What Puerto Rico's Bankers Have to Teach About Confronting Change

Puerto Rico's bankers are embracing the curse.

The U.S. island territory has endured six years of recession. It has 15% unemployment and dismal growth prospects. Its stock of banks is on the verge of shrinking to six from the nearly three dozen that once operated there.

One couldn't blame Puerto Rican bankers if they felt, er, jinxed. But — unlike their more resistant mainland counterparts — the survivors have readily accepted the new reality: merge or get off the island. Consolidation in Puerto Rico is something bankers and investors are begging for.

"Let's get this done," says Richard Carrion, the chairman and chief executive of Puerto Rico's largest bank, Popular (BPOP). "We've been talking about it [consolidation] for so long, so let's … get on with what we have to do, which is compete and fight the hell out of each other."

Jose Rafael Fernandez, whose Oriental Financial Group (OFG) agreed last week to buy the Puerto Rican operation of Banco Bilbao Vizcaya Argentaria (BBVA) for $500 million in cash, was even more blunt.

"This market has been overbanked for many years," Fernandez says. "There are still too many banks on the island, and a second wave of consolidation has to occur."

Oriental's deal would leave Puerto Rico with six banks based on the island, down from a dozen banks in early 2010. That year three banks failed and a fourth bank was sold to a small Florida bank now called Banesco USA. But the deal involving BBVA's unit, with $5.2 billion of assets, marks the largest on the island in recent memory.

"It's a big deal for us, it's a big deal for Puerto Rico," Fernandez says. "I don't think anybody was expecting this to happen — at least not so soon."

But some investors have been expecting it. They have pumped capital into several Puerto Rican banks despite the lack of organic loan growth and a shrinking population. First BanCorp. (FBP) received a $525 million capital injection last year, and Oriental received $84 million to help fund its BBVA deal.

"Investors are looking for further consolidation. That's a hope for them," says Michael Sarcone, an analyst at Sandler O'Neill & Partners. "At the end of day, the focus is still on the difficult operating environment, and asset quality is still a pretty big issue."

Investors in Puerto Rico's banks have been able to buy stock at such low cost to book value compared with mainland banks that even the smallest improvements in credit quality can pay off.

"If they get in at 40% of pro-forma tangible book in a capital raise and the multiple goes to even 65% of book value, there's a 25% return for you right there," Sarcone says. "The banks are really cheap and as long as credit quality improves; the discount to book value should narrow over time."

Most of the Puerto Rican banks are losing money, but there are signs of improvement. Past due and nonaccruing loans were a median 15.7% of total loans in the first quarter, compared with 16% a year earlier, according to the Federal Deposit Insurance Corp.

That's more than twice as high as the state of Georgia, which had the worst ratio (6.8%) in the first quarter.

Since the 1970s Puerto Rico has lost 30 banks chartered on the island.

Big banks including Wells Fargo & Co. (WFC), JPMorgan Chase (JPM) and Royal Bank of Canada (RY) have sold their operations. Citigroup (C) is the only big U.S. bank left, but it sold its retail operations to Popular and kept some commercial business.

Most foreign owners pulled out when a tax incentive for mainland companies on the island, known as Section 936, expired in 2006.

The shrinkage is a good thing, most observers say.

"Puerto Rico … will probably end up with another one or two [banks] exiting the island over time" likely through a sale, says Derek Hewett, an analyst at Keefe Bruyette & Woods (KBW). Further consolidation "will be beneficial longer term in making the overall market more attractive, and the banks will be able to earn an acceptable return on capital."

Puerto Rico's population of 3.7 million is larger than Connecticut, Kansas or West Virginia. But the number of banks in those states ranges from 50 to more than 300, according to the FDIC.

The survivors in Puerto Rico speak favorably about the intensified competition.

Peter Bessey, the chief executive of Scotiabank de Puerto Rico, a unit of Scotiabank Group in Canada, welcomed the Oriental deal with BBVA.

"I see it as a positive," Bessey says. "I see it as demonstration of faith in the Puerto Rican economy."

BBVA's deposit rates are lower than Oriental's, so the deal would help decrease the combined institution's cost of funds and ultimately, increase its value, Fernandez says.

It also could also help drive down deposit costs in the market. Many banks on the island were offering higher rates to attract core deposits.

The cost of interest-bearing deposits in Puerto Rico is 1.3% compared with 0.56% among commercial banks in the U.S., according to research provided by KBW.

Net interest margins are expected to benefit. "In Puerto Rico, even as we've seen pressure on asset yields, they've been able to more than offset it with improvement on funding costs so you have seen their margins increase," Sarcone says.

The challenge remains, however, where to find growth.

Most of Puerto Rico's banks have gone to the mainland to tap growth, including Popular, First BanCorp and Doral Financial (DRL).

Though Carrion acknowledges there are more growth opportunities in Popular's mainland markets, he was adamant that prospects will improve in Puerto Rico.

"Our main market continues to be Puerto Rico," he says. "We form an important part of this community, and we're not going to assume that growth will be weak."

For the island to recover, the local government has to catch tax-dodging companies, toughen oversight of energy costs and promote trade, Carrion and Bessey say.

"We have plenty of diagnoses — we just have to get on with the job of doing something about it," Carrion says. "We have to do our part so that growth is not weak."