1st Interstate on Verge of Heady, Risky Texas Foray

The brightly colored cardboard map of Texas was top secret, so the First Interstate Bancorp executive whipped it off his desk and turned it against a wall. But not before a visitor had glimpsed the confidential words, “First Interstate of Texas.”

The shareholders’ votes will not be tallied until Friday and the name has not been revealed yet, but, if all goes according to schedule, Allied Bancshares of Houston will be bought by First Interstate for more than $300 million and will become First Interstate Bank of Texas late this week.

The cardboard map and the new name are part of splashy campaign planned by First Interstate in Los Angeles to herald its plunge into the treacherous waters of Texas banking.

The nation’s ninth-largest bank holding company, which already owns banks in 12 Western states, is a few days away from concluding the biggest, and perhaps most daring, acquisition in its history.

Allied, which will increase First Interstate’s assets by almost 20%, is the $8-billion parent of 50 Texas banks concentrated in the Houston area, where the company has its headquarters in a gleaming 71-story building.

But the shine on the Allied building does not reflect the battered nature of banking in Texas, where the sharp drop in energy prices and the collapse of real estate values have left commercial banks and thrifts with crippling loan losses.

The bad times set the stage for First Interstate’s opportunistic move into the Texas market with a deal for Allied that one analyst termed “nearly bulletproof” for First Interstate shareholders.

“There isn’t any such thing as a no-risk deal, certainly not in the state of Texas right now,” said Joseph J. Pinola, First Interstate’s chairman and the force behind its aggressive growth. Besides owning banks in 12 states, the company franchises its name to banks in six other states and the District of Columbia.

First Interstate has tried to minimize the risk for its own shareholders from further deterioration of Allied’s loan portfolio and to provide a means for Allied shareholders to benefit from possible improvements in its earnings.

The shareholders of both companies are now voting by mail on whether to close a deal that was first announced last May. The results--overwhelming approval of the merger is expected--will be disclosed at simultaneous shareholder meetings in Los Angeles and Houston on Friday.

The central elements of the complex deal represent insurance for First Interstate. One part of the deal pegs the eventual price to Allied’s earnings over the next five years and the other isolates $250 million of the Texas banking company’s worst assets into a new bank that will belong to the Allied shareholders.

‘Major’ Presence

Tying the price to performance is part of what makes determining a price for the deal difficult. Since the price was reduced $41 million last month because of continued problems with Allied’s loan portfolio, analysts have estimated that the acquisition will cost First Interstate between $320 million and $380 million.

What First Interstate gets for its money is a major presence in the nation’s third-largest consumer banking market, which fits neatly with Pinola’s expansion strategy. He already operates banks in neighboring New Mexico and Oklahoma, but Texas represents a far bigger opportunity--and a greater risk.

In the 1970s and early ‘80s, Allied was one of the highest-performing banks in the country. The bank stressed commercial loans to small- and medium-sized businesses, which often pay higher interest than major companies. Management was viewed as particularly strong and entrepreneurial, and profit peaked at $122 million in 1985.

Ripples From Crisis

But even as that profit was posted, trouble was in the offing.

The problem was that many of those small- and medium-sized borrowers depended directly or indirectly on the state’s oil economy, which, in 1982, had begun a long descent toward financial disaster as the price of oil dropped.

The ripples from that crisis afflicted the state’s once-booming real estate industry, dragging down values and rents on commercial and residential projects and adding to the woes of the banks.

“You can’t not place any blame upon Allied’s management or the Texas bank management in general,” said Sandra J. Flannigan, a banking analyst in Houston with the investment firm of Paine Webber. “You can make the case that they should have seen the handwriting on the wall and been more prudent. But, on the other hand, we have had economic changes that were unprecedented within the state.”

The state Legislature responded to the plight of Texas’ banking industry by enacting a law in September, 1986, that allowed out-of-state banks to take over Texas institutions. Speculation was widespread that the nation’s big banks would move quickly to snap up Texas institutions. But many were scared off by the uncertainty of the state’s economy.

The first big bank to come in was New York’s Chemical Bank, which announced in December, 1986, that it was acquiring Texas Commerce Bank for about $1.19 billion. It was the largest U.S. banking combination ever.

The deal, which included creating a spinoff bank from Texas Commerce’s worst assets and tying the price to earnings, proved to be a model for the First Interstate-Allied transaction.

About that time, Allied had hired the San Francisco-based investment banking firm of Montgomery Securities to scout merger prospects. The bank posted a loss of $17.6 million in 1986, and management could see that the figures would get worse.

“Remaining independent was an option but not the one we would prefer,” Jay C. Crager, Allied’s chief financial officer, said last week.

At the time, Montgomery Securities was representing First Interstate in its headline-grabbing and ambitious attempt to take over Bank of America. Even before Pinola’s assault on B of A collapsed last February, the investment banking firm had set up preliminary talks between Allied and First Interstate.

As the B of A undertaking demonstrated dramatically to the rest of the financial world, Pinola was set on expansion. He had tasted success in another troubled energy state with the 1986 acquisition of First National Bank of Oklahoma City. The deal that created First Interstate of Oklahoma, with $74 million in government assistance, was starting to show a profit by early 1987.

Allied and First Interstate seem well matched. Texas has traditionally been a weak state for consumer banking; major banks grew fat on profits from the big oil companies and related businesses and never spent the money or developed the expertise to build a strong base of consumer deposits.

First Interstate, on the other hand, is known for its ability in consumer banking and has developed innovative loan and account packages that are used at its affiliates throughout the West. First Interstate’s presence in New Mexico and Oklahoma could provide a handy marketing tool for Allied in attracting consumers by touting convenience.

Further, Allied was one of the few Top 50 banks in the country without any international loans, and its management did not want to join an institution saddled with extensive Latin American loans. First Interstate’s Third World exposure, while substantial, is smaller than that of most other major banks.

On May 21, the deal was announced.

The transaction called for First Interstate to pump about $250 million in new capital into Allied, partly to replace the assets that would be spun off into the new National Asset Bank.

Under the agreement, Allied would place $250 million of its worst loans in the new bank, which would be owned by Allied shareholders. If the assets were eventually sold at a profit in an improving economy, Allied shareholders would benefit.

If the assets went down, the loss would not be passed on to First Interstate. No matter how it works out, Allied would be cleansed of $250 million from the bottom of its asset barrel.

Allied shareholders would also receive two types of new stock issues from First Interstate. The dividends on those shares, however, would be tied directly to the earnings of Allied in the coming years. If Allied fails to show a profit, the shareholders get no dividend for two years on one form of stock and for five years on the other.

In a speech last November, William M. Weiant, an analyst with the New York investment house of First Boston, praised First Interstate’s expansion in general and added: “The proposed acquisition of Allied Bancshares appears nearly bulletproof from a shareholder standpoint.”

Along with providing First Interstate with a hedge against further losses at Allied, the deal offered incentives for Allied’s management and employees to remain and work hard because they own 17% of the Allied stock.

First Interstate officials said last week that retaining Allied’s management was essential to the success of the deal and that the holding company intends to support the existing team.

As further insurance for First Interstate, the banks negotiated new terms last month. Allied had to add $40 million to reserves for potential bad loans to cover the deterioration of its loans, and the price for the bank was reduced by $41 million.

The $40 million was in addition to $30 million that Allied was required to add to reserves in November after being rebuked by federal regulators for understating real estate loan problems.

Last week, Allied reported a loss of $318 million for 1987, which was deepened by the two additions to reserves but remained within the range anticipated in the negotiations.

More important, Allied met two requirements for closing the deal: Its adjusted net worth was slightly above the floor of $300 million, and its allowance for potential bad loans was 33.3% of its total exposure, exceeding the 30% required by First Interstate.

Nearly three-quarters of Allied’s $689.6 million in non-performing loans are real estate loans. But once $250 million of the worst assets are spun off into the new bank, existing reserves will cover nearly 50% of the possible losses remaining--a level considered substantial by banking analysts.

Still, there is no way to eliminate the risks of entering an economy as perilous as that of Texas.

‘Crystal Ball’

Despite repeated projections that the Texas economy has “bottomed out,” analysts said one potential pitfall for First Interstate is further deterioration of business conditions within the state. Another is the possibility that not all of the problems have been spotted in Allied’s loan portfolio.

“I wish our crystal ball were very clear, but history has shown us that it often takes longer for turnarounds than we expect,” Flannigan of Paine Webber said. “1988 will be a very difficult operating environment for Texas financial institutions.”

Whatever the risks, the Allied deal proves that Pinola and his company may have been down, but not out, after losing their bid for Bank of America.