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Auburn Finance Prof Weighs Chance of Recession

Albert Wang, the Synovus Fellow and associate professor of finance in the Auburn University Harbert College of Business

In the last two weeks, if you turn on the television all the news shows are talking about the possibility of a recession. Many of them are citing the U.S.-China tariff escalation and the slowing growth in the United States as two precursors, as well as slowing economies abroad and the uncertainty of Britain’s future as it leaves the EU. All of this has led to jitters on Wall Street.

Albert Wang, the Synovus Fellow and associate professor of finance in the Auburn University Harbert College of Business, recently shared his thoughts on the possibility of a recession in the U.S. Wang researches empirical corporate finance, corporate governance, mutual funds and behavioral finance. His research has been published in the Journal of Financial EconomicsReview of Financial StudiesJournal of Financial and Quantitative AnalysisReview of Corporate Financial Studies and Financial Management. 

What do the financial indicators reveal?
Let’s first take a look at some financial indicators that may point to the recession. Those include gross domestic product growth, consumer spending, commodity prices, interest rates, the yield curve, unemployment data, confidence index, house prices, house sales, etc.

GDP grew 2.1 percent in the second quarter. Through July, retail sales have increased by 0.7 percent, after 0.3 percent in June. Commodity prices are growing: The oil price is up over 50 percent, and aluminum and copper are both up over 30 percent since 2016. The unemployment rate remained at an exceptionally low 3.7 percent in July. U.S. existing-home sales rose 2.5 percent in July and marked the year-over-year uptick in 17 months. All those numbers indicate the economy remains strong so far, but there are some other indicators listed below that raise some concerns. 

What is the inverted yield curve and what does it indicate about the economy?
On Aug. 14, the 10-year treasury yield briefly fell below the two-year yield, prompting a wide selloff in stocks, with the Dow Jones Industrial Average falling 3 percent. An inverted yield curve, most commonly defined as the 10-year treasury minus the two-year treasury, has preceded each U.S. recession since 1955. The yield curve inversion does not explicitly indicate a recession, but is instead a predictor of interest rate cuts. Because the Federal Reserve cuts rates in response to harsh economic times, the yield curve inversion is typically followed by a recession.

However, in a period of historically low interest rates, the yield curve may not be as good of an indicator as it once was. “An inverted yield curve has preceded recessions in part because inflation was allowed to get out of control, and the Fed had to tighten, and that put the economy into recession,” said Federal Reserve Chairman Jerome Powell at a news conference. “It’s really not the situation we’re in now.”

What about consumer confidence?
A survey by the University of Michigan shows that U.S. consumer sentiment plummeted to a seven-month low in August on growing concerns about the economy. This represents the biggest drop in confidence since January, which underscores the growing odds of a recession. The consumer confidence will have a significant impact on economic growth, because cautious consumers may reduce their spending in anticipation of a potential recession. Less spending will lead to lower sales, followed by less corporate investment and more layoffs.

How does the trade war with China and the Fed’s monetary policy affect the U.S. economy?
In my opinion, even though most of economic and financial indicators in the U.S. are strong, the risk of recession is highly correlated with two factors: (1) the trade war with China, and (2) the Fed’s monetary and fiscal policy to sustain economic growth. Not only does the U.S. economy suffer adversely from China’s counter-tariffs, the uncertainty about whether the trade war between the two largest economies in the world is going to be escalated in the future imposes a huge dent on investor confidence, which is evidenced by recent enormous volatility in the stock market. The recent interest rate cut by the Fed is also taken negatively by investors who believe that the rate cut is a result of the Fed’s growing concern on lower than expected inflation and potential recession.

Is it a matter of whether or when regarding a recession?
It has been 10 years since the last recession. Considering the fact that any economy follows a boom-recession cycle, the real question is not whether but when the recession is going to hit us.

Louisiana Bank Buys Bank of York, in Alabama

Photo by Aleksandar Hubenov

Louisiana-based Investar Holding Corp. and its wholly-owned subsidiary, Investar Bank, announced Tuesday that it plans to purchase the Bank of York in York, Alabama in a $15 million deal.

Investar will pay $15 million in cash merger considerations to Bank of York shareholders. The Bank of York will be permitted to make regular and special pre-closing cash distributions to its shareholders in an aggregate amount of approximately $1 million.

Bank of York had approximately $99.5 million in assets, $46.0 million in net loans, $82.3 million in deposits with $19.6 million in noninterest-bearing accounts, $11.2 million in stockholders’ equity, and a loan-to-deposit ratio of 56.53 percent as of June 30.

It offers a full range of banking products and services to the residents and businesses of Sumter and Tuscaloosa Counties. Operations in Alabama include a main office in York, a branch in Livingston and loan production office in Tuscaloosa, expected to become a full service branch after the closing of the transaction.

Investar’s acquisition of Bank of York is part of a multi-state expansion strategy and would expand Investar’s branches along the I-20 corridor in Alabama.

Although Bank of York will transition to the Investar name, the Bank of York staff is expected to remain substantially intact.

How ServisFirst Keeps Scoring

Top management at ServisFirst, from left, CEO Tom Broughton, COO Clarence Pouncey and CFO Bud Foshee. Photo by Cary Norton

Since it opened 14 years ago, Birmingham-based ServisFirst Bancshares has remained focused on its initial game plan to keep things simple — and the numbers say that’s working.

For the fifth year in a row, ServisFirst has been honored as a Raymond James Cup winner, which recognizes the nation’s best community banks. ServisFirst ranked fourth overall of 258 banks considered for the award in 2018 and was the only bank in the Southeast chosen.

The Raymond James award was based on various profitability, operational efficiency and balance sheet metrics. Banks eligible for the award included all exchange-traded domestic banks, excluding mutual holding companies and potential acquisition targets, with assets between $500 million and $10 billion. ServisFirst’s assets stood at $8.3 billion at the end of March this year.

ServisFirst doesn’t concern itself with everything, but it’s obsessed with fostering strong customer relationships and a disciplined approach to controlling costs and pricing loans.

“We try to do just core banking,” says ServisFirst Chief Financial Officer Bud Foshee. “We make loans and take in deposits, and our board has been really good at keeping us on that path.”

ServisFirst has not taken on the risks associated with having a wealth management unit, a trust department or a capital markets group. And it has opted not to offer other services provided by some banks, such as insurance. Says Foshee: “We have insurance companies as customers; why would we want to compete with them?”

To reduce costs, ServisFirst outsources as much of its work as possible, including its core systems, all audits and asset liability management. Such services can be handled by outside vendors instead of higher-overhead employees. Since it was founded, ServisFirst has always stressed the use of technology — such as remote capture of deposits — to keep overhead low, according to Foshee.

“There are some things we do and some things we don’t,” says ServisFirst CEO Tom Broughton. “You just have to know what’s in your wheelhouse. You can’t be everything to everybody, and we don’t try to be. We try to concentrate on and be good at a few things.”

Measurements that Raymond James used to choose its Community Bank Cup winners were efficiency ratio, return on average assets, return on average tangible common equity, 5-year core deposit percentage, net interest margin and nonperforming assets to loans, and real estate owned.

All of those measurements are related to — and support — each other. In the Raymond James analysis, ServisFirst scored exceptionally high in efficiency ratio, return on average assets and return on average tangible common equity. But what, exactly, does that mean when it comes to the company’s operation?

The efficiency ratio is a valuable measurement because it shows how much money it takes for a bank to create a dollar of revenue. “It takes ServisFirst about 35 cents to create $1 in revenue, with a lot of banks above 50 cents, some are above 60 cents,” says Clarence Pouncey, chief operating officer at ServisFirst. “So, we’re about 35 percent on our efficiency ratio, which shows we’re very efficient with the capital we’ve been entrusted with.”

The bank’s return on average assets for 2018 was 1.88 percent, well above the 1.33 percent return other commercial banks reported last year, according to the Federal Deposit Insurance Corp. Return on assets is a key measurement because it shows how well a bank uses its assets to generate income.

The return on average tangible common equity at ServisFirst was 20.96 percent last year, almost double that of other commercial banks, according to the FDIC. Return on equity shows shareholders the return on their investments. Also, a higher return on equity is a sign that a bank is increasing its ability to generate profit without needing as much capital.

ServisFirst also graded extremely high on its 5-year average core deposits, which indicates a stable source of funds from a pool of loyal customers in the geographic areas it serves. The compounded annual growth rate on deposits for the five years ending last December was 18 percent, with total deposits standing at $6.9 billion at that time.

Of the measurements used in the Raymond James analysis, Foshee believes ServisFirst concentrates the most on achieving a healthy net interest margin. Having a good net interest margin requires a never-ending quest to make rates on deposits attractive enough to gain and keep customers while pricing loans high enough to create profitable margins.

Doing those things and staying competitive is easier said than done, but ServisFirst has managed to stay well ahead of the curve. The bank grew its gross loans from 2013 to 2018 at a compounded annual rate of 18 percent, and it ended last year with a net interest margin of 3.75 percent. That easily beats the 3.45 percent posted by other commercial banks last year, according to the FDIC.

ServisFirst has been able to increase its loans without sacrificing loan quality. That’s the main reason that the bank’s percentage of nonperforming assets to loans and real estate owned at the end of March was only 0.49 percent, well below that of most other banks.

“Since day one, we’ve always grown but when you do that, you’ve got to have controls in place, especially when it comes to loans,” Foshee says. “We have a very disciplined risk management platform.”

Solid loans are nice, but they must be complemented by controlling rates on deposits. “Right now, loan rates are not going up, so you’ve got to look at a way to control deposit costs,” Foshee says. “At our annual directors’ retreat in May, one of the things we discussed in our management meeting was how to control deposit costs going forward.

“If the Federal Reserve cuts rates, we’re going to have to tell our clients we’re cutting their (deposit) rates, and that’s not easy. Other banks will have to do that, too, but it’s still not a conversation you look forward to having with clients.”

Foshee and Broughton have been with ServisFirst since it started, and Pouncey joined the company a year later. Although recent interviews with them were to be based on numbers and ratios, each of them quickly segued to talking about ServisFirst customers.

“All of our bankers are customer focused,” says Broughton. “It’s just our kind of thing. Some people would call us a cult bank because we are a bit of a cult. Eighty percent of our customers come from referrals by satisfied customers. We don’t do any marketing to speak of and practically zero advertising. All we have to do is take care of our customers, and we’ll keep going. A lot of bankers spend time in meetings. We’re the exact opposite. We like spending time with clients.”

ServisFirst now has 10 regions stretching from Nashville to Charleston to Tampa. The company’s net income almost tripled between 2013 and 2018, from $52.3 million to $137 million last year. That, Broughton says, is largely because each of the bank’s regional CEOs has the same mindset regarding customers.

In considering leadership teams for regional locations, “If we talk with someone and they have a warm-chair concept, they’re not going to work with us,” Broughton says. “The main reason we won’t work with someone is if they don’t like getting out and meeting with customers.”

Charlie Ingram and Cary Norton are freelance contributors to Business Alabama. Both are based in Birmingham.

Bank Exposure on Commercial Real Estate Creeps Higher

According to a recent report in National Real Estate Investor, a “day of reckoning” may be looming for banks with too much exposure on commercial real estate loans.

“Some industry observers are cautioning that there could be greater risk exposure emerging among some banks that has the potential to snowball into bigger problems in the event of a downturn,” the trade magazine reported.

K.C. Conway, director of research at the Alabama Center for Real Estate at the University of Alabama, is cited as saying “there is likely a ‘day of reckoning’ looming. He expects a test to come sometime in 2020.”

Conway, who is also chief economist for the Certified Commercial Investment Member Institute, said that banks are underwriting construction loans at 75 to 80 percent loan-to-cost and that, over a period of 24 months, rising costs could push the loan-to-cost close to 90 percent or higher, requiring developers to put in more equity when transitioning to permanent financing.

“I fear that the loan-to-value will be north of what the permanent market is willing to take it out at,” said Conway. In some cases, he noted, rising loan-to-cost levels during the construction cycle may result in the bank having to hold a loan on their books longer than anticipated. A loan might also have to be reclassified as a high volatility commercial real estate loan, which would require a bank to hold more capital in reserve.

Conway said he expects a challenge will come in 2020 when borrowers try to move construction loans to permanent financing.

Yet “banks are not likely to fall into the financial abyss as they did in the last recession,” Conway told the NRI. “The good news here is that this not going to be a 2009 type of real estate crisis, and banks do have more capital than they did then to absorb it.”

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