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Kelly King's Conservatism Steers BB&T Safely Through Crisis

Can CEO Kelly King maintain a disciplined credit culture while growing the regional lender?

For years being the third-largest bank in North Carolina delivered few accolades. BB&T Corp. may have generated steady earnings, but the lender was often regarded as something of an also-ran — the trusty Ford pickup to Bank of America Corp.’s Ferrari and Wachovia’s Jaguar, neither racy nor ambitious enough for some critics’ tastes. Many analysts and investors asked, Why didn’t the Winston-Salem–based bank pursue growth more aggressively or generate the same kind of profits as its bigger rivals?

“Our answer was, ‘There’s always a tight relationship between risk and reward,’” says Kelly King, BB&T’s chairman and chief executive. “Those banks were getting those rewards because they were taking risks that we didn’t think were acceptable relative to the potential rewards.”

Today, King can enjoy no small measure of vindication for his conservative stance. Wachovia crashed after its badly timed 2006 acquisition of California mortgage lender Golden West Financial Corp., just as the housing market started to crack, and was taken over by Wells Fargo & Co. Bank of America needed a lengthy pit stop and billions of dollars in Treasury bailout money to keep its engine running after it bought Merrill Lynch & Co. But King and his team’s disciplined lending culture has steered BB&T safely through the crisis.

The bank’s earnings declined 51.3 percent in 2009, to $729 million, or $1.16 a share. Still, BB&T was one of only three large regional banks, along with Minneapolis-based U.S. Bancorp and M&T Bank Corp. of Buffalo, New York, to turn a profit in every quarter of the financial crisis. Among the majors, only JPMorgan Chase & Co. managed that feat. BB&T has also suffered fewer loan losses than its peers and boasts stronger reserves for future losses.

“The conditions are the worst I’ve seen in my 37 years of banking,” King says with a drawl that betrays his rural North Carolina roots. “If you judge companies based on absolute performance, everyone would get an F. We haven’t done everything perfect, but relative to the results others have gotten we’ve done well.”

So well, in fact, that King is moving quickly to capitalize on BB&T’s relative strength and expand. In August the company acquired most of the assets of failed Colonial Bank from the Federal Deposit Insurance Corp. The deal brings BB&T $22 billion in assets, $19.3 billion in deposits and 346 branches and gives it a top-five market share in Florida and Alabama as well as a toehold in Texas. To off-load a bank with more liabilities than assets, the FDIC agreed to pay BB&T $4.1 billion, cover 80 percent of the first $5 billion in losses on Montgomery, Alabama–based Colonial’s loan portfolio and pick up 95 percent of any losses after that. The transaction added about 5 cents a share to BB&T’s fourth-quarter earnings, and “it’s probably worth 20 cents per share for us in 2010,” says chief financial officer Daryl Bible. The company will consider other FDIC-assisted acquisitions, he adds, provided they can be accretive to earnings.

“We have a very strong growth ambition, but we’re not out there saying we need to get to $300 billion” in assets, King says.

The CEO and his team are also taking advantage of the troubles plaguing some of their surviving competitors in the mid-Atlantic and Southeast markets to win business. BB&T’s revenues rose a smart 18.1 percent in 2009 from a year earlier, and the bank grew deposits in previously existing branches by 7.9 percent; loans at those branches declined by 1.2 percent. Thanks to Colonial and other small acquisitions, overall loans were up 8.9 percent in 2009, and deposits grew by 23.5 percent.

“There’s a strong sense around here that this is our time,” says Ricky Brown, BB&T’s head of retail banking. “There are businesses — 100-year Wachovia customers, longtime BofA customers — who have moved their business to us. They wouldn’t even take our call three years ago.”

The burst of growth has given King some serious bragging rights. With $165.8 billion in assets and a market capitalization of $22 billion, BB&T is now the country’s ninth-largest bank by both measures.

BB&T is not without blemishes of its own. The bank’s loan losses have risen in recent quarters and likely won’t peak until the middle of this year, if not later, some analysts say. The company is a big commercial real estate lender — the sector accounts for 30 percent of the bank’s lending — and the recessionary fallout already felt in places like Florida and Georgia, where BB&T is a relatively bit player, is creeping northward to its core markets in Virginia and the Carolinas. BB&T also has been holding on to more foreclosed properties than most banks, waiting for real estate prices to rebound, and some analysts worry that the company might not be writing down its portfolio aggressively enough.

Kevin St. Pierre, a senior analyst with Sanford C. Bernstein & Co., notes that BB&T’s shares have been among the most heavily shorted in the banking sector. “There have been a lot of investors waiting for BB&T to crack, for its credit costs to catch up with peers,” he says. Late last month, BB&T’s shares were trading at about $32, the highest level in 15 months but off more than one third from the all-time high of $44, hit in late 2007, and little changed from a decade ago.

Thus far, however, the naysayers have been disappointed. In most key categories, BB&T has been lapping the competition. The bank’s pretax, preprovision return on assets — a closely watched measure of earnings power — stood at 2.38 percent in 2009, compared with 1.93 percent for a group of 12 peers that includes U.S. Bancorp, PNC Financial Services Group and SunTrust Banks. Reduced lending competition enabled the bank to boost its net interest margin last year by 8 basis points, to 3.66 percent, well ahead of most peers.

The bank also has fewer bad loans, and greater capacity for dealing with credit problems, than most rivals. Nonperforming loans accounted for 2.65 percent of BB&T’s assets at the end of last year, compared with a peer-group average of 4.72 percent. Net charge-offs were 1.79 percent of loans, versus 2.77 percent for the peer group. The company set aside $2.8 billion in provisions for future loan losses, boosting its ratio of reserves to nonperforming loans to 96 percent, above the peer-group average of 86 percent.

Perhaps most importantly, BB&T boasts strong capital backing, with tier-1 capital equal to 11.48 percent of risk-adjusted assets and tier-1 common equity of 8.5 percent. That compares with ratios of 9.61 percent and 6.8 percent at U.S. Bancorp, 9.25 percent and 6.46 percent at Wells Fargo and 11.1 percent and 8.79 percent at JPMorgan Chase.

The company, which reluctantly took $3.1 billion in capital from the Treasury Department’s Troubled Asset Relief Program in late 2008, was among the first banks to repay the government last June, after raising $1.75 billion in fresh equity. The bank also issued an additional $1 billion of equity to pay for the Colonial acquisition.

The bank’s performance appeals to some large-cap value investors. Institutional Capital, a Chicago firm that manages $15.5 billion in assets, began buying BB&T last May and, by the end of 2009, had amassed 9.2 million shares, or 1.3 percent of the total outstanding. Jerrold Senser, ICap’s CEO, says he likes the aggressive approach of the company’s management team, the demographics of its markets and its 15-year history of superior credit quality.

“In the financial sector companies with strong capital positions like BB&T’s will be able to take advantage of their competitors’ weakness and improve their earnings power,” Senser says.

That’s an objective that King is eager to fulfill. “We’re seeing a lot of the weaker players going away,” he says. “That gives us the opportunity to solidify ourselves as a major player in some really, really good markets.”

King has spent his entire career at BB&T, one of a small team of executives that transformed Branch Banking & Trust Co., the group’s commercial banking subsidiary, from a tiny North Carolina agricultural lender into one of the nation’s top ten banks.

The son of a tobacco farmer, King grew up on a small farm near Zebulon, a tiny dot on the map just east of Raleigh-Durham. The second of four siblings in a cash-strapped family, he spent much of his childhood in the fields and remembers picking tobacco leaves and hanging them on strings in a heated barn to prime them. “You’d cure it to where the leaves became a nice and pretty yellow, and then you’d take it to the tobacco warehouse to sell it,” he recalls.

Smarts and hard work paved the way out of farming. King attended East Carolina University, an hour down the road in Greenville, earning a B.S. in business administration and then graduating first in his MBA class. He was hired by BB&T in 1972, straight out of school, and entered the management training program at what was then a sleepy $250 million farm lender with ultraconservative management. He rose rapidly through a series of assignments and by 1978 was the bank’s top executive in the state capital of Raleigh.

King joined the bank at about the same time as a cadre of other sharp, young MBAs, including former CEO John Allison IV, who retired last year, former chief operating officer Henry Williamson Jr., former CFO Scott Reed and former chief credit officer W. Kendall Clark. These ambitious men were chafing for BB&T to expand beyond its agricultural, East Carolina roots. King recalls delivering a blunt message in 1980 to then-CEO Thorne Gregory as they walked to lunch one afternoon: “If things don’t change I’m worried some of us will leave.” Gregory met with the group a week later, and BB&T began to expand its operations, acquiring 18 small banks over the next decade. That strategic shift was critical to the bank’s future, says King.

“If we had stood pat, with what’s happened to agriculture and textiles, we wouldn’t be here today,” he explains.

In 1989, Allison became chief executive and ramped up the growth strategy, making 42 bank deals over the following 15 years. The most significant was the 1995 merger of equals with Southern National Corp., which transformed BB&T into a $20 billion-in-assets, 437-branch company spread across the Carolinas and Virginia. King was a key member of Allison’s team, running the retail network for much of this period, overseeing the integration of Southern and rising to become chief operating officer in 2004. Allison “was a visionary,” King says. “John would buy the banks, and I would run them.” Allison also used acquisitions to diversify the business, buying 80 small insurance agencies since 1994 and 31 other nonbank companies, mostly in the investment management and consumer finance arenas. BB&T turned cautious after 2004, however, reflecting Allison’s and King’s concerns about valuations. The company has acquired only five banks in that period, including Colonial.

The results of this corporate activity are impressive. Today’s BB&T has 6.3 million customers and 1,837 branches in 12 states and the District of Columbia. In 2009 the company got 60.1 percent of its revenues from retail and commercial banking, 11.1 percent from insurance services, 9.5 percent from financial services such as asset management and 8.6 percent from the residential mortgage business; the remainder came from other areas including treasury and specialized lending. Fully 42.8 percent of revenues came from fees, prized in the industry for their relative immunity to interest rate fluctuations. That beat BB&T’s peer average by nearly 3 percentage points.

As important as the acquisitions have been, King insists that the company’s success lies in a strategy and culture honed over some 30 years. Allison is a staunch capitalist and disciplined banker who believed the best way for BB&T to prosper was by helping customers do the same. He kept the bank away from many notorious subprime products, such as negative amortization mortgages, saying they were bad for borrowers. Allison is also a devotee of the philosopher and novelist Ayn Rand, who extolled laissez-faire capitalism and individual liberty and decried governmental activism. He created a BB&T foundation that gave money to numerous universities to promote the study of Rand’s works, including a $2 million gift to endow a professor’s chair for the study of Rand’s philosophy of objectivism at the University of Texas at Austin. In a September 2008 letter to Congressional representatives, Allison blamed the subprime crisis on government efforts to promote home ownership and the Federal Reserve’s low interest rate policies, and he criticized TARP as “a bailout of poorly run financial institutions.”

It’s a testament to BB&T’s stability that, in the midst of the financial crisis, Allison handed over the CEO post to King as scheduled in January 2009 and ceded the chairmanship to him 12 months later.

A practicing Baptist, King is no fan of Rand, who loathed religious faith as irrational, but he shares his predecessor’s capitalist fervor and devotion to sound business practices. He is constantly promoting to employees the bank’s core values, including such virtues as honesty, productivity, self-esteem and teamwork. “If you really want to change people’s behaviors, you need to change their beliefs,” says King. “And the way you change beliefs is with the constant delivery of factual, reliable, credible information from a powerful source. As CEO I have to take the primary lead. I have the bully pulpit.”

The company runs BB&T University, which was ranked last year by Training magazine as the best in-house corporate training program in the U.S. banking industry. The program preaches the need to provide service that is “reliable, responsive, empathetic and competent.” People will pay more — a slightly higher interest rate, a little more in fees — if they believe they’re getting better service in return, King believes. Every worker is expected to do at least five days a year of training, either off-site or online. “We’re serious about building the competence that leads to great client service,” says retail banking head Brown. Customers seem to appreciate the effort. Some 35 percent of them use at least five BB&T products. After the Colonial deal, BB&T reduced head count by 2,500, to 31,000, but it tries to find other positions for affected workers and has avoided pay cuts. “If, during the tough times, you cut pay and benefits, then you begin to deteriorate your relationships with employees,” King explains. “Over time that hurts your relationships with clients.”

The emphasis on service is more than just rhetorical, according to one client. Mark Engel, owner of BMW-Ducati-Triumph-MV Agusta MC of Charlotte, a motorcycle dealership, recently took out a $1.9 million construction loan for a new store from BB&T after talking with a number of banks. BB&T’s terms “weren’t quite as low-priced as the others, but they did a lot for me to show how much they wanted it,” including giving his company a bigger credit line, Engel says. “They came in like partners and did everything they could to help us get the deal done in a difficult environment.”

Even as it stresses customer service, the bank has managed to keep a tight lid on costs. The company’s efficiency ratio, or expenses as a percentage of revenues, was 50.4 percent last year, compared with a peer average of 60.6 percent.

BB&T’s policy of competing on quality instead of price also has made it a more-cautious lender. More than 72 percent of its $15.7 billion in residential mortgages are prime loans, while less than 4 percent qualifies as subprime; the remainder are Alt-A and construction loans. For commercial real estate loans, the bank pays close attention to a borrower’s personal financial situation and typically limits loans to 70 percent of a property’s value. “We want equity in projects — real equity — from clients,” Brown says.

The approach is backed by incentives. Loan officers’ pay depends, in part, on credit quality. “We look at past-dues, nonperformers and charge-offs on the loans they’ve made,” Brown notes.

BB&T’s methods have produced strong results, but some skeptics question whether the bank’s prospects are bright enough to sustain its premium valuation. At a recent price of $31.60, BB&T’s shares were trading at about 2.2 times tangible book value and 21.6 times consensus earnings projections of $1.46 a share for 2010. In comparison, U.S. Bancorp was trading at 16 times 2010 earnings estimates and SunTrust Banks was trading at about 1.2 times tangible book.

Some analysts suggest that BB&T’s relative success may reflect geography more than lending prowess. “The concern is that instead of being relatively immune to credit-quality issues in the market, they’re just going to reach their peak later than competitors,” says Kevin Fitzsimmons, a managing director for Sandler O’Neill & Partners, who predicts the bank’s earnings per share will rise 16.4 percent this year, to $1.35. The fact that the bank nearly doubled its provisions for loan losses last year underscores Fitzsimmons’ concerns.

Just 8 percent of BB&T’s loan portfolio is in hard-hit Florida, while 53 percent is in the Carolinas and Virginia — markets that haven’t seen huge drops in real estate valuations but that are increasingly feeling the impact of the recession. South Carolina’s unemployment rate hit 12.6 percent in January, up from 10 percent a year earlier; North Carolina’s rate rose by 1.9 percentage points over the same period, to 11.1 percent; Virginia’s jumped 1.2 points, to 6.9 percent.

A poor job market tends to drive down real estate prices. Those three states are home to 53.4 percent of BB&T’s $15.7 billion in residential mortgages and two thirds of its $13.5 billion portfolio of one-to-four-family and retail lot loans. Combined, the two portfolios account for nearly 30 percent of the company’s loans. Both showed increases in nonperforming loans and charge-offs last year.

Conventional wisdom also holds that CRE loan performance tracks closely with unemployment rates. BB&T’s commercial real estate portfolio includes $6.3 billion in residential acquisition, development and construction loans. At the end of the fourth quarter, the bank had charged off 7.4 percent of those loans, while 13.63 percent were nonperforming, up from 12.08 percent a quarter earlier. A further $12.4 billion in non-owner-occupied “other CRE” loans had charge-offs of 1 percent, with nonperformers rising to 2.35 percent of the total from 1.82 percent in the second quarter.

BB&T executives say that crisp underwriting and portfolio “granularity” — the average commercial real estate loan is just $543,000, according to Brown — should lessen the fallout from a weak economy. Even so, Paul Miller Jr., who follows the company for FBR Capital Markets, notes that BB&T’s overall nonperforming loans continue to grow, up by $143 million in the fourth quarter after rises of $612 million in the third and $590 million in the second.

A related concern is the company’s bulging portfolio of real estate holdings. BB&T has been moving aggressively to foreclose on bad loans, but some say it isn’t moving fast enough to dispose of the underlying properties. The bank had $1.5 billion of “other real estate owned,” or foreclosed properties, on its balance sheet at the end of 2009, the highest level relative to capital of any U.S. regional bank.

King readily concedes that his OREO portfolio is larger than what a bank of similar size would typically have, because the losses on those sales would be too great. “We’re not willing to sell them in this environment,” he says. Other banks maintain higher levels of 90-day-plus nonaccrual loans or troubled debt restructurings on their books. BB&T has been more aggressive moving bad loans out of those categories and into OREO, King says, because property owned by the bank endures “a very methodical process for disposing of it,” making for better results in the long run.

Not everyone shares King’s optimism. FBR’s Miller believes the bank’s accounting policies understate actual credit losses. He predicts that nonperforming loans will continue to accelerate, peaking at $4.8 billion this year, compared with $4.2 billion in 2009. Given the company’s late-cycle exposure, says Miller, “we do not expect BB&T to reach normalized earnings until 2012 at the earliest.” He has a market-perform rating on the stock, believing the bank will earn 90 cents a share this year.

Other analysts take comfort from BB&T’s track record, though. “They have their share of CRE, but management has a history of underwriting prowess,” says Robert Stoll, lead analyst on BB&T for Institutional Capital. “They didn’t stretch for growth outside of their footprint and didn’t get into products they didn’t understand. And they haven’t made a lot of strategic shifts during the last couple years.”

That formula has served BB&T well. And King is convinced the bank can continue to grow while maintaining a conservative credit culture. “We’re trying to build long-term shareholder value, not to optimize short-term results,” he says. “We don’t want shareholders who aren’t consistent with that vision.”

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