NJ Bank Marketing Seminar, December 6, 2012: Forecast 2013 - Chapter 2 - Christopher Martin

Good morning. First thing, most of this was written on a plane coming back last night around 11 o'clock from Florida, so I'll have to stick to the script. Kevin, I like all your words. I love the CPA business and I always go back to 'gee, it was paralysis by analysis,' so he got over that. I think that's a good thing. As a large shareholder, I appreciate the dividend. It's interesting that Kevin was more optimistic than I am, so I'm sorry it's going to be a little drudge here. Everything goes to Dr. Hughes, who actually does understand this, so we'll leave all the graphs and charts. But I have a little bit of a presentation that goes along with this. I will be sticking to a script, so to speak. As I'm reading, realize these opinions I express are my own. I'm sure I should have a disclosure: don't trade on this, don't do anything of that nature. We'll keep the attorneys out of the room. As we mentioned, we're the oldest bank in New Jersey, 173 years young. We trade on the New York Stock Exchange. We went public in 2003, a full conversion. I was the product of the first acquisition that Provident made. We are down to 78 branches; we've consolidated as we've looked at the business. We have 920 FTEs. We did not take TARP money or any government assistance. Our balance sheet is about 60% commercial, 40% consumer. Relationship banking, somewhat like investors top to bottom, that's what we live and that's in our DNA. What I'm going to focus on are four items that have a major impact on the banks and the economy in general. You can read them; I'm not reading them to you, but I'll go through some of my comments. It's the New Jersey economy, government leadership or more to the lack of government leadership, what is coming down the pike for the banking industry, and how will the business of New Jersey be impacted by the above three. Let's go over what has happened over the last four years. If I duplicate some of Kevin's comments, I apologize. The New Jersey housing market is still struggling despite record low interest rates. Refinancing has represented the majority of the loan volume in the consumer sector, but only for those with good credit and actual jobs. The judicial foreclosure process has delayed the recovery in the housing market, and New Jersey ranks in the top three or bottom, depending on how you look at it, in the country in the delays of the process. So we're frustrated by that, and I know you all are also. Certain urban markets have been especially hard hit by the difficult economy, and numerous abandonments have caused blight and destruction of neighborhoods, which is something that I know the legislation is trying to look at right now. Until the supply of homes coming through foreclosure is diminished, the housing market will probably languish. Home prices, according to CoreLogic, increased nationwide during the month of October, which marked the eighth straight month that there were year-over-year increases, showing evidence that the housing market is getting a little bit better, albeit very slow. But the five states with the greatest appreciation during October were Illinois, Delaware, Rhode Island, New Jersey, and Alabama. It's really sad that we're stuck in that bad mix. The volume of new home production is way behind where it was in previous recessions due to the struggling job market in the US and New Jersey, and certainly a more cautious consumer. Further evidence of this can be found in the high-end market, which is having trouble finding purchasers of McMansions. Even with low mortgage rates, it would be beneficial if the government would use the agencies of Freddie and Fannie to try to help out those borrowers. They've tried several times, good job. Our problems with the mortgage way of doing refinancing and accounting treatment to try to fix these problems, we figured out maybe they can help people that are underwater and subsidize that. Probably be better than taking over four. Unemployment in New Jersey has been trending the wrong way, as Kevin has said, over the second half of 2012, reaching 9.9% in September. I think the lack of confidence in the ability of our elected officials to reach a compromise, and businesses in New Jersey unsure of the impact of possibly going over the fiscal cliff, company of consumer demand, and the implementation of the Affordable Care Act have increased volatility and have made them hold more liquidity than necessary and curtailed capital expenditure and investments for future business expansion. So it's certainly a problem when you don't have confidence; you're not going to go out here and invest in people and process. Taxes are a challenge in New Jersey as we have one of the highest state income tax rates, I know you don't have to tell you people around the table, in the country, and we also have the highest real estate taxes. This, with the backdrop of a challenge of keeping the wealthy in New Jersey because we're going to tax that much, they're going to move to Florida, Texas. Along with municipalities struggling under their own challenges and now with the impact of Sandy, it's tempting our elected officials to try to tax the job creators, which we know what that does: it'll stop the jobs. With the talk of the administration in Washington wanting to close the deficits on those making over $250,000, that level in my opinion is way too low when you compare the cost of living in New Jersey and other areas like New York, certainly Connecticut, with that of Kansas and Nebraska. There's a whole different paradigm there, so the amount of tax revenue that will be exacted from the state will be disproportionate with most states in the US. I'm going to be a little bit on the government, of course. Let's talk a little bit about leadership in Washington. As much as I don't like getting in, well I do love getting into the politics, and they always try to keep me out of it. We're all aware of the difference in the ideology of Washington and the equal split between the electorate being 51-49, so that's certainly not a mandate that our president thinks he has. There's a split in this country that we have to fix. But with the lack of adults in the room and the citizenry hanging in the balance, we continue to languish and a lack of confidence will remain. The Democrats in Congress are keen on keeping the focus on revenue increases rather than further spending cuts in the fiscal cliff negotiations. A poll shows that most Americans doubt that the fiscal cliff negotiations between President Obama and Congressional Republicans will be successful, depending on your measure of success. Additionally, more than six in ten Americans believe that failed negotiation will result in an overall negative impact on the economy as well as a blow to their personal finances. While we look at the European economy and note how fundamentally unsound it is, we are heading down the same path if something isn't accomplished to reduce record deficits. So that's a very dangerous precipice to be on. Now, some of my people that helped me create this little presentation thought it'd be great to show my bald head, which is a lot balder than Kevin's, would distract from the realities of what's coming our way all too soon. Basel 3 has been postponed for now, and I think a lot of us wrote letters saying how bad that was going to be. We don't mind if you want to have more capital, that's one thing, but the process of analyzing it was just onerous on any institution, so I was happy that we did get that moved around. But the capital levels, Basel 3 capital levels, regulatory changes, the CFPB, tax reform, and the impending cliff, which I refer to as a hill, are clouds on the horizon. With all those clouds referenced on this slide, they have made any decisions on the direction of the economy and future improvement to growth of businesses very difficult. The level of regulations being imposed on businesses small and large are constraining growth in jobs and expansion, and the backdrop of higher taxes doesn't help them. We do need patriots and adults in Washington, as Kevin was mentioning. We need to get people that are just going to think clearly for the citizens if long-term reform is to be achieved and we are going to address our deficits responsibly. Negotiations will require both parties to take actions that are counter to their respective political identities. Most of the banking regulators are overwhelmed with the implementation of Dodd-Frank as they promulgate the myriad regulations into rules that all banks comply with. Businesses have over 19 new environmental regulations to deal with. The Eurozone crisis and increased volatility in the global markets have diminished most CEOs' confidence in the near term. We're one of them. They are less confident today than two years ago. 90% of CEOs describe the US economy as being in fair to poor shape, so I'm not the only one that's really depressed, I guess. Growth in the economy is anticipated by 75% compared to 58% of small business owners last year, so at least there's one group with a little optimism. You appreciate the fact that small business has the most optimistic view. 77% of all US CEOs think the private sector alone is the engine that drives job growth, and we agree. All agree that the most effective way to accelerate permanent job creation is for the government to reduce business tax rates, something that we're probably not going to see in the near term. I'd say that the president's agenda is certainly counter to that assessment. Now, finishing up on government leadership: if the economy is going to grow GDP at an acceptable rate, it's all about jobs. The lack of job creation lies at the center of what ails the US economy. The 8% national unemployment rate does not include discouraged workers who have given up looking or underemployed. I was looking at some other thing called the U6; it says a complete tally of how many people who are really out of work is 14.7% nationally. So what's troubling is all these net new jobs come from newly formed firms as opposed to small firms, so the true entrepreneurs which we need. With the burden of regulation and the effect of Obamacare, it's difficult to see that many of them will put up their own equity to start their own new businesses and achieve success. Getting into the banking industry, which we're all part of: the US did restructure its financial system, Europe hasn't, so they have a long way to go in that regard. Now Dodd-Frank, we use that word constantly and every day it's something else with Dodd-Frank. We're all tired of hearing those two names, specifically the two people that caused half our problems. But the law requires a dozen new agencies to create 243 new rules, conduct 67 studies, issue 22 periodic reports. That's not simplification by any stretch. Certainly right now, fewer than 45% of those rules have been written. There remains a possibility and there is an opportunity, I think, that there might be some modifications and some revisiting of what was trying to come out of Dodd-Frank. Some of it very good and makes sense, some of it was just a reaction. The creation of the CFPB, which I know some of you have had a little bit of run-ins with, is yet another regulator. They're struggling to establish workable new mortgage rules, which is going to be costly for all of us. You have to evaluate the borrower's ability to repay a mortgage, and certainly developing a new set of underwriting rules and the simplification of RESPA and TILA, they want to get it down to two or three pages. We all agree, but I think it's 450 pages of instructions to get to the two or three pages, so maybe less attorneys in Washington. The Volcker Rule imposes tough new limits on proprietary trading by banks, which I'm pretty sure nobody in the room does that. But it does address new restrictions on hedging and derivative activities. I think they forgot that banks are in the risk management business; those are tools you have to have. Then I was just going through my notes last night, there's a little-known piece of Dodd-Frank on the certification in our proxy if you're a public company: conflict materials. I don't know how many people know this: gold, tin, and tungsten, they're mined in the Democratic Republic of Congo or neighboring states. You have to have a disclosure in your document. I'm like, I don't know how that got into Dodd-Frank at all, which explains what happens in Washington when they're making sausage. They estimated it's going to cost just that disclosure and everything else in the investigation to make sure you're not involved. Banks aren't, but we have to do that disclosure. $16 billion, so where is that helping anybody? Doesn't really. We all know what the Durbin Amendment did to us, reduce fee income. How many of you know Elizabeth Warren is going to be appointed to the Senate Banking Committee? So get ready, we're going to have a lot more things coming down the pike out of Washington. Community banks were not the cause for the meltdown. We are going to have to deal with all the new enforcements no matter what size you are. It all trickles down, and we're going to be treated as if we're one of those two big too-big-to-fail banks. The added cost to comply will put further pressure on our earnings and capital formation. So as earning pressures continue, compliance costs, employee benefits increase exponentially. How are we going to, how are banks going to meet all the changing needs of our customers, deliver an adequate return to our shareholders, when they have to carry excess capital levels? So everything's elevated to meet return on equity hurdles for stockholders. It may require that institution reach out on the risk curve by extending duration, loosening up on the credit standards, or putting on an exorbitant level of interest rate risk, as Kevin mentioned. So with the flat yield curve and the low absolute level of interest rates, when someone says I'm going to go borrow 2.5% for long term, it always scares me. What happens two years from now with that loan if I own it? That's going to be underwater if rates do go up at all. The challenge in our industry is the net interest margin for the most part, as deposit rate hits bottom. While the borrowings may require yield maintenance to pay them down, there is little wiggle room to reduce our institution's cost of funds. I know many of you don't want to answer that phone when the commercial customer is calling up and saying 'I want to reset my rate, and if you don't do it, I'm leaving.' So the cost of that business going somewhere else, you have to evaluate that and know that that's going to compress your margin. Hence the conundrum and certainly the squeeze in the margin. The temptation is probably to stretch out on the curve, what curve there is, which requires extending duration or putting on a high level of negative convexity or optionality that favors their counterparty. You could hold that longer duration paper like a 30-year mortgage on your books, but that does increase your interest rate risk profile. You could lower your credit standards to generate additional volume, but we're all too familiar what that can do if we hit another rough patch in the economy or this recovery stalls. You can go into riskier asset classes such as asset-based lending, reverse mortgage, business insurance financing, indirect lending, trade finance, syndicated national credits or participations, or lending out of your primary markets going elsewhere. Just make sure that you've done the analysis of that risk versus the return. As many of us have had a huge influx of deposits, they keep coming in even though we don't want them. There's no place to leverage them without reaching. I always say beware. I know I have Mr. Current Conor here about the current on the bonds. There's always going to be something new coming out of Wall Street. Be careful, make sure you do your risk assessment on all those, and the regulators will want you to do that too. So in order to meet bank hurdles, earnings projections, and to placate our board and shareholders, I think operating costs is what we're going to spend a lot of our time in the next couple years working on. That means job cuts, that means using technologies to achieve more efficiencies, which includes if you get rid of jobs, that means more people are unemployed and then more delinquencies. So everything is cyclical. We do need job growth. I think all that does result in is there's going to be probably bank consolidation. I hope that everybody can survive and get through this, but I think it's just going to be something as we address the new normal that we're going to be up against. So you can see the tables have leaned on one side. The balance is tilted the wrong way. Until the burdens are lightened up, it's going to be very difficult for the housing market and the economy to expand. Without a reduction in the challenges that we face, it's difficult to see our customers being confident to grow and to borrow, expand their businesses with this as a backdrop. As Kevin was referencing, can you imagine running a business with a deficit of over $1 trillion per year and you report back to the board that you cannot come up with $100 billion in annual expense reduction? No wonder the Business Roundtable is frustrated. I agree, we should have business people in Washington, less politicians. Now this is a tough chart. Can you read that in the back? If so, I don't need you in my eyeglass plan, that's for sure. I always have this print out, there's a lot of information. It's all about the fiscal cliff. I'm going to go through a few of these things, and then I'll get into the 2013 what we see as the future. This describes what the fiscal cliff has avoided, and if we go over the edge, as we anticipate the volatility in this market is going to continue right through the year end and probably through January because there's no way they're going to get something done probably by December 31st. I think with the rating agencies, they're waiting, but they'll probably wait till the new Congress is put in place before they start doing any rating changes. So those that have probably heard a million times, I'm going to go through the major components of the fiscal cliff. Dr. Hughes, if I'm stealing your thunder, I apologize. Payroll tax will expire, Bush-era tax cuts to expire, estate and gift tax cut to expire, AMT patch expires, 2012 tax extenders and 2011 extenders that expired but hadn't been renewed, federal extended unemployment benefits to expire, and automatic spending cuts to kick in. So what happens next year if the fiscal cliff cannot be averted? Bad news is Q1 GDP will probably be negative. Virtually everyone would see taxes going up. The amount varies by state, but the average family in New Jersey, again when you put AMT in there, they say it's going to have an extra $6,000. It's a lot of money. Then they're going to point fingers at each party and it's going to be a blame game, and we'll deal with that. If the fiscal cliff is averted, the economy continues on its anemic recovery, confidence improves slightly, consumer still is overleveraged, small business remains cautious in terms of hiring. The outcome would in all likelihood be kicking the can down the road for a year when true tax and entitlement reform will attempt to be achieved again. The global economy will not implode. Neither side, Democrat or Republican, will be satisfied if the deal is hastily reached. Banks would continue to lend but conservatively. Inflation is always a question mark if it does happen, which I sometimes say you know what, that may force adults to do something. The impact of $600 billion of savings via tax increases and spending cuts would probably cause a recession and affect the global economy, but it would create a discipline in Washington. Because of income and payroll tax changes, workers' checks would shrink in 2013. Too much fiscal tightening too fast will slow the economy further from its anemic rate. The CBO estimates that reducing the deficit so quickly would likely reduce growth from 4.4% to just 0.5%. So we talked about AMT tax would rise, tax cuts from 2001 and 2003 will expire, and new taxes from Obamacare are starting. I don't think a short-term recession would be that bad personally. I think it gets people to realize that you have to handle a problem as opposed to kicking it down the road for our kids' sake and our grandkids' sake. Unemployment will rise because they're not going to generate a lot of growth, so that could move up to 8.5% to 9%. Likelihood that small business will not hire is up 18%. The credit market and global economies probably wouldn't implode, but they would certainly be constrained. Here's one that scares me: top tax rate would be 43.4%. So the perverse good news is that an increase in tax revenue and the cut in government spending associated with the implementation of sequestration would reduce the fiscal 2013 deficit. So that's not very exciting or very uplifting by any stretch. So I'll smile as I go to my economic points. Interest rates: the slow-growing economy and the actions of the Fed to keep rates near zero until the job market recovers will result in interest rates staying low through 2013 and probably 2014. The 10-year Treasury may inch higher but still probably stay below 2%. Rates on 30-year mortgages will remain below 4%. The caveat would be if no agreement on the fiscal cliff is attained and the rating agencies downgrade the US debt, that could put some upward pressure on rates. Unemployment: payroll numbers nationally have shown consistent improvement, though it's way behind where we were for other recessions. The unemployment rate will get to about 7.5% by year end 2013. Nationally, it could be stronger if businesses were more confident about the fiscal cliff. In New Jersey, I think it'll be a little bit better rate of improvement. It's not going to be down at that level, but I think it's going to get better, and it could be because of the impact of Sandy: hiring and people buying furniture and everything else. Inflation: very muted, although food prices have increased from the drought out in the Midwest. The drop in CPI in the last part of 2012 should keep the Fed comfortable with their inflation targets. Mirroring what Kevin said, core inflation was approximately 2% in 2012. I'm guessing about 2.5% for 2013. Housing: should pick up momentum even in New Jersey as new legislation for abandoned properties and uncontested foreclosures is hopefully put in place. Historically low interest rates will help the mortgage market. There are additional government assistance programs that could gum up the works, so hopefully they just stay out and let this market find its own place. They're starting to see some increased construction activity in pockets around the country, so builder confidence is maybe improving a little bit. They're going to put a stake in the ground. Business spending will continue to struggle. It'll be a positive number but well short of 2012 growth. Overseas will remain slow. The economy will not get much assistance from an increase in inventories; they've already been built up a little bit. Confidence is probably the biggest issue with businesses. GDP: the economy should be better in 2013 but towards the second half of the year as we have to deal with the indifference in Washington first. First quarter very slow, I have about 1.3%, especially with Europe and the slowing growth in China. Cuts in federal spending and higher tax rates and the expiration of tax cuts will cut about 1.25 percentage points off GDP in 2013. I think the second half of the year the consumer will feel better. Productivity gains might be playing out as businesses will have to probably hire people because you can only squeeze so many efficiencies out of people. I see some people from Provident there saying 'you know, sleep is overrated, just work, it's okay.' In New Jersey, we start talking about what's going on in CapEx expenditures and technology. Hopefully businesses will do that in New Jersey. Retail sales are going to slow. I think we're having supposedly the holidays are doing very well, so I think that'll be something that'll probably slow up in the first quarter. But New Jersey and other areas, we talked about builder supplies and everything else. We have a client that borrowed an extra million dollars to buy shingles at a discount rate back in the summer. Didn't know Sandy was happening, but now he's sitting in the catbird seat because it's going to happen and he knows he's got the product, and he's very excited about that, though in a bad way. Energy: certainly is something that we look at and watch. It's going to go up slightly in 2013. Global demand picking up slightly, and natural gas has certainly been a place where storage levels are high, so shouldn't affect us too much. I think my closing comment, and I'll answer some questions, is everybody goes 'wow, it's very depressing, how do you stay focused and how do you enjoy?' I said this is the most exciting time we'll have in the banking industry. I know that some people have been through a lot of exciting times in the banking industry going back into the 80s and all the real estate debacles and everything else, but you have to have power, strength, and lead through this. I get excited about we've been lending throughout this crisis, we never stopped. Kevin's company the same. We compete head-to-head, but we realize this is a business you want to be doing on your own merits and make sure you win your business effectively. Guess what? There are opportunities out there. So you should be positive. We should be always saying there's always a way to one, make money, two, help customers, and three, build your business. So those are my prepared comments, and I say good luck out there. Thank you very much.