Rancho Santa Fe’s John Eggemeyer III gets reams of favorable publicity for buying, rehabilitating, and flipping small banks. But now the stock market is flipping the bird at his prize, the newly renamed PacWest Bancorp, San Diego’s largest community bank, formerly named First Community Bancorp. Also getting flipped off is Eggemeyer’s second-most-prized monument, Guaranty Bancorp, a collection of small Colorado financial institutions.
Stocks of small regional banks have been beaten up over the past year, although there was a big recovery last week. It was spurred in part by the Securities and Exchange Commission’s declaration that it would crack down on investors betting that stocks of the major financial institutions would go down. So those stocks soared, and the effect spilled over to smaller regional institutions. At the beginning of last week, PacWest stock was down 79 percent from its high; on Monday, the loss was 71 percent. The stock gained $5, rising to $18.11 in five trading days. Guaranty had been down 55 percent; the loss dropped to 48 percent over the same period. Both financial institutions were built through multiple acquisitions. And both have recently had to write off the value of the banks they bought.
Eggemeyer heads Rancho Santa Fe’s Castle Creek Capital, a private equity group that takes in funds from heavyweight investors and looks for small banks to invest in. Once Castle makes an investment, it takes a major management role. In particular, it likes to shift a bank’s emphasis to small business lending. Also, it prefers to pay low rates of interest on accounts — say, stressing money market accounts rather than certificates of deposit. Castle also introduces numerous efficiencies at the banks it buys. Then it may sell — or flip — the reconditioned banks, or, in the case of PacWest and Guaranty, keep them in the portfolio. Right now, Castle has five bank chains in its portfolio, including PacWest and Guaranty.
PacWest began in 2000 with the purchase of Rancho Santa Fe National Bank. Then it bought 18 more Southern California banking institutions, including the former First National Bank in downtown San Diego and Bank of Coronado. The parent’s headquarters is at 401 West A Street. PacWest has 60 branch banks in San Diego, Los Angeles, Orange, Riverside, and San Bernardino counties.
But here’s the rub. Of $4 billion in loans at the end of last year, 53 percent were commercial real estate loans and 10 percent were commercial real estate construction loans, according to PacWest’s 2007 report to the Securities and Exchange Commission. The construction loans are made to builders working on both residential and commercial projects.
And right now, Wall Street is bracing for small regional banks to begin reporting big losses on such loans, particularly to residential builders. Analysts expect the banks to begin the mea culpas in second quarter reports. Southern California has been one of the hardest-hit real estate areas in the nation. How many of those loans will go sour? Investors are anxious.
“I think small banks are going to be in the news in the next few months,” says Peter Q. Davis, retired banker who headed one of San Diego’s small banks. “It reminds me of the savings-and-loan-crisis years” of the late 1980s and early 1990s. Many analysts are anxious about possible bank failures.
Eggemeyer claims that he is not anxious. “We feel very comfortable,” he says. “We saw the economy softening a year and a half to two years ago and began to take action accordingly. Our real estate construction and development loans have been coming down every quarter. We feel we are very well positioned throughout Southern California.”
Companies that make a lot of acquisitions, such as PacWest and Guaranty, have another potential problem: goodwill. When a company pays more than the value of assets for another company, the acquiring firm has to make an accounting entry, goodwill, to reflect the overpayment for those assets. In the old days, the acquiring company could write off the goodwill little by little over a long period of time. But in 2001, the accounting profession said that a company had to evaluate its goodwill every year. Typically, if a company decides it is not going to rake in enough money from that acquisition for which it paid too much, it takes a write-down called a “goodwill impairment.”
For the first quarter of this year, PacWest took a $275 million hit for goodwill impairment. Then, even before announcing second-quarter earnings, PacWest wrote off the rest of its goodwill — a whopping $486.7 million — stating the move was in response to volatility in the banking sector and the beating that bank stocks, including PacWest’s, were taking. PacWest noted that it was not a cash write-off, so it didn’t affect the bank’s liquidity. “Clearly the write-off was so large as to be alarming,” says Davis. “Investors may be worried.” However, says Davis, “They [PacWest] deserve credit for doing this.” It doesn’t mean that Eggemeyer’s strategy of making lots of bank acquisitions is no longer working.
Eggemeyer agrees with that summation. “Actually, we are doing what the accounting profession requires,” he says. “It is very bad accounting, but we have no choice.”
Since the huge first-quarter write-off wiped out the company’s earnings, it could no longer pay dividends under California law. So it changed its incorporation to Delaware and also changed its name to PacWest, because Delaware had a conflict with the former name of First Community. Now PacWest stock yields a juicy 7.5 percent.
Almost entirely because of the goodwill write-offs, PacWest lost a whopping $10.05 a share in its first quarter and $17.47 a share in its second quarter. The company noted, however, that net operating earnings (not including financing expenses, taxes, etc.) improved sharply from the first quarter to the second. But loans and deposits decreased from the first quarter to the second, as did net interest income. Nonperforming assets doubled in that period. One good sign is that construction loans declined. The stock market reacted positively to PacWest’s write-offs, but the rally may not last. Eggemeyer may be superconfident, but it’s easy to see why investors aren't.
Guaranty had taken a goodwill-impairment charge of $242.2 million in 2007. It had also boosted its provision for loan losses by $20.4 million.
Eggemeyer is active in each of the five bank groups in Castle Creek’s portfolio. He has been praised for being both a banker and bank investor. I asked Davis if Eggemeyer might be spreading himself too thin. “There is a point where even smart guys are spread too thin and begin guessing at choices,” says Davis. When one strong person is active in several companies, “others defer to him, and he then has a problem judging the performance of the individual banks and management.” However, Davis doesn’t know that this is true of Eggemeyer.
Davis does say that banks can grow too fast. “Whether you acquire quickly or grow quickly, you are exposed to a sudden change in the market. They used to say, ‘Small volume, small problems. Big volume, big problems.’ ”
Eggemeyer, however, sees the ailments among small community banks as an opportunity for Castle Creek. “Going back over 18 years, we have stepped in to recapitalize and help restructure banks having difficulty. We haven’t had a lot of banks in that category since the early part of the 1990s,” he says. Now there are more banks needing help, “and we are excited about that. We may buy some more. The current environment is unparalleled in my 40-year banking career.” Prices of banks are much lower, but those lower prices reflect problems.
He says that “market-oriented investors” have been dumping small-bank stocks in the past year, but sophisticated players, such as private equity investors, may see “enormous opportunity.” Castle Creek may well raise more money and go fishing.
But Castle Creek may have to prove its mettle with its crown jewel, PacWest. The company has enough capital “to make it through the present situation,” says Davis, “but there could be a long delay before it brings the $60 a share the market valued it at just a short time ago.”