blown recession, but definitely a “slowdown” label would be in order. I think we will see the same in residential and commercial property sales figures,not necessarily a decline, but more than likely a slowdown or flattening.
Hahn of Pacific Coast National
The recent UCLA Anderson Third Quarter Economic Forecast projected that the U.S. economy will experience slow growth through 2006. However, the slowdown is now considered to be more gradual than predicted in June as the projected reduction in housing construction is still in the future. I believe most bankers are both realistic and optimistic. All indicators show we will begin to slow; however, the outlook for Orange County still appears good.
I see very little change or impact on the bank in the first three quarters of 2006. My personal opinion is that we should see slowing beginning in the third quarter into 2007. Hopefully, interest rate increases will be held to a minimum in 2006.
Hildt of MetroPacific
A recession sometime in the next few years may not be a stretch. A key question here is will the new Fed Chairman Ben Bernanke follow the same path as Alan Greenspan? If you consider the dynamics of past economic expansions you’d say a recession in the next few years is a possibility but not a certainty. The U.S. economy has been in an expansion for around 14 quarters. Many economists are wondering how long it can last. We have rising oil prices, the Iraq war, a question on the stability of the real estate market, hurricanes and the spread narrowing between the yields on short and long term securities. If interest rates continue to rise, how will that affect smaller companies’ ability to service debt? Alan Greenspan last year stated the rising federal deficit represents a long-term danger to economic stability.
Tjan of CommerceWest
I don’t see a recession in the near future. I do see some potential of inflation and a vulnerable residential real estate market. We see our lending going up because we are on the business side of it. The rising rates for the most part should not materially affect us too bad.
Carpenter of Carpenter & Co.
No signs of a recession in the next 18 months are on the horizon. There will be a mild lending slowdown in the real estate sector. On the loan side the federal deficit affects banks with significant international business lines. The competition with the government for debt financing is the most significant factor causing rising rates.
Gough of Orange County Business Bank
We have not seen any signs of a recession among our clients,businesses or individuals. It is difficult to predict economic activity. I believe that the appetite for credit always is there if you are willing to make the effort to find it. However, the niche on which we focus in Orange County seems to be more resilient than most to economic downturns.
The rising federal deficit will definitely have an impact at some point on interest rates despite the widely talked about “savings glut” in the world today. At some point, foreign holders of dollars and dollar-denominated investments could get cold feet about too many dollars sloshing around the globe with the continued erosion in its “store of value”,the measure of maintained spending power. Just in the past 20 years, the dollar lost about half of its value with those 3%-a-year inflation rates taking a toll long term. If foreigners were to dump dollars and dollar-denominated investments because they lost faith in the dollar’s ability to maintain its spending power, then the impact would be widespread in our economy with a combination of inflation and high rates,just like in the President Carter years. A rising federal deficit makes this scenario more likely.
Dellerba of Pacific Mercantile
With the high cost of fuel, coupled with higher interest rates, the economy will certainly slow down. Two consecutively declining quarters usually define a recession and although there seems to be no sign of this currently, with all these people saber rattling and predicting a declining economy, it will most certainly help fuel one. That, in turn, will cause lower consumer spending. The consumer market will definitely start slowing down due to higher interest rates. The commercial market has been descending for the past 10 years, regardless of what interest rates have done during that time period. The federal deficit always has an impact on banks, because they compete for the same dollars utilizing treasury instruments, which also affect interest rates.
Im of Uniti Bank
I don’t see a sign of recession in general. But I see that growth in the local economy will slow down. We must have been spoiled by the fast-growing economy in the past decade, if we consider 4% GDP growth as a recession.
What’s your bank’s strategy amid rising interest rates?
Yott of South County Bank
We see sustained growth during Orange County in 2005 and continued development of business relationships for our bank. These relationships bring more lending and core deposit opportunities. Our customer service allows us to attract a base of lower cost deposits rather than costly CD money.
Hahn of Pacific Coast National
Many Orange County businesses are not just looking for a bank,they are looking for a banking relationship. Pacific Coast National Bank offers both experienced relationship bankers and flexible rates and terms. We actively watch the deposit market to provide fair and competitive rates and terms.
Hildt of MetroPacific
As one of the few remaining locally owned banks in Orange County (there were around 45 in the mid-1980s) we bring uncommon expertise, experience and creativity to banking in Orange County. Opportunities abound. In the Irvine Business Complex alone there are 3,762 residential units approved and another 5,644 pending. There are 12,350 units planned for the Northern Sphere and 3 million square feet of commercial and industrial uses for Irvine’s Great Park. To meet the needs of our community we have employees who speak Mandarin, Vietnamese, Spanish, Farsi and Korean. We offer expertise in SBA lending, residential and construction lending, and business lines of credit.
Tjan of CommerceWest
We still are primarily going after checking and business checking accounts to keep our cost of funds down. Businesses in Orange County seem to be headed in the right direction and we are seeing growth in many industries. When the feds are increasing interest rates, it historically has meant that small, midsize and large business are doing well and they see that in the near future businesses are spending more monies and growing, which could cause inflation.
Carpenter of Carpenter & Co.
On the lending side of the balance sheet for the Orange County banks all is well and the dynamics are excellent. For commercial real estate lenders, the aggregates are up 12% over last year at this time. Draw downs against business lines are up 18% against total commitments. On the deposit side of the balance sheet, the aggregates are more difficult. The cost of deposits has risen more quickly than many anticipated and they are more difficult to find at the lower end of market rate costs. Robin Hood has reversed his role and is now providing more interest income to the rich and making loans more expensive for needy borrowers. With some progress in the stock market over the next few quarters, significant deposit holders will continue to experience disintermediation into the market and other investment alternatives. For those banks with low-costing core deposits, profits will be up significantly.
Gough of Orange County Business Bank
As one of the most under-banked and deposit rich counties in the U.S., the opportunities in Orange County are huge. The key is to set yourself apart from the competition by serving clients with unusual service levels and making the extra effort to meet their needs quickly and efficiently. We focus on the part of the market that would rather earn a little less in order to get a whole lot more.
Dellerba of Pacific Mercantile
Pacific Mercantile will continue to solicit the business community for loans and deposit requirements. There is plenty of business in the small business lending non-SBA market for wholesalers, retailers, manufacturers, professionals and distributors, which require custom lending. We offer a full line of deposits, which include transaction and interest bearing instruments that can be custom fit to businesses, professionals or individuals.
Im of Uniti Bank
I have seen a growing number of businesses owned and operated by ethnic minority groups, such as Korean, Chinese, Vietnamese and Hispanics, to name a few. Many of them are involved in small businesses in the fields of retail, service industry, manufacturing and commercial real estate development. Uniti Bank considers these minority-owned small businesses as an important target market.
