Banks and Financial Institutions Had Big Plans for OC Last Year,but That Was Then
It was less than two years ago that financial institutions were flocking to Orange County.
And why not? The economy was booming, a record-high stock market was creating an endless stream of new millionaires and the mood was one of nearly boundless enthusiasm.
Trust companies, investment bankers and stock brokerages opened offices here or expanded their existing operations, hoping to cash in on the good times in one of America’s most upscale locales.
Today, of course, it’s a vastly different story. The economy is either headed for, or already in, recession. The stock market plunge has wiped out fortunes. And already-growing consumer fears and business worries have accelerated in the wake of the Sept. 11 terrorist attacks.
Once gung-ho financial institutions suddenly are tabling expansions, imposing hiring freezes or cutting back.
Last week the two largest depository institutions based in Orange County reported lower third-quarter earnings. Westcorp, parent of Western Financial Bank and WFS Financial Inc., said profit fell 55% year-to-year to $8.2 million, due largely to credit-related losses from the weak economy. Downey Financial Corp. reported an unexpected year-to-year earnings drop of 17%, to $21.8 million; it blamed refinancings for lowering the value of its mortgage-loan portfolio.
“The markets have been tough on everybody,” said Scott Browning, managing director of the Orange County office of myCFO Inc., the Mountain View-based wealth management firm that opened its OC office last year. “When you lose trillions of dollars of wealth, obviously that’s not helpful for the financial services market.”
The outlook for financial institutions is daunting:
The U.S. economy, which was growing at a brisk 4% annual rate in early 2000, has come to a screeching halt; it most likely had a negative growth rate in the third quarter. Capital spending has dropped sharply and consumer confidence, which was holding on despite the economic malaise, has crumbled since Sept. 11.
The Dow Jones Industrial Average has fallen 20% from its high in April 2000, while the S & P; 500 has shed 30% of its value. The Nasdaq is down almost 70% from its all time high on March 10, 2000. For equity investors, it has meant a loss of nearly $5 trillion.
But the problem goes far beyond paper losses.
Banks have become more cautious with their lending in response to rising corporate defaults; problem loans have risen threefold. A series of rate cuts by the Federal Reserve Board, intended to boost the sagging economy, has been squeezing the bank’s interest spreads and margins.
The IPO market has almost dried up and M & A; activity has fallen almost 40%.
Some large stock brokerage firms have seen a 30% or more drop in business. Wealth management groups, trusts and asset management firms have seen their assets under management decline sharply because of a fall in the market.
So with their world, and the local scene, suddenly turned upside down, where do financial institutions go from here?
For trusts companies, investment banking firms and stock brokerages, it’s time for pause and retrenchment. Staffs are being frozen or trimmed, and expansion plans have been tabled. Stock brokerage U.S. Bancorp Piper Jaffray recently closed its OC office, which it had opened just last year.
For commercial and retail bankers, long accustomed to consolidation, the immediate impact will generally be less severe. But these institutions are feeling pain, too, particularly from increased loan losses and shrinking interest spreads.
On the other hand, declining interest rates are helping mortgage-loan writers, who have seen a new wave of consumer refinancings, and sub-prime lenders, whose borrowing costs are falling faster than are the rates they can charge their high-risk clientele.
This special report examines how key segments of the local banking and the financial services industry are faring with the economy in a recession and the country at war.
THE LENDERS
As goes the economy, so go commercial banks.
After nine years of good loan performance and rising spreads, commercial banks finally are seeing a deterioration in the business climate, rising bad loans and falling margins.
“We had forecast 2001 to be a tougher year, both in loan production and from loan quality, than 2000,” said Christopher Warmuth, senior executive vice president and chief credit officer at United California Bank. “But 2001 has shown itself, before Sept. 11, to be tougher than what we had forecast. And clearly, since Sept. 11, it took another degree of downturn that is still really unknown,” he said.
On the other hand, some other lenders are faring nicely in the current climate.
Last week the two largest depository institutions based in Orange County reported lower third-quarter earnings. Westcorp, parent of Western Financial Bank and WFS Financial Inc., said profits fell 55% year-to-year to $8.2 million, due largely to credit-related losses from the weak economy. Downey Financial Corp. reported an unexpected year-to-year earnings drop of 17%, to $21.8 million; it blamed refinancings for lowering the value of its mortgage-loan portfolio.
United California’s Warmuth said that because of the sharp slowdown, most commercial banks are faced with higher problem loans than what they had anticipated as borrowers are finding it more difficult to meet their interest obligations in a slowing economy.
Non-performing loans as a part of total assets have risen to 0.83% as of June 30 from 0.35% in the fourth quarter of 1999, according to Atlanta-based Sun Trust Robinson Humphrey.
“The problem loans could have reached 0.90% for the third quarter,” said Christopher Marinac, senior analyst at Robinson Humphrey.
“You have seen the economy slow down and the borrowers have become a bit stretched,” said Marinac. “It is becoming difficult for them to pay.”
While the non-performing loans have risen almost threefold, they are still manageable. But a further increase in problem loans may not bode well for the industry. To prevent loan quality deteriorating further, banks have become more cautious when it comes to lending.
United California Bank, which is a big lender to the agricultural sector, said it has tightened its credit in sectors such as cotton and grapes because both commodities are in oversupply right now.
“Definitely the amount of due diligence has increased that we will do on new customers,” said Warmuth. “The number of questions bankers are asking today has clearly increased from a year ago. The attention we are paying to customers’ projections and business plans is higher than it had been previously.”
“You have more bankruptcies, companies that have slower businesses,” said Marinac. “Margins have contracted and they have contracted for most of the banks.”
Most of the problem loans that banks have seen so far are in commercial lending; retail lending has been relatively stable and has not seen many defaults so far. But bankers said that if the economy worsens from here, you could see more problem loans on the retail side as well.
“The rise in problem loans has been in commercial lending loans and the performing loans have been the consumer loans,” said Fred Cannon, executive vice president at California Federal Bank. “We might now see problems with consumer loans.”
And Russell Goldsmith, CEO of City National Corp. said that as unemployment rises, the industry could see more defaults on retail loans.
The slowdown in the economy, fall in the stock market and nine quick interest rate cuts have affected banks in more ways than one. Besides rising problem loans, banks have seen their spreads,the difference between their lending and borrowing rates,come down. With their spreads coming under pressure and rising problem loans, banks have also seen their margins coming under pressure.
“I don’t think there is any bank in the country that hasn’t had some margin compression,” said Goldsmith. For the quarter ended Sept. 30, City National Bank saw its net interest margin come down slightly to 5.28% from 5.32% in the third quarter of last year.
That said, banks lending to real estate firms and construction firms have seen better margins and lower levels of non-performing assets. Mortgage and subprime lenders are also busy.
At Dynamic Access, a mortgage banker in Laguna Niguel, a 2-percentage-point drop in the prime rate over the past 15 months has translated into a 50% increase in business, said mortgage broker Earl Brown.
“Our cost of funds at the bank as well as the mortgage company has dropped precipitously,” said David DePillo, president and COO of Commercial Capital Bancorp. “Our average cost of borrowing today is probably 300 to 400 basis points below what it was six months ago.”
According to Stephen Gordon, chairman and CEO of the company, its net interest margin for the third quarter improved to approximately 3% from 2.75% in the second quarter. Commercial Capital specializes in lending to investors in apartment buildings and other commercial real estate in California. DePillo said that the company is originating loans of approximately $40 million to $50 million every month because of the demand in California for rental housing.
“The construction and real estate side has been very strong for us, and we have few problems there,” said Warmuth. “And low interest rates helps a lot of that marketplace.”
Subprime lenders also have seen their spreads widening as interest rates fall.
“We generally don’t lower our lending coupons with the falling interest rates so, in fact, our spreads get wider,” said Charles Bradley, chief executive of Irvine-based Consumer Portfolio Services Inc., which deals in auto loans to people with with less-than perfect credit. “Basically they (spreads) have been the widest in 10 years, if not ever.”
“Some people say that the economy has a great (negative) effect on subprime lending,” said Bradley. “Our view is that the economy or the recession don’t have a big effect on subprime lending because our customers need to have car to get to work.”
With falling interest rates, and demand for high-yielding and high-grade paper on the rise, Consumer Portfolio Services completed a $68.5 million sale of loans to investors in September, its first securitization since hitting hard times in 1998.
Bankers said that with pockets of strength and a stronger balance sheet, the banking industry is in a much better position than it was in the early ’90s when the U.S. economy was hit by a recession.
“While the economy and interest-rate environment has been problematic, the capital situation is very strong here,” said CalFed executive VP Fred Cannon.
“The capital base and the reserve base of the banks is much stronger than the last time we went through a recession in the early ’90s,” said Warmuth. “So problem loans are much more digestible today for the banking industry than it was previously.”
THE ASSET MANAGERS
Inspired by the nine-year bull market, wealth management firms, trust companies and boutique asset management firms were until recently opening up their shops in Orange County to get a piece of the growing pie.
Wealth, trust and money management firms from Mountain View to New York decided to open up offices in Orange County to serve the growing list of millionaires here.
But things have changed significantly since early 2000 as the newfound wealth has disappeared as quickly as it was made. Expansion plans have been put on hold and even large asset management firms have had hard times dealing with the fall in the market.
First American Trust, a unit of Santa Ana-based First American Corp., which has been in the trust business for more than 20 years, has delayed its plans to open an office in Los Angeles. The trust company had firm plans for opening the office in the third quarter. But with the fall in the stock market and the slowdown in the economy, First American has now set the opening for the second quarter of 2002.
Newport Beach-based Palley Needelman Asset Management Co. is another company that has been buffeted by the fall in the stock market, the economic downturn and investor nervousness. The firm, which had more than $4 billion under management at one time, today has less than $200 million under management. The firm, which maintains that it has actually outperformed most funds despite the withdrawal of investors, had around 40 employees a couple of years ago; today its staff strength is down to a dozen or so.
“Given the difficulties in the markets, it’s affected just about everybody,” said Guy Williams, managing director of Southern California operations at Merrill Lynch & Co. Inc. Besides stock brokerage and financial advisory operations, Merrill also has a large wealth management practice in California.
Trust and asset management firms manage money for wealthy individuals and families, for a fee. They also help clients with their estate planning needs.
“Certainly the past year or so we have seen a decline for most trust companies of assets under administration,” said Thomas Kelley, president and CEO of First American Trust.
Wealth management firms are similar to trust companies but they focus on estate planning and other needs of wealthy families and individuals. The stock market plunge has wiped out fortunes and some of the wealthy families that these firms were targeting have fallen off the radar screen.
“People that had $20 million have gone down to $5 million and, yes, our market for those people have gone down,” said Scott Browning, managing director of the Orange County office of myCFO Inc., the Mountain View-based wealth management firm for individuals and families.
MyCFO and other wealth management firms mainly have clients with net worths of $10 million and upwards. The Mountain View-based firm opened its OC office early last year and went on a hiring binge, ramping up its OC office to 40 people. Browning said that, while the firm has no plan to lay off anyone in OC, the firm is more or less fully staffed and now hires only select professionals in Orange County.
Meanwhile, in April, myCFO laid off about 30 software engineers in their Mountain View office.
“We laid off people because of technology. We were trying to build a model from scratch and then we decided to build a different model,” said Browning.
Since myCFO opened its local office, other larger and more established players also moved into OC. Citigroup Inc. of New York opened its office in May and now has a staff of seven here, while Wilmington Trust of Delaware started their operations here couple of months ago.
So far, Citigroup said it is moving forward despite the economy.
“Right now we are hiring on more support staff,” in Orange County, said Ethan Morgan, vice president at Citigroup. “Our real hiring is up in LA where we are also actively looking at the prospect of an office in the West Side,” he said. “We are very bullish on California.”
Still, almost everyone concedes that a year ago, they didn’t expect to be in the predicament they are today. Executives said that while they had expected the stock market to come down in 2001, none of them had factored in this sharp fall and its impact on their business when they did their budgets last year; none of them had factored in a possibility of a war.
“No I can’t say that I reasonably expected the decline in the market value. I knew it won’t continue up as much,” said Kelley. “In our budgeting process we didn’t project (the market) to go up as much but we didn’t expect such a significant downturn.”
First American’s assets have remained flat over the past nine months at about $2.1 billion,something that Kelley cites as an achievement, given current market conditions. He said the firm has maintained its asset level by adding new clients.
“Our new sales have been as much or more than what we had projected,” Kelley said.
Some managers said that a choppy stock market, like the current one, can be a help for their operations because it prompts many people to seek the advice of consultants and of someone to handle their assets.
“Lots of our clients are not just new money but are old money as well,” said Browning, who also said that myCFO’s assets have remained at the same level or grown from last year. “Some of our clients have actually gone up in net worth,those that have real estate holdings and likes,” he said. “If you look at total net worth of our clients last year then what we have today, we are almost flat.”
THE I-BANKERS
Until recently in Orange County’s investment banking scene, the popular hiring strategy was “poaching.” Firms looking to grab a piece of the growing pie of public offerings and mergers-and-acquisition deals typically would try to add staff by hiring talent away from OC competitors.
But since early 2000, poaching has been replaced by “freezing.”
Investment banks have stopped growing and instead have put on hiring freezes and curtailed recruitment as the market for public offerings has almost dried up and M & A; activity has shrunk by 40% or more.
“It takes a lot of adjustment. The first part of the adjustment is shaking out the excesses of the bull market. Everyone had to do that,” said Patrick Allen, president of Roth Capital Partners LLP. During the dot-com euphoria Allen had seen some of his key investment bankers being recruited by larger investment banking firms.
But an investment banker who had left Roth and joined Deloitte & Touche’s M & A; practice sometime back recently quit Deloitte to join his old firm again.
“Clearly, business prospects in general are down and there is much more uncertainty,” said Andy Graham, senior vice president in charge of Los Angeles-based Barrington Associates’ 8-month-old OC office. Earlier this year, Barrington opened its office in Irvine to serve the middle market for mergers and acquisitions. But since then investment banks have seen a big fall in their M & A; and advisory business.
“The IPO and the secondary financing market has virtually come to a stop,” said Kimberly Valentine, partner in the national corporate finance department at Deloitte & Touche. “We have had general attrition. We are not immune from economic downturn.”
In Orange County, Deloitte & Touche has seen at least two senior bankers leave the firm in the past six months, Valentine said. She would not comment whether they were laid off or if they left on their own. She said that Deloitte has put an overall freeze on new hiring.
Valentine said that many good investment bankers have lost their jobs in this tough market where employers are trying to cut costs. She said that while she was getting a couple of resumes a month for a possible job opening, these days she get about 20 a month.
“When you get M & A; shops with high overheads based on prior deal volume levels and all of sudden you have deferral in deal volumes, people decide to cut some overheads,” Graham said. He said that investment banking firms have been pro active in their cost cutting efforts since the past six months.
In 2000, the M & A; activity on a nationwide basis declined for the first time in nine years. The total value of M & A; deals declined by 7% to $1.325 trillion according to data complied by Los Angeles-based Mergerstat. In 1999, the value of M & A; deals had risen 19% to $1.425 trillion.
Graham said that so far this year, the number of M & A; transactions are down by around 20% while the overall volume is down by about 40%.
There are several reasons for the decline in M & A.; One of the main cause is the fall in stock prices. Share prices of many technology companies have fallen by as much as 90% or more from the highs they reached early last year. This has reduced the attractiveness of corporate equity as a currency with which to pay for acquisitions. Also, valuations have come down, which means that companies are paying less than they did a year or so ago. This has impacted the overall volume of M & A; business.
Initially, when the stock market started sliding in April last year, investment banks and securities firms were unperturbed. They said that if private companies could not tap public markets, they would look at mergers and acquisitions. But the M & A; route hasn’t panned out very well, either.
With the market decline, acquirers are also less willing to pay lofty valuations for private buyout targets. Thus, a fall in stock prices is having a cascade effect on the valuations of private companies as well. According to Mergerstat, the average price of a company that was acquired in 2000 was 11.2 times its earnings before interest and tax, down from 12.4 times in 1999. Analysts said that in 2001, the valuations have dropped further and that the terrorist attack on Sept. 11 has made companies even more cautious.
“The Sep. 11 tragedy has people on notice, and they are more cautious than they were before,” said Valentine. “But fundamentally for sound companies that have revenue and profitability, the M & A; market is still active.”
But investment banks that are nimble have been quick to cope with the changes.
“This is a very volatile business,” said Allen. “Step two in this business is you have to fine-tune your business model. One of the things that we have started doing is rationalize our outside offices. We have decided to close several of them and consolidate others. We have done some PIPES (private placement of public entity) and raised some money for private entity and we have helped with restructuring debt for companies. It’s a little tough and we have to do a lot more work.”
Barrington and Deloitte, on the other hand, are focusing on their restructuring practices.
“A lot of businesses are underperforming significantly and are having some issues with their debtors. We have a group that tries to maximize the value of the business for the various stake holders prior to heading into bankruptcy or even during a bankruptcy,” Graham said. In addition, by focusing their marketing efforts on specialty practices that serves some stronger sector in the economy, such as health care services and medical devices, Barrington is seeing reasonably strong new deal activity, Graham said.
“We are trying to help them (companies) if they are having some difficulties in restructuring and things of that nature,” said Valentine. “We are refocusing our efforts a little bit, in the short term, to help our clients to deal with economic down turn,” she said.
But Graham said that while the M & A; activity is lower, his firm is getting some sizable deals to keep it going.
“This market is going to test the staying power of firms,” said Graham. He said that firms that have the wherewithal would emerge stronger in the next cycle. “We are going to consider investing in this market as opposed to laying people off and we expect to come out of this more stronger than before.”
And while the market has been brutal, investment bankers said that expanding in the Orange County market was not a mistake.
Graham, who moved to Orange County from Florida earlier this year to open Barrington’s office, said that even if Barrington had known that the M & A; market would collapse this year, his firm would have opened an office here anyway.
“Orange County represents a significant and underserved opportunity for Barrington,” he said.
THE BROKERS
The ’90s bull market was very, very good to the stock brokerage business. In fact, despite inroads by on-line trading and the rise of the day trader, many investors still wanted a relationship with a personal broker, and that fueled hiring at traditional brokerage firms.
In Orange County, many brokerage firms expanded their operations, while U.S. Bancorp Piper Jaffray opened an office here to join in on the action.
But things have changed since April 2000. Piper Jaffray is already pulling out. Other brokerage firms that were expanding have imposed hiring freezes. While there have been no announcements of major layoffs, many firms are reducing payrolls through attrition.
“We have lost some younger financial advisors,” said Guy Williams, managing director of Southern California’s operations at Merrill Lynch & Co. Inc. “Apart from that, we have done quite well.”
Merrill Lynch also consolidated its Irvine office with one in Costa Mesa in order to cut costs, although no one was laid off in this consolidation, Williams said.
The effect on U.S. Bancorp Piper Jaffray has been more pronounced. It opened its first Southern California offices,in Newport Center and La Jolla,last year with fanfare, then quickly opened a second Newport Beach location, in MacArthur Court. Six more offices were planned in Southern California.
With the turmoil in the stock market, Piper Jaffray has put further expansion in Southern California on hold. In August, the firm consolidated its MacArthur Court office into the Newport Center location. And at the end of this month the firm plans to close the Newport Center office as well, completely pulling out of the Orange County market. The closing will eliminate 21 brokers and nine administrative staff.
Other firms are also coping with the meltdown in paper wealth.
“Obviously the markets have been very difficult, in general,” said Patrick Allen, president of Newport Beach-based Roth Capital Partners LLP. “This is the toughest period that anybody has seen in their career, who is still working.”
Earlier this year five brokers that left Roth for Piper Jaffray were not replaced. The firm is also shifting its strategy.
“On the retail side we are taking a different approach,” Allen said. “We are emphasizing more of the corporate services aspect of the retail brokerage side.”
To replace lost individual clients, the firm is attempting to do more work with its corporate clientele, such as managing retirement plans, stock option plans and executives’ assets.
Williams said that the industry was already facing pressure from a falling stock market, but the terrorist attacks on Sept. 11 made it worse for the industry.
“After the Sept. 11 attack, we had suspended some of our seminar activity but we have ratcheted that back up now and we are doing more of that now than ever before.”
This is not the first big crisis for the brokerage industry in recent times. In fact, just three or four years back, full service brokerage houses like Merrill or Morgan Stanley were pushed to the brink by start-ups such as online broker E*Trade Group Inc. and discount brokers like Charles Schwab Inc.
Williams said that although the fall in the stock market has impacted the entire industry, brokers at Merrill have been getting more phone calls from people seeking expert advice. He said that after the steep fall in stock prices, people are realizing the drawbacks of trading online without expert advice and are willing to pay an extra amount for financial planning and consultancy.
Merrill has quadrupled its marketing budget this year, in its efforts to lure customers from discount and online brokerage firms. The firm has also been moving away from commission-based advice to fee-based services.
Roth on the other hand has been putting more emphasis on improving its research staff. It recently hired two analyst to cover the telecom sector. Allen said that on the research and institutional sales side, the firm is still selectively hiring.
“Reality is that we had to downsize, like the rest of the industry and are looking for folks who could contribute to the top line directly,” he said. n
