Some healthy credit unions have called on Sandler O'Neill todiscuss the opportunity to add scale through merging with atroubled CU. While this might make sense intuitively, we'veactually seen many credit unions grow increasingly reticent tomerge, given the true asset quality of the would-be mergerpartners. We hope the caution spreads to all potential buyersbecause there may be nothing more distracting and debilitating thana bad merger.

The healthy merger transactions we've been advising on have beenon the bank side.

With credit unions, we continue to see the same obstacles thathave always held back healthy mergers or mergers of equals,particularly the lack of accountability that gives some boardscover to reject otherwise good (for the members) combinations. CEOswho thought that the Great Recession would make healthy mergerseasier have told me that little has changed.

Clearly, mergers should be part of most financial institution'sstrategic plan, and here are some thoughts as the planning seasonbegins amid so much turmoil and uncertainty.

Since the 1980s, the roster of banks and credit unions hasdeclined, from 32,000 to 16,000, as the consumer determined themost efficient lenders and simultaneously put 58% of U.S. depositsin the top 50 bank holding companies, according to FDIC and NCUAstatistics.

The Great Recession further exposes the weaker players and willlikely lead to an accelerated pace of consolidation.

Further, the imbalance of supply and demand (too many lenders),leaves the math of the consumer lending business model in extremeduress, if not broken. All lenders have seen their marginsdeteriorate to a level where, if not for fees, many would post flatto negative earnings. Net interest margins at both banks and creditunions are down 20% since 1995.

And now, fee income of all types is vulnerable to reductionthrough legislation.

For credit unions, the math is worse. Without fee income, creditunions would have recorded an ROA at 0 to 10 basis points over thelast four years (banks 30 to 60 bps). If legislative proposals toreduce various fees are enacted, credit union income will becomeeven less competitive. (This is based on NCUA-FDIC statistics forbanks and credit unions with $100 million to $40 billion inassets).

The market is dealing with the oversupply of lenders by drivingmargins tighter, which has led to increased consolidation that weexpect will continue. The consolidation within credit unions ismuch less efficient due to issues regarding accountability, socialconsiderations and field of membership restrictions.

When good mergers happen, customers benefit with improvedconvenience and service offerings as the combination providesincreased branching while the cost saves produce betterefficiencies. The cost saves allow the new financial institution topass along the benefits to the customer. In a commoditizedbusiness, there are other reasons to consider mergers (strategicmergers can add expertise in a product line, such as small businesslending), but most are an opportunity to gain efficiencies throughcost saves and potential for leveraging the brand into morehouseholds. We still don't see many healthy or mergers of equalsoccurring among credit unions.

Mergers involving a troubled financial institution are adifferent consideration. These tend to be higher risk due to agreater number of unknown variables in the troubled FI. If atroubled financial institution is being offered to a healthy one,sufficient capital should be provided by the regulator or thehealthy institution could suffer inordinately. We continue to hearof loan losses two to three times greater than anticipated by theacquirer in troubled CU mergers.

Smart acquirers considering mergers have been well served inthis environment to remember, “When in doubt, do without.”

What's more, the daunting task of the sheer volume of troubledcredit unions creates a manpower issue for the regulator, leavingthe troubled CU on life support for an extended period of time. Theunintended consequence of a wounded financial institution onextended life support is that the resolution becomes more expensiveto the acquirer. In the case of forbearance, perhaps only aftermonths of deterioration does the institution get shopped.

The troubled merger too often adds less scale than previouslythought once the true level of bad assets is eventually known.

The real damage for troubled mergers comes with the resultingimpact on capital. The acquiring credit union sees its capitalratio decline significantly and strategic plans become vulnerableto severe restrictions. You can see examples of this in themovement today. Finally, one must consider the distraction to staffand potential impact on morale brought on by a bad merger.

For healthy financial institutions, there is a silver lining tothe financial crisis, and it's called opportunity. Healthy FIs willuse their capital (or raise secondary capital) to make acquisitionsat historically low levels. They are also in a position to exploitopportunities created by the consumer's sudden appetite for safeinvestments such as government-insured deposits.

In the Northwest, both credit unions and banks enjoyed a boom indeposit growth after WaMu collapsed. Today, Citibank isreorganizing its strategy and selling branches all across theU.S.

This trend will continue for the next two or three years,bringing with it
an opportunity for substantial growth for healthy, well-capitalizedfinancial institutions.

Peter F. Duffy is associate director with Sandler O'Neill &Partners LP. He can be reached at 212-466-7871 [email protected]