The worst of the credit crisis has passed, but many banks are still living on borrowed time.

So contends Kamal Mustafa, the chairman and chief executive of Invictus Consulting Group in New York, which specializes in stress-testing banks.

Mustafa says some 2,000 banks should be trying to find buyers. The Invictus chief knows a few things about consolidation, having served as the head of global mergers and acquisitions for Citibank, along with the investment banks BlueStone Capital and Wildwood Capital. Unlike many other deal-happy investment bankers, he has become concerned about banks that are acquiring mortgage portfolios, credit cards and specialty assets for the sake of growth.

Below are excerpts — and warnings — from a July 20 conversation with Mustafa.

What trends do you see from stress-testing regional and community banks?

KAMAL MUSTAFA: There are two trends. One is a decline in loan volume. But more disturbing is that the new loans coming on the books have lower spreads, and this creates compression of yield.

So for a bank to effectively be in a position to improve earnings, it ideally needs less competition within their geographical footprint and the ability to increase existing loans within their existing cost structure. This means bank or bank asset acquisitions.

What is your take on the lack of M&A? Where is it headed?

There are about 2,000 banks that are going to limp around with such low or negative returns over the next four years — barring a major miracle — that they don't have a financial reason to exist. Those banks have to be assimilated into the marketplace.

Banks facing bleak prospects need to recognize that capital losses, increasing regulatory capital requirements, and declining [loan] volumes and spreads will inevitably reduce their market value. Those are the banks that should be selling today. The sales would be at discounts to their existing capital but would still be at higher valuations than they are likely to get [in the future].

For buying banks, they need to augment earnings and get their efficiency ratio up. I used to do a lot of acquisitions, and when we bought someone we looked at what particular assets or deposits we wanted to increase and their concentration within the target. Then we looked at how to unwind what we weren't interested in and who would be interested in buying that.

It was efficient because we had enough capital. In those days, growth was the name of the game. Today, no one has enough capital, and people want to grow profitability, not necessarily size. Given the diversity of lending [among] large national and regional banks and community banks, the most logical and efficient acquirers would be stronger community banks operating within the same geographical footprints as the target banks.

How do you feel about banks buying loan portfolios or specialty assets?

This is the one area in which I believe the regulators could be making a mistake. If I buy a portfolio of a bank in trouble, it is not going to sell the best loans. It will sell me the worst loans though it may not be classified as nonperforming. If I buy it, I'm going to discount the heck out of it. Hypothetically, I'd pay $70 for a $100 portfolio. By doing so, I created the appearance of profit and higher yield on the books. At the same time, I have bought a lot of junk and, over time, under stresses, that portfolio is going to start generating losses.

It looks like I made a great deal, but what I haven't done is stress-tested it under heightened capital-adequacy requirements to properly evaluate the discount level and potential future impact on capital requirements.

A lot of banks are buying assets. They're looking bigger and improving their earnings because it's at a discount. Everyone sees the earnings, and the regulators are approving it. But these are still pre-recession loans. You could very well be buying a problem for the future.

Don't most banks conduct heavy due diligence before closing a deal?

When you ask a buyer what kind of thorough due diligence they have done on the portfolio they typically say they brought in a credit review specialist or some third-party real estate analyst.

But all they can do is a static test of problem loans. They're not stress-testing capital-adequacy requirements on a dynamic basis against all loans over time. A proper stress test focuses on the ongoing deterioration of good and bad loans as they slide down the classification tables.

We're going to be in an artificially low interest rate environment and a jobless recovery for a while. Even the banks not required to stress-test are starting to realize they better do it. But they don't realize how to. The regulators are saying this is not a formal exercise; this has got to be a part of their daily living.

The bottom line is if some of these bank management teams really stress-tested themselves they'd see, given the economic and regulatory trends, they will have lower earnings with higher capital requirements translating to low returns on investment. There should be a lot more deals happening today, but people are keeping their fingers crossed with no relief in sight.

Some banks are expanding in mortgages and credit cards due to low pricing and weak demand for commercial loans. Do you have a preference on what type of loans banks should be sticking with?

I'll take C&I over the credit card or mortgage business any day. With C&I, you have an asset that should be more liquid, and you're lending to a corporate entity, so at least you're goosing the local economy.

When you make an individual loan at a time where the economy is in a jobless recovery, you're going in blind, even if it gives you great yields. The good customers are paying off their credit cards on a monthly basis [so there is no yield return]. Weaker customers cannot get long-term debt, so they are living off their credit cards and piling up debt. When rates rise, those customers will face credit compression all over the place. Banks will find that the same ones giving you yield right now could very well be the worst clients to lend to.

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