OUTLET: Inside Business
By Jared Council
jared.council@insidebiz.com
Before introducing the main speaker at Old Dominion University’s economic forecast last month, TowneBank President and Chief Banking Officer Morgan Davis mentioned the record profits his bank had in 2013.
Profits at the region’s largest community bank by assets grew 10 percent over the previous year to $41.8 million. But Davis quickly noted that the bank faces many headwinds in 2014, which he said he believes is “going to be the most challenging year for our company since we started in 1999.”
Davis spoke in a recent interview about threats, opportunities, the industry and more.
What are some of the headwinds the bank faces?
Headwinds can be internal or external. The first thing is, since we have reported record earnings 14 years in a row, one of the headwinds we face for both employees and directors is becoming complacent about our success. Just because we’ve had one great year after another, some might think, “I guess we’re just going to have a great year.” So internally, complacency is a headwind, and we are constantly reinforcing: “You have to go out and act like we just opened the bank yesterday.”
I think things are better. You can see it in residential real estate sales. You can see it in lower levels of foreclosures. You can see it in a lot of economic indicators in the Hampton Roads area. But there is still an air of uncertainty, I think, among a lot of businesses about what effects a variety of things are going to have on our economy. I will say there’s definitely a note of optimism, but there are still a lot of wait-and-see attitudes. And that results in a sort of malaise.
The headwind that was probably the most upward in my mind dealt with the Federal Reserve. The new head of the Fed, Janet Yellen, is espousing the same philosophies that Ben Bernanke was, and that is low interest rates for the foreseeable future.
What will that mean?
Well, I think that is really good if somebody is going to borrow money for a home mortgage. That means I’m going to pay less for my monthly payments.
If you’re a saver or someone on a fixed income, it means once again the rates are low.
For certificates of deposit and other products, the rates are very thin. For bankers, it means in what we do for a living today, we’re selling things for about half the price of when we started our bank back in 1999. The prime is 3.25 percent, sitting flat. Short-term rates are a quarter-percent, very low.
We can’t lower our deposit costs anymore. If we did, you’d be paying me to keep your money.
So we squeezed out all that we could in terms of cost of funding. And we have a very enviable cost of funding because almost 30 percent of our balance sheet is in non-interest-bearing checking accounts. So we lowered our cost of funds, and yet we can’t raise our pricing on loans any more. So our net interest margin is thin – as thin as I’ve ever seen it in my career since 1974. It’s less than 4 percent. I remember days in the ’70s when net interest margin was over 7 percent.
I can’t squeeze the expenses on the money any lower. So that headwind of a low interest rate environment makes it very difficult to grow profits.
Any silver linings?
Well, on the flipside, what’s really good is that our asset quality – our level of loan problems – fell in half last year compared to 2012. So our charge-offs were about half of what they were from a year earlier. We charged off approximately two-tenths of 1 percent of our loan portfolio. So for every $100 in loans that we made, we charged off a quarter. There’s not a banker out there that wouldn’t take that. At our worst, our charge-off levels were maybe a half of 1 percent. So our asset quality indicates people are having an easier time paying their bills.
One of the great benefits of low interest rates is that it does make it easier for the borrower to pay money back. But we can’t improve asset quality much more than we have already, so a headwind for us is, OK, we had a double-digit increase in earnings last year, but it’s unlikely we’re going to get down to zero charge-offs.
A low interest rate environment also has implications for borrowers rushing to get a good deal on a loan. What have you seen?
We grew our balance sheet by a couple hundred million dollars last year and really didn’t have any more money in top-line bank income. So with a couple hundred million dollars more in loans, we didn’t have any more income from those $200 million in loans that we had the year before. And the reason for that is a lot of people who had a lot of cash, they paid off loans early. Or they renegotiated the interest rates on existing loans they had with us, which means they said, “We love you, but you got me at this rate and I know rates are lower than they were so can you lower it? If you don’t, there’s somebody across the street that will do it.”
So what bankers have been doing in Hampton Roads and across the country for the past several years is making a lot of loans, but all they’re doing is taking it from Bank A and moving it to Bank B at a lower interest rate. So there hasn’t been a lot of growth in loans, but a lot a trading. That’s an issue we’ve been battling for several years now. But it has slowed down tremendously because mortgage refinancing has fallen off dramatically.
In the mortgage business, rates have kicked up a little bit because the Fed has this “Operation Twist” where they keep short-term rates low but move the intermediate term higher. So that’s resulted in mortgages being a little more expensive and that’s cooled off the refinance boom.
Everybody who was going to refinance their mortgage, just about, has already done it. And most of the people who were going to refinance business loans, they’ve done that, too. So we don’t expect nearly the rate of refinancing of loans in ’14 as we saw in ’13 and ’12. That will be helpful. But at the same time, I don’t see loan demand going off the charts. It’s steady. I would characterize it as “OK,” but it’s not “wow.”
Might there be some pent-up demand somewhere for new loans? What’s your synopsis?
Where I see a lot of demand relative to a couple of years ago is entry-level to moderately priced homes. We’re seeing construction activity pick up. We’re seeing a lot of apartments being built and, in fact, I would suggest that maybe apartment construction is at a point where we need to think, “Do we really need this many new apartments?” I wonder what will happen when people start comparing rental pricing with a new home. It is amazing the level of apartments that have been built in the past 36 months.
But I have to say, the occupancy levels are showing that they’re being rented. So I think what might be happening is the newer apartments are renting up to the expense of some of the older units that don’t have the amenities of the newer units.
I think there were a whole bunch of people who were taken out of the housing market because of the overreaction to mortgage underwriting standards. It was far too easy to get a mortgage loan in 2006, and I would suggest it’s far too difficult today. So that means a big swath of people have been pulled from the ability to qualify for a home mortgage because of the difficult underwriting standards. So what do they do? They go rent instead. In some cases they’re not renting apartments, they’re renting single-family homes that were foreclosed on and the owner thinks it’s better to rent than to resell it.
That’s something to keep our eyes on because new home construction is starting to see some traction. We’re seeing that for the first time in a while. And that feels good because new homes are being built and sold.
Talk about last year’s profits. What helped drive that and could that help in 2014?
The one big thing, which I mentioned, was the tremendous improvement in asset quality. We had half the level of loan losses in ’13 that we did ’12. We also had a conversion of a convertible debenture into stock that had a high interest rate on it, and that money was converted into common stock last year. And there was interest expense that was saved on that. It meant that the income available to our common shareholder was increased significantly by that one event, and we’ll have the full effect of that for all of 2014.
I think the main thing for us in 2014 is, we have a very aggressive loan and deposit growth goal. And we feel that with the economy improving just slightly, we should be able to increase our loans and deposits by double digits in ’14. In order to do that, we have our entire sales force – all of our commercial lenders, our private bankers, our branch managers, everybody – out with aggressive calling efforts. From Williamsburg down to Kill Devil Hills in the Outer Banks of North Carolina, we have almost 200 directors. And we’ve asked them to help us in an aggressive calling campaign, to go out and talk to everybody they know to make sure that if there’s any opportunity of any significance out there that we’re getting it.
We’re not waiting for the phone to ring; we’re going out and making it ring.
Where are the areas in which the bank is still struggling in the wake of the recession?
The slight bump in home mortgage rates has turned off the spigots for refinancing. So the mortgage business is not nearly as vibrant as it was.
Twenty percent of our income comes from other lines of business other than what we think of as traditional banking. We’re the largest insurance broker in Hampton Roads. We’re the largest provider of employee health benefits in Hampton Roads. We do more purchase-home mortgages than anybody else in Hampton Roads. We have 400 agents in our Prudential Towne Real Estate company. All those businesses, except mortgages, have had great, record-breaking years last year and have started off this year better than last year. And we need for them to do that because the mortgage business is off mainly because refinances have gone away.
Mortgage is the challenge for us in 2014. I’m pretty optimistic about what I call the financial services division of our company. The investment division is doing great, having a record year. Insurance is doing great, having a record year. One of the issues for insurance is finally, the premiums are going up. The underwriters are looking for more underwriting profit. These low interest rates affect insurance companies the same way they affect the bank. They take your premiums and they go invest it. So because they can’t get returns on investments, they have to get it through underwriting.
The insurance business is the opposite of banking today. For the same customer they had last year they’re going to get paid more to write their insurance policy whereas in banking, we’re doing the same thing and getting paid less.
Since TowneBank has its hand in both, do you benefit no matter what storm is taking place?
It’s interesting you say that because there was a strategy. Back in 2000 we decided that investing in the mortgage business was a good idea for us because when rates are high, the bank margins are better and mortgage business is slower. When rates are lower, mortgages are on fire and the bank doesn’t do quite as well. So rather than going up and down and up and down, you tend to have a slow but steady increase. In fact, over 14 years, that really is what happened.
If you go back to the early 2000s, there were years when the mortgage business was saving our bank. We were making as much in the mortgage business as we were in the bank. But in the last half of 2013, the mortgage business just went down, down, down. And that’s a challenge for any bank in the mortgage business right now.
Were there risks of venturing into the other financial services?
Yes. You don’t know what you don’t know. We know banking. And now I would tell you we know these other businesses fairly well. Insurance is exactly like banking backwards. In banking you collect information, evaluate risks and put money on the table and you wait for people to pay you back. In insurance, you collect information, you evaluate risks, you get money and you hold onto it and hope you never have to pay it back in a claim. There are a lot of little nuances, but we thought diversifying our income stream was the smart thing to do because traditional banking is very competitive in the U.S.
In 1985, there were 15,000 banks in the U.S. Today there are fewer than 7,000. But even with that 7,000, we still have more banks here than in the rest of the world combined. So it’s still too many banks. But I think you see fewer and fewer because of regulation.
Can you elaborate?
This will put regulation in perspective. Safety and soundness is an examination where the regulators come in and they look at safety. And the reason they care about that is because they want to protect depositors’ money. If there’s a claim on the bank, the Federal Deposit Insurance Corp. has to pay the depositors their money back if the bank can’t. So they want to be sure that the price you pay as a bank for FDIC is regulation.
In those examinations they’re looking at liquidity – “Do you have enough money in reserves to pay people as they ask for their money?” And the money that you don’t have in liquidity, which is the money you have in loans and investments, the question is, “Are those loans good and are those investments safe?”
So that’s a pretty important thing. The examiners come in here and they spend a few weeks looking at safety and soundness. The examiners came in last year and spent 10 weeks looking at compliance. The examining forces spend twice as much time looking at compliance issues as they do looking at the safety and soundness of the bank.
Now, maybe that’s because our bank was in good shape. If we were in bad shape I guess they’d spend more time looking at safety and soundness. The point is the amount of time spent looking at whether we are complying with all the laws and rules. If it’s that important to the regulators, you can imagine how important it is to us and how many people we have employed who have to spend time making sure we are doing the things we’re supposed to be doing.
One example is disclosures. Consumer compliance is just incredibly complex today. The new Consumer Financial Protection Bureau. Oh my goodness. The intentions are really good so people aren’t dealt with in an unfair way. But you have one rule and another rule and another rule, and it gets more and more complex. And to monitor that takes a lot of people.
I would say that for small banks, to be able to have the staff necessary and the expertise to deal with all that, it’s very difficult for them to do that and make the kinds of returns stockholders want. It’s not a profit center for the company. You avoid paying fines, but you don’t make any money.
Many banks are closing or consolidating branches as clients are getting their banking needs met online. But TowneBank appears to be expanding its brick-and-mortar footprint. Why is this?
If you look at our average branch size, you’ll see that it is well in excess of $100 million in deposits. We have a small branch network for a bank of our size. So we have a few strategically positioned branches that are very large. Our largest branch in this market runs just over $300 million and our smallest branch probably runs around $20 million. I won’t talk about a competitor in particular, but if you look at how many branches we have in Virginia Beach compared to the bank that has the most branches in Virginia Beach, you’ll see they have almost 10 times the number of branches we have.
The reason you see us opening new offices is we have a small branch network to begin with. So we’re opening in strategic areas to get into markets where we feel there’s an opportunity to develop a higher retail presence. We’ve got a new branch coming to Wards Corner. We’ve got a branch approved in the Ghent area of Norfolk. We opened one in Kempsville in Virginia Beach last year. We renovated our office in Southern Shores, N.C., and made it much larger.
The reason we’ve done that is there are market niches that we think have great deposit opportunities. Maybe not the deposit opportunities of our flagship branches, because we want our average branch size to be over $100 million. We have 26 or 27 branches today, and we’ve got in excess of $3 billion in deposits. When you go into some of the markets where we’ve opened recently, it’s not realistic to expect that those branches will bring $100 million in deposits, but they could probably bring $50 million. And $50 million is larger than the average branch size in Hampton Roads. I don’t have the stats in front of me, but I’d say the average branch size in Hampton Roads is around $40 million.
So to continue our growth, we’ve decided to open a few branches in strategic areas. Having said that, I believe that nationwide, most banks have too many branches.
Most of our branches are in excess of $100 million and for the ones that aren’t, there’s a strategic reason why we placed it in that market.
I don’t think you’ll see us open a whole bunch of new branches, but you’ll probably see us expand geographically to other markets including Richmond and Raleigh. There won’t be much expansion in Hampton Roads because we’ve got Hampton Roads covered reasonably well.
Why does TowneBank have fewer branches compared to other banks?
Because we’ve been through it before. What happens is, when you have lots of branches it leads to more turnover in personnel. And more turnover in personnel leads to more unhappy customers, which leads to more expenses – it’s a vicious cycle. A few strategically placed offices makes sense.
When we opened the bank in 1999, even then people were talking about the death of the branch and going paperless. Some said checks were a thing of the past. Even today, we still process millions of checks a year. But I will tell you that in the past 24 months, we have seen the volume of checks really start to decline in a measurable way. And that’s because of online banking.
I would say the majority of people at least have signed up for online banking, even if they’re still writing checks. They’re using online banking in some way. So why would you build a bank branch? Well, in a way, you do need some branch presence. If you think about the online retailers, the ones that have had phenomenal success are the ones that have physical bricks-and-mortar presence but you could also do business with them online.
Any acquisition plans in the works? Any offers for TowneBank?
We are always in active discussions for expanding all of our lines of business, whether it’s insurance companies or banks. I can tell you there’s zero discussion about us selling the company. But we are actively looking to expand, not only in other lines of business, but also geographically in terms of the North Carolina and Virginia markets.
We have a small insurance presence in Richmond and a mortgage company there. We’re in Raleigh in the insurance and mortgage business, but we’re not in the banking business in either one of those markets right now.
Any other frontiers that you haven’t gotten into? We know TowneBank partnered with and took an ownership stake in cyber security firm Sera-Brynn last year.
Cyber security is intriguing. We tell people if you trust us to protect you money, you might trust us to protect your information.
We’re also looking to expand our property management companies in southern North Carolina down toward Myrtle Beach, S.C. There are a number of property management companies along Sunset Beach, Emerald Isle. Property management business leads to real estate sales, which then leads to mortgages. It’s two steps away from the lending business.
In the Outer Banks area there are 12,000 houses that people rent weekly. And when you go all the way down to the South Carolina border, there are thousands and thousands. We love the property management business.
