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Shakeup in the local banking industry

After several years of speculation and rumbling among bank executives, financial analysts and industry insiders about a consolidation of the island’s banking industry, the planets finally aligned on April 30, 2010, with the “assistance” of federal regulators.

The banking-industry consolidation that wiped out three of the 10 local institutions was a painful but necessary step in Puerto Rico’s economic recovery, industry and government officials concurred at the time.

By strengthening the island’s more viable financial institutions at the expense of its weakest, the Federal Deposit Insurance Corp. (FDIC)-assisted consolidation was aimed at fortifying the entire sector with the expectation lending activity would increase, an urgent requirement for the languishing Puerto Rico economy to get back on track.

While government and industry officials have been publicly referring to the consolidation in the past tense, the reality is it could very well continue.

While Banco Popular, Oriental Bank & Trust and Scotiabank were fortified by their purchase of the assets of Westernbank, Eurobank and R-G Premier Bank, respectively, players that missed out on the FDIC-induced opportunities, such as FirstBank and Doral Bank, may become takeover targets or look to hitch up with partners, including each other, to bolster their positions in a dramatically reshaped banking landscape, industry observers say.

As of the time of this report, First BanCorp, the parent corporation of FirstBank Puerto Rico, was prepping for an up to $500 million stock offering as part of the Puerto Rico-based bank’s ongoing efforts to shore up its capital position.

The proposed secondary offering is the latest step in the recapitalization strategy drawn up by First BanCorp under orders from the FDIC and the Federal Reserve Bank of New York.

The stock plan calls for the conversion of the U.S. Treasury’s series G preferred stock into 380.2 million shares of common stock, the company said. In July, First BanCorp issued a new series of preferred stock in exchange for the preferred stock the U.S. Treasury Department held under the Troubled Asset Relief Program (TARP).

In August, First BanCorp issued some 227 million in common stock in a swap for preferred stock held by investors. Some 320 million shares are outstanding.

The FDIC’s deal

The island’s geographic isolation, and the fragility of the island’s banking system, were the driving factors behind the FDIC decision to induce a coordinated consolidation, rather than simply shutter the troubled banks, both industry and government sources said.

It was Puerto Rico’s largest bank consolidation in more than two decades, as well as one of the FDIC’s biggest resolutions of failed banks in the financial crisis that struck in the fall of 2008.

The consolidation cost the FDIC $5.28 billion, less than the $6 billion originally expected. Five banks presented offers, and a total of 18 different bids were reportedly submitted.

In the end, Banco Popular de Puerto Rico agreed to acquire the deposits and about $9.4 billion of Westernbank’s assets, with the FDIC keeping the remainder for eventual sale. Scotiabank de Puerto Rico agreed to buy all the assets and deposits of R-G Premier Bank, and Oriental Bank & Trust is acquiring all the assets and deposits of Eurobank.

Under the deal, the FDIC and Banco Popular also agreed to share losses on $8.8 billion of Westernbank’s loans and other assets. The agency and Scotiabank agreed to share losses on $5.4 billion of R-G Premier Bank’s assets, while the FDIC and Oriental Bank & Trust are sharing losses on $1.6 billion of Eurobank’s assets.

The FDIC also required bidders to work with commercial and consumer borrowers to help them stay current on their loans.

The good news is the deal drew greater-than-anticipated interest in the private auction for the bank assets, saving the FDIC millions and demonstrating the benefits of participating for existing institutions. FDIC chief Sheila Bair called the local banks’ ability to raise $1.8 billion in capital “pretty phenomenal.”

“This shows optimism in the future of Puerto Rico,” Bair said a day after the bank consolidation. “The consolidation will strengthen the banking sector.”

In the view of Alfredo Padilla, Puerto Rico’s Financial Institutions Commissioner and top local bank regulator, the system as well as the regulatory process worked well, including the media campaign sponsored by his office regarding the confidence FDIC insurance provides to depositors— featuring former Menudo member-turned-financial adviser Xavier Serbiá.

“Here you have a regulator/insurer that demonstrated its commitment to Puerto Rico, to the point that FDIC chief Bair came to the island to be with us during the bank operation, the first one she has ever witnessed,” Padilla said. “Her presence underscored the magnitude of this event, categorized by the stateside media as a milestone and one of the most significant in the history of the FDIC since it was founded,” Padilla said.

After the three bank closures, Keefe, Bruyette & Woods analyst Bain Slack said the remaining management teams would apply greater rationality when making decisions on future capital allocations.

“While future consolidation is still feasible in the Puerto Rico banking sector long term, I think the remaining institutions might pause to let the dust settle, focus on integration and look for organic growth via market-share movement opportunities among the fallout,” said Slack, adding he didn’t know if that would take three to six months, or one to two years. “I think, at a minimum, we need to get through the rest of the second quarter before really having any clues as to where we go from here.”

A welcome shot in the arm

That, however, shouldn’t diminish the importance of the April 30 FDIC-coordinated transaction, which had the equivalent of injecting $6.53 billion into the island’s financial system, an outstanding amount given it tops the $6.49 billion in American Recovery & Reinvestment Act (ARRA) federal stimulus funds Puerto Rico is receiving over a two-year period running through the end of this year—a lifeline local officials acknowledge is the main thrust of the local economy right now.

The new injection is a combination of the FDIC’s cost of $5.28 billion for the three failed banks and the $1.8 billion in fresh capital raised by the three winning banks in addition to Doral Financial Corp., which raised capital but was outbid in the FDIC auction.

The economy may be starting to show signs of stabilization, but the fortunes of island banks are expected to take a bit longer to turn around, part of a natural economic cycle known as the lag effect. In addition, real-estate defaults are due to increase this year, which will hold down real-estate prices.

According to the Puerto Rico Planning Board, the island’s economy contracted 3.7% in fiscal year (FY) 2009, which ended June 30. The Planning Board is forecasting a slight 0.4% growth during FY 2011, which started July 1 and ends June 30, 2011. This year’s loss marks the fourth-straight year of recession, with the economy having contracted 2.8% in 2008 and 1.2% in 2007.

Despite the dreary landscape, government officials believe the $6.53 billion boost is big enough to jolt commercial and consumer lending which is sorely needed to spark the economy.

“The process we have been going through is critical to enable the economy to grow and move forward,” said Gov. Luis Fortuño. “Now, this solid and strengthened banking industry must help move the island economy forward by lending money to finance our economic growth and development.”

There apparently will be more pressure to do so. Government Development Bank (GDB) President Carlos García said there would be report cards on banks’ ability to lend, saying it was necessary for the banks to support eight priority public-private partnership projects the administration has on tap, which include powerplant upgrades, new highway projects and an aggressive school-modernization program.

“Without a solid banking industry that can lend money to the establishment of new businesses and projects, the economy can’t move forward and grow,” García said. “We’ll have a report card soon about banks’ ability and willingness to lend.”

More than $2 billion was raised in the banking sector and investors expect this capital to be deployed into the economy to produce a return on their investment. Two of the banks that made winning bids, Popular and Oriental, raised a combined $1.25 billion in capital.

Doral Financial Corp., the holding company of Doral Bank, retained $180 million in capital raised but returned to investors $420 million in additional funds raised contingent on an acquisition of one of the three seized banks.

Doral didn’t pick up any part of any of the three banks that were auctioned off in the FDIC-imposed consolidation.

“Now, we have a financial sector with the capacity to lend and we expect them to do so,” García added. “We expect the banking sector to put their money and capital on the table to support the public-private partnerships and tourism projects we have on the table. There is no excuse now.”

Yet, economists caution, while the consolidation is positive, it will still take some time for the industry to turn things around and return with renewed vigor to lending. Chances are that banks will be so busy with the merger activity they won’t increase their lending activity for now.

“It is positive, but this is no quick fix. The rest of the banks still have significant issues with nonperforming loans, largely construction loans,” said Sergio Marxuach, policy director at the Center for the New Economy, an island think tank. “The rest of the banks still have significant issues. What we will see is a gradual writing down of these assets over time. That will lead to a significant repricing of real estate.”

Popular completed the integration of Westernbank in September, while Oriental did the same with Eurobank in November. Scotiabank has indicated it expects to complete the integration of R-G Premier Bank in 12 to 18 months, although certain areas such as mortgage have already been integrated.

 


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