Some early predictions about banking this year have not materialized, and the past six months have brought new predictions. Margins. As 2004 drew to a close many said margin pressures mould plague the business in the new year. But many asset-sensitive banks predicted significant margin expansion. Of course, banks' balance sheets vary. Banks that have relied on FHLB advances and whose balance sheets resemble those of traditional thrifts' are suffering the most. Their problems are compounded by the heavy carrying cost of the advances and the reliance on rate surfers, who expect and demand best rates at all times without much loyalty. These banks' cost of funds rose faster than those with a better core deposit mix, and this will continue through December. No relief is in sight, short of major balance-sheet restructuring. This means selling the advances at heavy losses to start with a clean slate (as Integra, First Community of New York, and many others have done) and something much more difficult: emphasizing core depositors while moving away from rate surfers. Banks with strong core deposits benefited from the rising rate environment; their margins expanded. They continue to make variable-rate, prime, or Libor-based loans funded partly by interest-free direct deposit accounts and low-cost money market accounts. Banks such as Frost, Sterling, and others, with 35%-plus in interest-free checking balances, are delivering margin expansion and will continue to do so. In short, we have had neither the monolithic improvement nor the deterioration that some predicted. Balance-sheet and customer focus have determined which banks are experiencing margin contraction and which expansion. This trend will continue throughout the year, because change is slow when it comes to balance-sheet and business-mix restructuring. How much is too much real estate? Real estate lending, both commercial and residential, has been growing as a percentage of loans at most banks. Bankers are telling me that real estate is where the business is. But analysts are expressing concerns about the rise of commercial real estate loans in banks' portfolios, and are not accepting the "market demand" defense. Real estate is not all created equal. Residential varies from lowest-risk (stand-alone properties with low loan-to-value ratios) to highest (co-ops and spec multi-unit buildings). The same is true for commercial real estate. Debate still rages on whether owner-occupied buildings are higher- or lower-risk than multipurpose commercial structures. The majority opinion is that owner-occupied is less risky. I concur; even though such buildings are typically single-purpose, the owner has a strong interest in keeping it. Real estate markets are also not all equal. Some are high-risk because of rapid price escalation and low affordability (high ratios of income to home price). Others, while expensive, are more affordable or appreciating more slowly. The growth of commercial real estate lending is, on the whole, not a negative in the balance sheet. It represents secured lending, which by definition is less risky than unsecured. However, when the value of the security is hugely inflated or the loan structure is faulty, with little of the builder's money on the line, the risk can be substantial. My prediction is that real estate lending will continue to grow, since it is easier to deliver, the average loan is larger than in pure commercial lending, and demand is high. So many buyers, so few desirable sellers. Foreign buyers continue to gobble up larger and larger U.S. banks. Fueled by the need for growth and low returns in their local markets, they funnel capital into this country through their subsidiaries and pay up for size, though not necessarily for quality. Bulk matters more than ever before to such buyers, whose hurdle rates and ROE requirements are significantly lower than those of U.S. banks. This trend will continue through 2005 and beyond, with larger subperformers getting the benefit through inflated prices that domestic buyers would not and could not pay. Domestic consolidation will continue at the current relatively slow pace as sellers see prices breaking new records and feel that - regardless of size, location, or performance - they are worthy of them. With the easing off of bank stock prices, fewer domestic acquirers are willing to pay the price. That unwillingness fueled explosive growth in branching two years ago. But because branching has generally failed to deliver (with some notable exceptions), the acquisition market is heating up - not only for aggregators but also for those looking for fill-ins and expansion to higher-growth markets. We will witness a slowdown in branching and an acceleration of acquisitions at all levels later this year and in 2006. Paying more attention to the business mix. The first six months of this year clearly demonstrated the importance of the quality of balance sheets. Carefully considering business lines and their true contribution to the bottom line is particularly important today. Margin compression and other concerns have demonstrated the value of diversification. Analysts and other industry observers have therefore become more sensitive to identifying revenue sources and their vulnerabilities. In addition, more attention is being given to risk-based returns in the wake of Sarbanes-Oxley and the emergence of enterprise risk management. Some banks have dabbled in many lines of business with little net impact on the bottom line. My recommendation is to build on those that make the best use of existing competencies. Select only a few expansion opportunities, since they sap management's energy and require focus and commitment. Overextension is a mistake many make, since they are weary of putting all the eggs on one basket and know that some new initiatives will fail. But start-ups need more time than expected, and small ones will not get the attention they need to flourish. (bu bird)