Sterling turns the corner after cease-and-desist order

A new Sterling Financial Corp. management team did not know what would be expected of them in October 2009.

Federal and state regulators had forced the board of directors to remove their predecessors. Atop a long list of other stipulations contained in a cease-and-desist order was a requirement Sterling raise $300 million.

And they had two months to do it.

Thursday, 10 months and $730 million later, Sterling completed what may be the most ambitious recapitalization plan ever executed by a Northwest bank, and one possibly among the most complex undertaken by any U.S. bank picking up the pieces of blasted balance sheets.

Players included the U.S. Treasury, individual investors from as far away as South Korea, East Coast private equity managers, and multiple regulatory agencies. Among the shifting elements in play were Treasury’s $303 million investment, obscure securities known as TruPS, and a $325 million tax loss that first becomes a Sterling asset constituting 35 percent of its new capital base, then an offset against future profits.

“I don’t know that we fully appreciated the journey we were about to embark on,” Chief Executive Officer Greg Seibly said last week in the company’s downtown Spokane headquarters.

He and Chief Operating Officer Ezra Eckhardt knew regulators were questioning the deteriorating quality of some Sterling assets, Seibly said.

For example, Sterling was carrying $1.8 billion in construction loans on its balance sheet as demand for new homes was evaporating.

Seibly said they were aware regulators wanted the bank to raise additional capital.

In December 2008, Sterling got some help from Treasury, which invested $303 million of Troubled Asset Relief Program funds. Sterling was also preparing a potential public offering of new stock, said Executive Vice President Dan Byrne.

Eckhardt said the bank was already moving toward taking that sale private when the Federal Deposit Insurance Corp. and Washington Department of Financial Institutions issued a cease-and-desist order imposing the management change.

Find out what regulators want

Seibly said the team’s first order of business was to find out exactly what the regulators wanted. Out of those discussions came four priorities: maintain liquidity, improve asset quality, make a best effort to raise capital, and assure regulators Sterling had a real probability of success.

With the regulatory ground rules set, Seibly, Eckhardt and Byrne headed for investor meetings in New York, then Boston, Los Angeles, San Francisco and Seattle.

Sterling also hired a team of legal and financial advisers that included Witherspoon Kelly of Spokane, as well as Barclays Capital, Sandler O’Neill, and other national and international firms.

Although regulators wanted $300 million in capital, Seibly said executives early on determined it might take as much as $800 million to make Sterling well. Still, investors nibbled at a potential deal.

“We had serious interest from at least two handfuls of people,” Eckhardt said, but nobody knew when the recession would end, or what path the push for regulatory reform might take. There were questions about the quality of Sterling assets, and the state of banking in the Northwest in general.

“There were some parallels being drawn with Florida and Georgia,” where regulators were already closing bank after bank, Eckhardt said.

Even Greece’s financial problems affected investor psychology, Seibly noted.

Nevertheless, he said, interested investors started showing up in Spokane in January, and those visits continued into June, when the recapitalization’s framework was all but done.

Recruitment of Wells Fargo exec was key

There was a hiccup in February when Sterling sought unsuccessfully to buy back $238 million in trust-preferred securities, or TruPS. That misfire was unfortunate, Seibly said, but not discouraging.

Sterling was making major strides on other fronts.

In March, Treasury submitted a letter saying it would accept an 80 percent markdown on its stock in order to encourage other investors. Eckhardt said Treasury, which stood to lose every cent, had monitored Sterling for several months in 2009.

When the bank in October reported a huge third-quarter loss of $459 million, he said, the department got in touch.

Sterling also disclosed in March that it had received a nonbinding letter of intent from an undisclosed investor. Thomas H. Lee Partners of Boston stepped out of the shadows a month later with a commitment to invest $134 million.

Byrne said Lee Partners was impressed by the strides Sterling was making internally, and with its five-state footprint.

New York-based Warburg Pincus Private Equity X, L.P. followed Lee into the deal in May.

The two firms, for $139 million each, would split 41 percent ownership of Sterling. When the deal closed Thursday, the investments had increased to $171 million, and 45.2 percent ownership.

Institutional investors, Seibly noted, have long held a significant majority of Sterling stock.

He said recruitment of individual investors was the last step. The final group of 30 committed $388 million, about $100 million of that from international investors, notably South Koreans.

“The way it came together involved multiple parties at multiple times,” he said.

Another key factor, Seibly said, was the recruitment of former Wells Fargo vice chairman Lee Biller to become chairman if the recapitalization effort succeeded. That was reassuring to investors concerned about future Sterling governance, he said.

A June agreement with David DePillo, a specialist in real estate workouts, to join Sterling as chief credit officer was another confidence-builder, Eckhardt added.

Seibly said investors were also encouraged by first- and second-quarter earnings reports that, while still deeply red, suggested the worst for Sterling had passed.

‘That’s huge for Spokane’

As the bank began to get a fence around its loan issues, Eckhardt added, investors also found comfort in the growth of Sterling’s non-brokered deposits, and growing customer base. Winning the coveted J.D. Power and Associates award for customer satisfaction reinforced the sense Sterling was succeeding at ground level, he said.

“All those things gave the regulators the ammunition to not do anything untoward,” Seibly said.

Brad Williamson, director of the state DFI Banking Division, has been among those regulators. Since Jan. 1, 2009, he and his federal partners have closed 11 Washington banks.

Sterling survived because management did a good job getting a handle on its problems, and because of the bank’s unique combination of asset size and footprint, he said.

And while regulators were giving Sterling slack, Williamson added, investors who were trying to knit together franchises on the cheap with FDIC help were realizing how tough assembling a $10 billion bank piecemeal can be.

The federal agency continues to close failing banks, but on much better terms for the government, he said. “The FDIC window is closing.”

Sara Hasan, a banking analyst at McAdams Wright Ragan in Seattle, said time has also provided more certainty Sterling can manage a balance sheet that has shrunk to $9.7 billion in assets from a peak of almost $13 billion.

“Those were some very scary times,” Hasan said. “They were looking at a cliff and nobody knew where the bottom was.

“They persevered. That’s huge for Spokane.”

Sterling employs almost 650 in Spokane, and a total of 2,700 throughout its 178-branch system. Seibly said the J.D. Power award was a testament to the contribution made by everyone, not just a few at the top.

“It took, literally, a village to get this done,” he said, adding that investors sensed more spirit in Sterling people when they were in the bank.

Back on the offense

Eckhardt said putting $730 million into the vaults does not end management’s work.

“We are interested in getting back to running the bank we know we are,” he said, “by building relationships and helping customers while maintaining focus on asset quality.”

“The hidden upside is that this deal is actually worth quite a bit more to everybody involved than it was in October or November,” Eckhardt said. “You have a bank that appears to be on the verge of returning back to a dominant position in the Northwest.”

Seibly said Sterling will play offense after months on defense, keeping in mind the basic blocking and tackling and hundreds of small things that make banks successful.

Looking back, he said the team did its best for all Sterling stakeholders, including longtime shareholders who will own less than 2 percent of the recapitalized company. Shares worth as much as $30 three years ago trade now at 60 cents.

“We’ve tried to effect the best outcome that we can,” he said. “There was no path to follow. The company actually had to forge a path.”