Buyers of Bad Banks Run Low on Accounting Gains

Brace for impact.

Buyers of failed or troubled banks that have used accounting rules to boost profits will return to earth this year, and investors are already pressing them on their plans to get airborne again.

In its 2013 outlook for small- and mid-cap banks, KBW identified 18 banks whose net interest margins are expected to fall precipitously in the next two years because of declines in accretable yield — essentially an accounting benefit from troubled-bank acquisitions.

Their median margin is expected to fall 29 basis points this year and 23 in 2014. The list is not exclusive; any bank that acquired a troubled institution in the last few years faces the problem, analysts say.

Given investors and analysts' preoccupation with net interest margins, acquirers will have a lot of explaining to do in 2013 and may cut expenses or do more deals to expand margins, says Chris McGratty, a KBW analyst who wrote the report.

"It is the nature of the accounting treatment. Optically, the accretable yield made banks look really good up front, but as it runs down, they draw unfairly tough looks," McGratty says. "Their margins are falling, and investors are obsessed with margin right now."

Bankers have to book the troubled loans they acquire at fair market value, a strict method that typically underestimates their actual performance. The difference, the accretable yield, adds to revenue.

For banks that bought troubled banks, or acquired failed banks from the Federal Deposit Insurance Corp., the yield has been a significant driver of earnings over the last few years. However, as those loans pay off or are worked out, the benefit gradually decreases. Net interest margins tighten, and profits shrink as a result.

The decline in accretable yield was expected; banks have long sought to inform their analysts and investors that the results they were posting included it. Many provide two sets of numbers, one of which excludes yield.

"The really savvy acquirers have been warning their investors that this is non-cash," says Rick Childs, director of financial services transactions for Crowe Horwath. "They have been preparing their investors for the fact that this goes away. …While it helps the first couple of years, they can't count on it."

Disclosure, however, sometimes fails to satisfy investors.

BB&T Corp. (BBT) experienced a backlash from its investors when it warned of the waning accounting benefits of its FDIC-assisted acquisition of the $25 billion-asset Colonial Bank in 2009.

"At the end of the third quarter, we decided we had to be really, really transparent because the message was not getting through — these assets really are running off, and there really is a reduction in accretable yield," said Kelly King, chief executive of BB&T, at the Goldman Sachs Financial Services Conference in New York last month. "I personally think there was a substantial overreaction to that."

Though BB&T reported a 28% increase in earnings from a year earlier, its stock tumbled from $32.27 the day before the quarterly release to $27.09 in the following weeks. It has since rebounded to about $30 a share. A call to BB&T was not immediately returned.

The reaction was unfair because it only factored the accounting benefit of the Colonial deal, not the strategic reasons, King said later in his presentation.

The accretable yield from the Colonial deal is expected to bring in net revenues of $600 million in 2013, but the organic growth BB&T has experienced in Colonial's territory is expected to total $880 million.

In theory, all of the troubled deals should work like that, analysts say. The acquirers bought those failed and troubled banks because of their growth opportunities in new markets, not for the accounting gains. However, given the interest rate environment and current loan demand, the strategic advantages of the deals have not materialized enough to offset the decrease.

"When banks would talk about the accretable yield they would say, 'Yeah, it will burn off over time, but the economy will be better then and it will sort of flatten it out'," says Mark Fitzgibbon, director of research for Sandler O'Neill. "Obviously, because of the rate environment and low loan growth, that offset has been sparser than what people had hoped it would be."

In the absence of growth, the banks affected are reviewing their expenses. To be sure, every bank is scrutinizing expenses in tight times. Nonetheless, several banks on KBW's list have initiated cost-cutting programs in recent months.

First Financial Bancorp (FFBC) in Cincinnati said in October that it would trim expenses by $17.1 million over the next year. Ameris Bancorp (ABCB) in Moultrie, Ga., last month announced it would trim $12.1 million off its annual expenses by shuttering or selling 13 branches. Home Federal Bancorp (HOME) in Nampa, Idaho, said in November it would close four of its branches to save $1.2 million annually.

Eric Nadeau, the chief financial officer of Home Federal, said the decrease in its accretable yield, which KBW projects will take 29 basis points off its net interest margin in 2013, was not a factor in the branch-consolidation plan. Rather, it was a reaction to the tepid economy, he says.

"We don't let accounting rules run economic decisions," Nadeau says. "It was market-driven. There was an absence of loan demand" to support those branches.

Those branches were in markets that Home entered through its acquisition of the failed LibertyBank in Eugene, Ore., in 2010. The accounting benefits hid redundancies in the branch network that are starting to surface, Nadeau says.

"I'm not a fan of it. It masks your operating inefficiencies," he says. "As it shrinks, it exposes the rocks along the shoreline."

While analysts say that some banks might make acquisitions as a way to revive accretable yield, some bankers say it is not enough of a motivation. They want deals that provide real value or a platform for eventual growth, not an accounting gimmick.

"Accounting rules are the tail, and you can't let them wag the dog," says William Traynham, chief financial officer of American National Bankshares (AMNB) in Danville, Va. "We are not going to make strategic decisions for tactical motivations."