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Transaction bankingDecember 30 2009

Puerto Rico's banks reach a critical juncture

Puerto Rico's dependence on the US meant that the subprime crisis hit its banking sector particularly hard. A period of consolidation is now expected, but who the winners will be - the big domestic players or foreign-owned entities - remains to be seen. Writer Jane Monahan in Puerto Rico
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Puerto Rico's banks reach a critical juncture

Puerto Rico has a small banking system with total assets of $95.7bn and just 11 commercial banks. Among these, one is owned by Canada's Scotiabank and two are owned by Spain's Santander and BBVA banking groups. Relative to the island's economy, with a gross domestic product (GDP) of about $85bn, the banking industry is significant, although it is in the throes of a major crisis.

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Ricardo Carrión, president of Banco Popular de Puerto Rico, the island's oldest and biggest bank, with a 22% share of the loan market and a 32% share of the system's deposits, called the current crisis "the worst in living memory". The Popular group was hit with huge losses in the US where it had an enormous exposure to toxic subprime mortgage assets, largely through a wholesale subprime mortgage company, Popular Financial Holdings, which has been shut down. This is in addition to an exposure of about $4.4bn in troubled Puerto Rican real estate loans.

Similarly, Troy Wright, CEO of Scotiabank Puerto Rico, the oldest non-US bank on the island, founded in 1910, which now has a 3.5% market share, believes the banking industry is at a crossroads. "It is one of those moments when the whole system is undergoing upheaval and the playing field is being completely realigned," he says.

Juan Moreno, president of Banco Santander Puerto Rico, the island's fourth largest bank with a share of about 12% of the deposit and loan market, says: "At a guess, no more than four or five [commercial] banks will be around in a few years." Scotiabank's Mr Wright, moderately more optimistic, says that five years from now there may be "two or three fewer banks".

Mr Moreno, however, believes consolidation is imminent. "In the second quarter of 2010 there will be consolidation. It is because those banks in difficulties [all US-owned] have a deadline for meeting regulatory capital requirements for that period. And if they don't comply, that will trigger a process," he says. This process would mean banks are either wound down by regulators, or merged, or face different combinations.

"The reason will be that some of the banks that are currently operating in the market don't have enough capital to survive. They won't survive, just as many banks in the US haven't survived," he says. In the first 11 months of 2009, more than 120 banks on the US mainland failed, the highest failure rate recorded by bank regulator, the Federal Deposit Insurance Corporation (FDIC), since the crisis began.

Feeling the squeeze

Meanwhile, highlighting which Puerto Rican banks are the weakest, Westernbank, the third largest in the country by assets, R&G Premier, in fifth place, and Eurobank, a small institution, have recently been issued with cease and desist orders by the FDIC and the Office of the Commissioner of Financial Institutions (OCIF), Puerto Rico's banking regulator. Such orders can be, but are not necessarily, the last regulatory step before a bank default.

As for the industry's two systemic banks, Banco Popular and FirstBank Puerto Rico, each with a 16% share of the loan market and 11% of the system's deposits, they received $950m and $400m, respectively, under the US government's Troubled Asset Relief Programme (TARP). In return, the US government has taken equity shares in these banks.

But just how did such a dramatic state of affairs come about? One reason is that although a recession started in the US in 2007 in the 'sunbelt' states such as California, Arizona, Texas and Florida, where Puerto Rican banks serving Hispanic communities tend to cluster, in Puerto Rico the recession struck in 2006. Puerto Rico's economy also contracted more than that of the US - by 1.9% of the island's GDP in 2007, 2.8% in 2008 and a huge 5.5% in 2009.

Crumbling foundations

The importance of the construction industry to the island's economy also means the collapse of that sector has been devastating. Construction accounted for about 15% of GDP prior to the crisis and grew at an annual compound rate of 7% for 20 years. "It was a machine that just kept going. It was self-financing, so everybody was after it. But it has come back to bite everybody," says Mr Wright, who was Scotiabank's executive vice-president and chief of international mergers and acquisitions before becoming CEO of the Puerto Rican bank in July 2008.

Alfredo Padilla, Puerto Rico's commissioner of financial institutions, says the banking system's main problem is the high concentration of loans in real estate construction. Out of total loans of $61bn at June 30, 2009, nearly $40bn (63%) were in real estate construction, $12bn (20%) were in corporate and small business lending and $6.7bn (11%) were in personal and consumer lending, according to OCIF.

Furthermore, OFIC reports that about 30% to 40% of outstanding real estate loans in November had characteristics indicating the loans were not performing as they had been contracted to.

"But that [high ratio of non-performing loans] may not necessarily translate into losses. Most are collectable loans. It is a timing issue," and depends on when the market starts recovering and demand for housing picks up, says Mr Padilla.

Notwithstanding that, in November, unemployment in Puerto Rico's construction sector had increased by 22% year on year, housing sales were virtually at a standstill and there was an overhang of about 26,000 housing units which will take more than four years to work off, say bankers.

According to Mr Moreno, in the third quarter of 2009, 89% of the system's total non-performing loans (NPLs) of $7.7bn were related either to construction portfolios, mortgages or commercial real estate loans.

Non-US banks have not been exposed to the downturn in the construction industry to the same degree as US-owned banks. They have also succeeded in turning around losses sooner. For example, both Santander and Scotiabank in Puerto Rico recognised losses in 2007 and 2008, respectively, and became profitable again in 2009. In contrast, Banco Popular, for the first time in its history, reported full-year losses in 2007, followed by full-year losses in 2008 and losses in the first three quarters of 2009.

Despite the severity of the crisis, Banco Santander also managed to maintain business levels in the year to the end of October 2009. Scotiabank, which reported a 20% rise in revenue, actually increased its market share in two business lines: car loans and residential mortgages, by 2% each, in the same year.

"We have basically been very successful at growing and taking market share at a time when many of the banks in Puerto Rico are either looking to downsize or are closed for lending. They are focused on their problems," says Mr Wright.

Mr Moreno says of Santander's approach: "We haven't been very aggressive in terms of increasing our market share but, on the other hand, we have been very aggressive in terms of lowering our [bad] assets."

This was achieved when the Puerto Rican-based bank was able to sell off most of the 10% of its total loans that it had contracted in the real estate sector to a specially constituted company, with the help of a $600m capital injection from the Spanish-owned bank's parent company. "I call it my personal TARP. [Banco] Popular got the TARP from the US government. I got TARP from Banco Santander," quips Mr Moreno.

Banco Santander Puerto Rico also maintained asset quality and reinforced credit risk management, with the result that in the third quarter of 2009 the bank had a 90-day past due NPL ratio of 3.43%, well below Puerto Rico's 12.32% average and lower than Scotiabank's 5.9% ratio, BBVA's 7.9% and Popular's 10.54%.

Table 1: NPL ratios of Puerto Rican banks, 90 days past due Q3, 2009

Table 1: NPL ratios of Puerto Rican banks, 90 days past due Q3, 2009

Table 2: deposit structure of Puerto Rican Commercial Banks at September 30, 2009

Table 2: deposit structure of Puerto Rican Commercial Banks at September 30, 2009

Domino effect

Meanwhile, extremely high unemployment rates in the Puerto Rican economy as a whole exacerbated weaknesses in mortgage portfolios, car loans and credit card portfolios. In these three business lines, NPL rates were close to 20%, 11% and 10%, respectively, in the third quarter of 2009. Also, reflecting the severe economic downturn, mortgage volumes, which were $8bn a year in 2006, were down to $3bn in 2009; and car sales, which amounted to 130,000 cars a year in 2006, had plummeted to 70,000 annually.

Only small business and corporate commercial lending have held their own in the Puerto Rican crisis, neither growing, nor declining, according to bankers.

Puerto Rico's banking system has historically had lower average profit levels than US mainland banks. However, according to FDIC data, in the second quarter of 2009 50% of Puerto Rico's banks were not profitable - nearly double the 27% that were not profitable in the US. Meanwhile, losses in the Puerto Rican system, which seemed to peak at $1bn in the fourth quarter of 2008, with $703m attributed to Banco Popular alone, were still a significant $575m in the third quarter of 2009.

Bankers emphasise that an important structural characteristic of the Puerto Rican banking industry is that only 55% to 60%, or $35bn out of total loans of $61bn at the third quarter of 2009, were funded with core deposits. The average ratio of core deposits to total deposits was just 46.5% at that time, compared with a 97.4% average on the US mainland.

The upshot is that several Puerto Rican banks are funded with more expensive wholesale broker deposits. Currently the ratio of core deposits to total deposits of the three banks with cease and desist orders are 38.8% for Eurobank, 49.5% for R&G Premier and 26.6% for Westernbank; and in all three cases the orders urge banks to reduce their dependence on buying deposits on the wholesale market. Only two banks in the system have a particularly high ratio of core deposits to total deposits: Banco Santander Puerto Rico and Banco Popular de Puerto Rico, with 91.2% and 90%, respectively.

Finally, the ratios of several banks' capital to risk-weighted assets are "in the lower tier compared with banks in the US market", says Mr Padilla. And the average coverage of bank reserves of NPLs at the third quarter of 2009 was just 29.5%.

"This is one of the problems that banks have. Even though NPL rates are going through the roof, the coverage of [bank] provisions is incredibly low. The system doesn't have the capacity to generate enough provisions," says Mr Moreno. He and other bankers estimate that the system needs between $3bn and $5bn of capital in order to enable several banks to withstand the crisis.

Against this background and despite the changing playing field, most people expect Banco Popular to keep its position as the biggest bank, with the largest branch network and customer base on the island. This is because although the bank has been hit hard at both the US and the Puerto Rican ends of its business, "the ability of Popular [in Puerto Rico] to generate top-line revenue is still there", says Mr Carrión.

However, Mr Padilla says that the banks which are best placed to take advantage of the consolidation that may occur because of the crisis are those that have "good foreign companies behind them. I am talking about the Canadian bank and the Spanish banks. Those entities are in the best position to take advantage of this situation."

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Troy Wright, CEO of Scotiabank Puerto Rico

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Juan Moreno, president of Banco Santander Puerto Rico

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Alfredo Padilla, Puerto Rico's commissioner of financial institutions

Bold ambition

Scotiabank is Puerto Rico's only non-US bank to announce growth plans. Mr Wright, the bank's CEO, has publicly stated that he wants it to expand from its current 3.5% market share to 10%, a target that he says cannot be attained by organic growth alone.

Moving towards that goal, in August 2007 Scotiabank bought 10% of FirstBank and it was clearly the intention, and publicly stated at the time, that Scotiabank would have the first opportunity to acquire a bigger participation later. But then the crisis struck and the bank's share price plummeted, depressing Scotiabank's original $90m investment.

According to Mr Wright, the main reason a transaction has been delayed is because neither party can agree on a floor price for FirstBank's toxic assets, "especially in the toughest category of assets which is residential real estate construction. It is the biggest millstone around the necks of [Puerto Rican] banks," he says.

Similarly, there have not been many sales of troubled banks on the US mainland, as few banks are willing to sell their toxic assets at current market prices because they would almost certainly be selling them at a loss.

As well as being one of the biggest lenders to the Puerto Rican government, Scotiabank is the largest bank in the Caribbean by assets and market share and has deep roots in the region dating back to the financing of the sugar trade between Canada, the Caribbean and the UK.

In contrast, the principal reason for Santander's investment in a Puerto Rican bank in 1976 was "because of the island's close links to the US", says Mr Moreno. He says the group has not been interested in establishing a bigger presence in the Caribbean or in nearby central America, another Scotiabank stronghold, because "these markets are small and require a lot of effort".

Santander and BBVA, which has a market share of about 8% in Puerto Rico, have also recently bought large US mainland banks. In January 2009, Santander, which had previously bought a 25% stake in Sovereign Bancorp, with operations in the north-east of the US and 750 branches, took the second step of acquiring the remaining 75% share for $1.9bn. BBVA focused its expansion on the US sunbelt states. After acquiring Compass Bancshares, with about 600 branches stretching from California to Florida in 2007, in August 2009 it snapped up Guaranty Financial, a struggling Texas bank, with $13.5bn in assets.

With such important developments and an ongoing interest in expanding in the US, according to public statements made by both banks' top officials, the Spanish institutions have not evinced much interest in increasing their operations in Puerto Rico - at least not so far.

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