Long Term M&A Cycle Creates Opportunity In Banking Industry..

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White Paper

Update

Long-term M&A Cycle Creates Opportunity

in Banking Industry

2011 in Review

February 9, 2012

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Table of Contents Executive Summary 3

Value Proposition Similar to Early 1990s 4

2011 Transactions in Review 5

Buyer Post-Transaction Price Performance 6

Bank & Thrift Deal Valuation Trends 7

Recent Transaction Highlights 8-10

Sector Performance Review 11

Industry Fundamentals 12

Review of Merger Trends: 1990 to 2011 and Beyond 13

Recent M&A Quotes from Industry Participants 14

Board Perspective and Consolidation Drivers 15

Why Banks Want/Need to Merger — 2011 in Review 15-16

Impediments to M&A 16-17

The Banking Landscape 18

Summary of Potential Market Opportunity 19

Update on FDIC-Assisted Acquisitions 20

About FJ Capital Management 21

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Executive Summary In this second annual white paper on bank M&A, we update our thesis on the emerging

M&A boom in the U.S. small cap bank sector. We examine the current banking environment and opine on pricing and other trends that should lead to an unprecedented level of bank transactions during the next several years. In establishing this view, we examine the factors that should create the need and opportunity as well as present the challenges that have slowed substantial consolidation activity.

Conditions highlighted in last year’s paper remain intact, with many recent acquisitions

driving very attractive shareholder returns. While U.S. banking fundamentals remain challenged, albeit improving, and the coming M&A boom cannot be timed precisely, history shows stock performance often front-runs such major trends as well as actual economic recovery. Given the extremely compelling potential returns offered by heavily discounted bank valuations, the time to invest is likely sooner rather than later.

The 159 bank M&A transactions in 2011 had an average one-day premium of 69% over the

prior day closing price. While transaction volume moderated compared to 175 transactions in 2010, outsized market premiums remain about the same. Still, beyond industry publications and local media, small bank M&A continues to draw little attention.

The U.S. economy continues to grow below trend following the great recession. Our thesis

takes into account a slow and uneven recovery, regulatory changes and a more realistic view of long-term banking conditions. We believe that as these factors sink in, M&A will pick up steam and produce a record number of transactions.

Challenges to our thesis also remain in place. With overall equity prices of buyers still

relatively undervalued and sellers expectations still lofty, the clearing price for record M&A has not presented itself. Furthermore, the government’s delay in writing the new regulations has caused banks to retrench and wait for clarity on the rules of engagement in this changing regulatory world. Finally, the accounting for transactions creates challenges for buyers and sellers to get on the same page with respect to potential credit marks. These realities have caused a more cautious stance and thus a slowdown in consolidation activity.

The irony is that the same challenges recounted above, eventually will lead to a pick up in

M&A activity. Smart executives and boards of community banks that lack the scale to handle these exogenous factors will grow more weary of the tough operating and regulatory environment and depressed equity valuations.

As managers execute their 2012 budgets, they see headwinds regarding both revenue and

expenses. Revenues are lower due to the interest rate environment (a result of Operation Twist and lower asset yields) and weak loan demand (as the economy grows below trend). Additionally, the prospects of new assaults from regulatory changes (Durbin and CFPB) create pressure to grow the top line. On the expense side of the equation, companies will incur significant costs in putting the necessary infrastructure in place to handle the roughly 400 regulations that have yet to be written.

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It is a buyers market, yet sellers benefit — we will look at how banks capitalize on this trend. Banks that produced solid returns throughout the downturn, armed with strong balance sheets bolstered by excess capital have opportunities to grow their franchises at historically low multiples. Prudent managers and bank boards that choose to partner with stronger and larger institutions are receiving currency that looks attractively valued and poised to recover as the economy stabilizes.

Value Proposition Similar to Early 1990s

If the past is prologue, prudently investing in the space before the M&A boom takes full force

and the credit cycle has fully normalized likely will lead to outsized returns. We refer to the early 1990s when bank equity valuations recovered well before credit deterioration reached its peak (see below chart). While banks surely have more losses to take, the worst appears to be behind them; and investors must consider that these losses already may be baked into bank equities, which are trading at historically depressed levels.

A focus on healthy, smaller banks with strong balance sheets, marked by excess capital and

solid credit quality, can produce outsized, risk-adjusted investment returns over a multi-year period. Current bank equity valuations aside, these institutions are NOT all equal. In fact, the fundamentally strong banks view this environment as a generational opportunity to strengthen their franchises by taking market share from weaker players.

Sources: SNL Financial LC & FJ Capital Research

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Valuation (P/TBV) vs. Credit Quality (NPAs) Over Time

P/TBV NPAs/Assets

Similar to early 1990’s, P/TBV is poised to rise as

NPAs/Assets fall

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Transactions in Review

In FJ Capital’s inaugural 2010 white paper, we highlighted our outlook for bank M&A. The theme of the paper was that a boom in M&A would drive the community and regional bank sector in the coming years. Our view was and continues to be that the next M&A cycle will rival the last major U.S. bank consolidation wave in the mid 1990s. While the past 12 months have seen a year-over-year decrease in the number of transactions, deal value increased during this time. There were 159 transactions in 2011, with an aggregate deal value of $16.9 billion vs. 175 transactions worth $12.2 billion in 2010. The long-term trend of industry consolidation continues intact as the United States has 3% less banks today than it did in 2010. We expect activity to increase modestly thorough 2012 and pick up steam in the 2013 to 2015 timeframe as the conditions highlighted in this paper come to fruition.

One day market premiums (below) continue to support our thesis that the equity markets are not accurately reflecting the franchise value of many community banks. In fact, the median community bank with below $250 million in market cap currently trades at just 70% of tangible book value. While sellers must adjust their valuation expectations, with peak pricing likely behind us, we continue to see opportunities to earn 25%+ IRRs over the next 3-5 years by investing in select companies.

Sources: SNL Financial LC & FJ Capital Research Data as of December 31, 2011

Recent M&A Activity Summarized by Year Period Number of Deals Aggregate Deal Value ($M) Avg. Deal Size ($M) Average P/TBV (%) Market Premium (%) 2011 159 16,941 182 108 68.5 2010 175 12,172 112 117 70.6 2009 119 1,328 20 114 64.9 2008 143 35,606 304 170 64.9

Rank Buyer Name/ Target Name Target State

Target Ticker

Announcement Date (m/d/yyyy)

Deal Value ($M)

Price/ Tangible Book (%)

1 Day Premium

(%)

AVERAGES 137.8 127.5 68.5

MEDIANS 37.6 125.0 51.1

1 Beneficial Mutual Bancorp, Inc. (MHC)/ SE Financial Corp. PA SEFL 12/5/2011 32.2 110.5 249.4

2 S&T Bancorp, Inc./ Mainline Bancorp, Inc. PA MNPA 9/14/2011 21.4 125.9 191.4

3 SCBT Financial Corporation/ Peoples Bancorporation, Inc. SC PBCE 12/19/2011 41.4 61.4 164.4

4 Opus Bank/ RMG Capital Corporation CA RMGC 6/6/2011 49.2 130.6 147.1

5 F.N.B. Corporation/ Parkvale Financial Corporation PA PVSA 6/15/2011 130.7 197.6 106.7

6 ESSA Bancorp, Inc./ First Star Bancorp, Inc. PA FSSB 12/21/2011 24.7 49.3 90.2

7 Sandy Spring Bancorp, Inc./ CommerceFirst Bancorp, Inc. MD CMFB 12/20/2011 25.4 106.7 79.7

8 AltaPacific Bancorp/ Stellar Business Bank CA SLRB 9/14/2011 17.4 98.8 72.7

9 Grandpoint Capital, Inc./ Orange Community Bancorp CA OCBN 3/10/2011 32.1 134.6 67.1

10 NBT Bancorp Inc./ Hampshire First Bank NH HFBN 11/16/2011 45.2 144.0 65.9

11 Brookline Bancorp, Inc./ Bancorp Rhode Island, Inc. RI BARI 4/19/2011 233.7 193.3 57.1

12 First PacTrust Bancorp, Inc./ Beach Business Bank CA BBBC 8/30/2011 37.1 119.1 53.8

13 Embarcadero Bank/ Coronado First Bank CA CDFB 3/22/2011 9.3 99.7 48.4

14 Susquehanna Bancshares, Inc./ Tower Bancorp, Inc. PA TOBC 6/20/2011 342.1 149.3 40.6

15 Berkshire Hills Bancorp, Inc./ Connecticut Bank and Trust Compa CT CTBC 10/25/2011 30.0 143.2 33.0

16 People's United Financial, Inc./ Danvers Bancorp, Inc. MA DNBK 1/20/2011 488.9 184.1 32.9

17 Comerica Incorporated/ Sterling Bancshares, Inc. TX SBIB 1/16/2011 1028.9 229.7 29.8

18 Valley National Bancorp/ State Bancorp, Inc. NY STBC 4/28/2011 266.9 188.2 25.7

19 Home Bancorp, Inc./ GS Financial Corp. LA GSLA 3/30/2011 26.4 95.4 21.7

20 Park Sterling Corporation/ Community Capital Corporation SC CPBK 3/30/2011 32.3 69.7 21.2

21 Kentucky First Federal Bancorp (MHC)/ CKF Bancorp, Inc. KY CKFB 11/3/2011 10.5 80.8 16.4

22 California United Bank/ Premier Commercial Bancorp CA PCBP 12/8/2011 38.1 91.6 15.9

23 Susquehanna Bancshares, Inc./ Abington Bancorp, Inc. PA ABBC 1/26/2011 273.8 124.1 13.8

24 BankUnited, Inc./ Herald National Bank NY HNB 6/2/2011 70.0 132.0 0.1

Excludes FDIC-Assisted Transactions1/1/2011 Through 12/31/2011

Public Whole Banks & Thrifts M&A Transactions

Sources: SNL Financial LC & FJ Capital Research Data as of December 31, 2011

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Overall, buyer stock price performance has been positive following the announcement of a transaction to purchase a target bank. This trend is illustrated in the below table.

While this table highlights post-transaction announcement performance for all acquisitive banks, the stock performance of the successful acquirers is muted by the stock performance of the less successful acquirers. The result of an industry with so many banks and so many deals is that a certain number of acquisitive banks have actually become quite successful acquirers and have turned it into a business in its own right. These institutions have seen much better stock performance than what is shown above, and represent another way to invest in banking consolidation.

Sources: SNL Financial LC & FJ Capital Research Data as of January 5, 2012

Median Buyer Price Performance Post‐Transaction Announcement

Year 1 Month (%) 3 Months (%) 6 Months (%) 1 Year (%)

1990 0.0% 0.0% ‐0.5% ‐4.5%

1991 0.4% 8.5% 18.4% 30.3%

1992 2.7% 6.5% 5.3% 19.2%

1993 0.4% ‐0.3% ‐0.5% ‐1.2%

1994 0.0% 1.2% 1.8% 9.5%

1995 1.5% 6.5% 9.8% 20.9%

1996 1.4% 7.6% 15.6% 40.8%

1997 3.9% 9.5% 20.0% 25.2%

1998 0.2% 0.0% ‐4.0% ‐9.5%

1999 ‐2.0% ‐5.2% ‐12.2% ‐18.3%

2000 2.2% 4.9% 7.5% 19.4%

2001 2.8% 2.8% 12.9% 11.9%

2002 ‐1.0% 1.4% 0.0% 15.6%

2003 1.6% 5.2% 10.4% 17.5%

2004 1.3% 1.6% 0.3% 5.9%

2005 ‐0.3% 0.6% 2.9% 4.8%

2006 0.3% 0.7% 0.0% ‐4.0%

2007 ‐1.3% ‐5.5% ‐8.2% ‐21.7%

2008 0.0% ‐5.3% ‐16.7% ‐24.0%

2009 ‐1.1% ‐1.2% 0.9% 0.6%

2010 0.8% 3.4% 3.6% ‐1.8%

2011 ‐0.1% ‐5.3% ‐9.3% NA

Grand Medians 0.7% 1.7% 2.7% 6.0%

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The next chart highlights M&A pricing trends and offers some key takeaways. During recessionary periods, transaction pricing averaged 125% to 150% of tangible book

value. The peak level of 264% of tangible book value was reached in 1998 due to a debt-enhanced

economy that is unlikely to repeat in the foreseeable future. Contrary to expectations, transactions are getting done, albeit at lower pricing of 125% to

150% of adjusted tangible book. Since 2009, over 450 deals have been announced.

In 2010, failed bank or FDIC-assisted transactions created a slowdown in whole bank acquisitions, a trend that began to reverse in 2011. The open-bank consolidation trend should continue as banks better understand the value of their balance sheets. We will later examine other factors that drive M&A and draw conclusions on the next great consolidation boom. But first, let’s review some of the recent transactions that highlight the compelling opportunity we foresee during the next several years.

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Transactions 203 299 380 470 526 436 443 450 476 334 254 251 212 261 269 270 293 288 143 119 175 159

P/TBV (%) 145 139 151 172 172 178 186 223 264 229 202 187 188 216 224 229 244 230 170 114 117 108

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Bank & Thrift M&A & Deal Valuations (P/TBV)

Early 1990's Banking Crisis

Early2000'sRecession

Housing crash, creditcrisis and recession (2007 to Present)


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Recent Transaction Highlights

Buyer: F.N.B. Corporation (FNB)Seller: Parkvale Financial Corporation (PVSA)

Announcement: June 15, 2011

Deal Value: $130 million Valuation: 198% of TBV

1-Day Market Premium: NM 1-Month Market Premium: 120.8%

Seller ROA: 0.4% Seller ROE: 6.6%

Buyer Expectations:

TBV Accretion: Flattish without equity raise and 5.7% accretive with equity raiseEarnings Accretion: 6% in year 1TBV Earn Back Period: N/A

Transaction Rationale:

In-market consolidation to strengthen FNB’s status in Pittsburgh, PA market, where MSA market rank increases from #7 to #3. Parkvale had security issues that detracted from a valuable Pittsburgh franchise. FNB capitialized on the opportunity to significantly add to its density in the Pittsburgh MSA.

Buyer: Brookline Bancorp, Inc. (BRKL)Seller: Bancorp Rhode Island, Inc. (BARI)

Announcement: April 19, 2011

Deal Value: $234 million Valuation: 193% of TBV

1-Day Market Premium: 57.1% 1-Month Market Premium: 58.5%


Buyer Expectations:

TBV Dilution: 22% or $1.66 per shareEarnings Accretion: 25% accretive to EPS in 2012TBV Earn Back Period: > 8 years


Out of market expansion to leverage excess capital via acquisition of a target in a less competitive market. Focus on long run EPS growth versus TBV. BRKL paid a full price to gain market share in Rhode Island. BRKL was searching for a catalyst to drive EPS and leverage its excess capital.

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Recent Transaction Highlights (continued)

Buyer: Susquehanna Bancshares, Inc. (SUSQ)Seller: Tower Bancorp, Inc. (TOBC)

Announcement: June 20, 2011

Deal Value: $342 million Valuation: 149.3% of TBV



Buyer Expectations:

TBV Dilution: 8.5% (PF TBV from $7.16 to $6.55 with Abington and Tower)Earnings Accretion: 10% TBV Earn Back Period: ~5 years


In market transaction improves Pennsylvania deposit market share from #12 (PF with Abington) to #5

Buyer: Berkshire Hills Bancorp, Inc. (BHLB)Seller: Connecticut Bank and Trust Company (CTBC)

Announcement: October 25, 2011

Deal Value: 30 million Valuation: 143.2% of TBV

1-Day Market Premium: 33% 1-Month Market Premium: 29.4%


Buyer Expectations:

TBV Dilution: 4% or $0.65 per shareEarnings Accretion: Core EPS accretion of $0.03 in 2012 before net deal costsTBV Earn Back Period: >8 years, per Sandler O’Neill research


Future accretion to benefit from revenue synergies and regional expansion. Demographically accretive, reflecting the comparatively high income and population densities in the Hartford, CT market. CTBC’s TARP to be repaid at/near closing.

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Recent Transaction Highlights (continued)

Buyer: People’s United Financial, Inc. (PBCT)Seller: Danvers Bancorp, Inc. (DNBK)

Announcement: January 20, 2011

Deal Value: $489 million Valuation: 184.1% of TBV

1-Day Market Premium: 33% 1-Month Market Premium: 38%


Buyer Expectations:

TBV Dilution: 6.7% Earnings Accretion: 2012 operating EPS accretion of ~$0.08TBV Earn Back Period: ~7 years


Leverages excess capital and accretive to EPS. Immediately adds scale to existing Boston MSA presence. Pro forma PBCT improves to 7th largest bank in Massachusetts (from #16) and Boston MSA (from #15) and 2nd largest bank in Essex County, MA (from #9).

Buyer: Home Bancorp, Inc. (HBCP)Seller: GS Financial Corp. (GSLA)

Announcement: March 30,2011

Deal Value: 26.4 million Valuation: 95.4% of TBV



Buyer Expectations:

TBV Dilution: MinimalEarnings Accretion: 10% accretive to EPS when cost savings fully phased in by 2012TBV Earn Back Period: N/A. Continued positive TBV growth, even during quarter in which transaction closed.


Expands Louisiana franchise via addition of GSLA’s presence into Orleans and Jefferson Parishes and leverages excess capital with a transaction priced below TBV.

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Sector Performance Review The anemic U.S. economic recovery drove the smaller cap bank index down 4.04% in 2011, while the NASDAQ Bank Index was down 12.4%. In 2010, the banking sector experienced a rebound as the economic picture looked “less bad”. The higher returns were led by the larger cap banks, which advanced 11.4%, while the smaller cap banks were up 5.2%. The relentless negative headlines centered around mortgage abuses coupled with economic headwinds and regulatory pressures caused a major break in large cap bank stocks in 2011. Smaller community banks fared better as their equity prices have not materially advanced since the start of the economic downturn in 2007. The volatility in the sector continued, as most of the declines were registered in August and September of last year, with the NASDAQ Bank index down 19% in the two-month span. Smaller cap bank stocks experienced less volatility than their larger brethren in 2011, outperforming the bigger banks and money centers by more than 20%. We believe this return disparity is justified due to the current steeply discounted multiple of book value for small cap banks stocks and the resurgence of both actual M&A activity as well as projected activity over the next few years. We would also add that the economic conditions of the “survivors” of the past cycle are stronger now than in 2007, as many of the non-performing loans continue to work through the resolution process. For sure, many headwinds exist, including continued weak economic activity characterized by fits and starts, margin pressure as a result of Fed intervention, and a lack of revenue resulting from the below trend U.S. economic environment. As shown in the following chart, since Nov. 30, 2006, the average market multiple has drifted well below tangible book value, with the current median at only 70% of tangible book value. The index that tracks 1,000 public banks and thrifts has traded off nearly 70% during this time.

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IndexP/TBV

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Down3 69%

Historically low valuation and

prices2,

FJ Starts 2/1/2008

Source: SNL Financial LC. 1The historical chart-line reflects a market-weighted index. 2The 12/31/2011 Micro-Cap (excluding MHCs) median valuation of 70% is based on an equal-weighted index. 3Micro-cap banks fell 18% from the 3/23/07 peak through 2/1/2008, then fell 58% more through 11/25/2011 for total fall of 70%.

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Industry Fundamentals The banking industry’s fundamentals have generally improved year-over-year (Y/Y). FDIC data shows that, despite 3.3% Y/Y industry asset growth, loans fell by 0.7%, a testament to an important challenge many banks face in growing earnings. In contrast, deposit growth has been very robust, up 9.9% Y/Y. Given the lack of lending opportunities, more deposits have been invested in securities, typically at lower yields than loans. The confluence of these trends can be seen in declining net interest margins (NIMs) in many recent earnings reports, although the below table, based on data from SNL Financial LC, shows marginal year-over-year improvement at the end of the recent September quarter. A significant aspect of the banking industry is a major bifurcation in the financial condition and performance of banks. In short, not all banks are equal, with many banks performing well or well-enough, and many other banks facing almost insurmountable challenges to manage problem loans, rising expenses and major growth headwinds.

The first two data columns of the above table highlight Y/Y comparisons of industry medians for select metrics. The third and fourth data columns highlight the Y/Y comparisons of the metric averages for the top half (50th to 100th percentile) of the metrics reported by all public banks (i.e., higher performers). The fifth and sixth data columns highlight the Y/Y comparisons of the metric averages for the bottom half (below 50th percentile) of the metrics reported by all public banks (i.e., lower performers). For instance, the top half of the banking industry is much more profitable than the bottom half, as the third quarter 2011 ROAA of the former is 1.03% and the ROAA of the latter is (0.37%). Comparisons made between the two sub-groups’ credit metrics and capital levels also demonstrate significant financial differences. Clearly, many banks are facing industry challenges much more successfully than others. On this front, size matters, and a rule of thumb used by many industry experts is that most banks eventually will need to be $1 billion in assets or greater in order to achieve the scale necessary to operate as an independent entity. Notably, non-interest income growth is currently anemic due in no small part to regulatory pressures against bank fees (i.e., Durban Amendment of Dodd Frank). Meanwhile, non-interest expense cuts can be achieved given the slower growth and improving credit trends, but this is tough for smaller banks that lack the asset base over which to spread rising regulatory costs. Cost cuts are more likely to come via M&A synergies. Looking forward, many banks will have too high a hurdle to clear in finding levers to pull that will achieve acceptable returns. This will drive a good number of these banks to the M&A alter.

Sources: SNL Financial LC & FJ Capital Research

Select Banking Industry Metrics9/30/2010 9/30/2011 9/30/2010 9/30/2011 9/30/2010 9/30/2011

Median Median Percentile: > 50 Percentile: > 50 Percentile: < 50 Percentile: < 50

ROAA (%) 0.48 0.61 0.95 1.03 (0.81) (0.37)

ROAE (%) 4.75 5.69 9.61 10.12 (12.28) (6.93)

Net Interest Margin (%) 3.71 3.75 4.25 4.30 3.19 3.26

TCE/TA (%) 8.57 8.84 11.83 12.06 6.26 6.33

Reserves/ Gross Loans (%) 1.71 1.80 2.72 2.78 1.22 1.28

NPAs/ Assets (%) 2.63 2.79 1.25 1.35 6.06 6.49

NCOs/ Avg Loans (%) 0.54 0.44 0.15 0.11 2.32 1.80

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Review of Merger Trends: 1990 to 2011 and Beyond

As demonstrated below, consolidation is clearly the dominant trend in the bank sector, with the number of banks and thrifts dropping by about half, from almost 16,000 in 1989 to well below 8,000 today. Furthermore, based on the “new normal” operating environment, there could be a similar decline during the next five years. In short, we believe conditions exist for a substantial rebound in M&A that could equal or exceed 1994 peak levels.

The above chart highlights the trends in bank transactions during the last 20 years, and our estimate of what they likely will look like going forward. The last major boom in M&A was the period from 1991 to 1998. After the 1990 to 1991 recession, which was particularly harmful to real estate lenders, there was a spike in consolidation activity as the economy began to show signs of improvement. Moreover, deals exploded to a peak of 526 transactions in 1994. Steady consolidation activity slowed considerably in 2000, however, as bank stock valuations took a back seat to the dot-com bubble and the resulting 2001 to 2003 recession. Thereafter, bank deals began to pick up until the recent financial crisis of 2007, the effects of which continue to plague bank balance sheets even today. The current recession is again centered on real estate and has crippled many companies in the sector.

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Number of U.S. Banks & Thrifts

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 6/30/2011

15,158 14,482 13,853 13,221 12,604 11,971 11,454 10,923 10,464 10,222 9,904 9,614 9,354 9,181 8,976 8,833 8,680 8,534 8,305 8,012 7,657 7,418

2012 2013 2014 2015 2016 2017 2018 2019 2020 Sources: FDIC & FJ Capital Research7,281 6,917 6,571 6,243 6,056 5,874 5,698 5,527 5,361 Data as of June 30, 2011

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Recent M&A Quotes from Industry Participants

A December 2011 article in SNL Financial highlighted the inevitability of bank M&A. “Declines in lending and spreads, coupled with higher capital requirements, will over the next three to four years leave some 3,000 banks — the vast majority of them community banks — unable to generate a sig-nificant return on capital,” said Kamal Mustafa, Chairman of Invictus Consulting Group and a former Citigroup Inc. banker in charge of M&A. Moreover, a “massive wave of consolidation” is inevitable as small community banks pair up or sell to larger players in order to gain the size needed to compete with the big banks and, equally important, to “eliminate destructive competition” among smaller banks, Mustafa said. He added, “It has to happen. There’s been a paradigm shift across the board, and there’s no other way to make it. There are 7,500-plus banks now. In five years, 5,000 would be too many.”

“It’s about scale. It’s about size. It’s about the ability to absorb the increase in operating costs in an environment that is difficult to grow your earnings,” “Revenue growth was becoming a challenge. As we forecast it out over the next couple of years, we feel that it is going to continue to be a challenge while costs are going to continue to increase,” said John Keach Jr., CEO of Indiana Community Ban-corp, which announced its sale to Old National Bancorp on Jan. 24, 2012.

“There’s been a lot more engagement recently from banks, people really starting now to explore their options, starting to have serious discussions” about possible sales, said John Boulware, Managing Director at Community Capital Advisors. “And at some point, things will begin to snowball — M&A activity will beget more M&A activity.”

"There's definitely something in the water," said Lee Bradley, Senior Managing Director at Commu-nity Capital Advisors. "There are more people looking to sell, and more buyers at least showing some interest." In an October SNL Financial article, Bradley said smaller banks — those with roughly $250 million in assets or less — are likely to account for the largest share of sellers, as such compa-nies with smaller bases over which to spread new expenses struggle the most to absorb rising compli-ance costs linked to the Dodd-Frank legislation.

“The ability to reduce costs through consolidation is one of the few tools that bankers have to improve operating results, as the fundamental business drivers will likely stay soft and banks face heightened regulatory compliance costs,” said Tom Tullidge Jr., a Managing Director at Cary Street Partners LCC.

“We think [banking consolidation] will occur in the next 24 to 30 months as a result of earnings pres-sure and the Fed’s flattening of the yield curve...” — Berry, CEO & President, Equity Development

“I know for a fact that a lot of thrifts are thinking hard about changing their charters to become a com-mercial bank…thrifts by regulation had to have 65% of their balance sheet in housing and housing-related assets. If we've learned any lesson it's that those levels of concentration don't make any sense and that the real future of community banking is in diversification. I do think it's on the mind of a lot of thrift executives and a lot of thrift boards — how do they find the right partner and what is the process they need to achieve a more diversified balance sheet.” — C.K. Lee, investment banker and former regulator

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Board Perspective and Consolidation Drivers The big question on the minds of bank management and directors is when is the right time to consider consolidation. Some sellers are pining and holding out for the peak pricing of previous cycles, while others recognize the challenges of the current environment and have decided to look for a partner. We believe peak pricing levels may be behind us as the economy has structural issues that will take an extended period to adjust. First, peak pricing was a result of a “hyper” economy driven by extreme levels of debt and irrational real estate gains. The hangover will last for some time and will be characterized by slower growth and higher-than-desired unemployment. Bear in mind that many banks have just been through one of the toughest recessions in memory and are dealing with the after effects, namely an extended low-rate environment that is pressuring revenue. Additionally, the pendulum of regulatory involvement has swung to the extreme with the final regulatory orders yet to be determined. So in addition to the past five years of economic weakness and financial meltdowns, they are faced with another three to five years of tepid growth, unnatural intervention by the Fed and a fight for well priced and solid credits to add to the loan portfolio.

Why Banks Want/Need to Merge — 2011 Review Generally speaking, the same drivers that existed in the early 1990s exist today. However, there are new important drivers not present in 1994. For starters, there continue to be too many banks competing for the same marginal deposit and loan. Major consolidation factors include: Cost Savings – The typical merger can save 20% to 40% in operating costs, thereby creating significant earnings accretion for the combined entity. Lack of Loan Growth – Due to banking competition and the over saturation of banks, loan growth could be muted in even the best of times. This is especially true in the current economic environment, with large businesses hoarding record levels of cash and small businesses not seeing the end demand needed to make capital investment. In addition, many individuals and households are working to repair damaged balance sheets and de-lever. Lack of Access to Capital Markets – Most small cap firms have limited access to the capital markets. Even if they have access, the punitive pricing commonplace in today’s market means this route may not be an economically viable capital raising option for many smaller banking institutions. Therefore, capital restraints will force banks to partner up. Fairly Illiquid Trading – Most smaller cap banks tend to have fairly illiquid shares. The boards of such institutions will consider this as they deliberate on ways to increase shareholder value. Most institutional investors will not invest in companies they deem illiquid, tending to shy away from market caps under $500 million. This excludes most of the public banks and thrifts from receiving direct investments by institutional investors.

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Management/Board Fatigue – Sophisticated management and boards understand that a bank must have a valid business plan in place, one that includes either organic growth or growth via acquisition. We suspect many leaders find it difficult to execute their original business plans in the current economic environment. This recession has been particularly tough on banks focused on real estate lending. Therefore, we believe many banking leaders currently are weighing their M&A options. Regulatory Reform – One recent factor is the Dodd-Frank legislation. The potential for change is yet to be fully processed by management teams and boards. It is clear the regulation will greatly increase operating costs and will reduce shareholder returns. In fact, new capital standards alone will make it much harder for companies to earn an acceptable return on equity to justify independence. Additionally, uncertainty surrounds the implementation of the new reform and the potential impact on generating acceptable returns.

Impediments to M&A Evolving Accounting Standards – The accounting for bank M&A has evolved from the favorable pooling of interest method (prior to 2001) to purchase accounting with new pronouncements, such as SFAS 141R, and other bulletins along the way. Pooling was favorable as it allowed the combination of assets and liabilities and did not create material goodwill. Under the current scheme, all transactions are now completed under purchase accounting. To complicate matters (or increase transparency, depending on your view) FASB introduced SFAS 141R along with several bulletins that, among other things, restrict transferring reserves over to the acquirer. These accounting rules, coupled with the credit marks assumed by the buyers, create issues for both buyers and sellers. The higher the credit mark (more conservative) the greater the goodwill, thus reducing the potential price a buyer can/will pay. We suspect the accounting treatment and the credit marks have had the effect of slowing consolidation. As the economy improves and loan books are more easily valued, the credit marks should moderate, paving the way for lower goodwill charges and higher multiples.

Regulatory and Legal Uncertainty - The process of approving transactions has appeared to slow somewhat as the agencies consolidate their base and turn their attention to writing new rules mandated by Dodd-Frank legislation. For companies with thin capital bases or credit quality issues, winning the approval of regulators will be more challenging than in the past. It is not to say that regulators have failed to look at these variables in the past, but rather more attention is given today as capital rules are yet to be written. On the legal front, it seems every transaction has some type of legal/investigation attached to it. While most of these suits are not grounded in strong logic, nonetheless it is one more consideration to pulling the trigger on an M&A transaction. Bank Stock Valuations – Arguably one of the most important factors in bank M&A is pricing. One of the factors that limit the potential valuation a buyer can pay is its own currency. Bank stocks have been under considerable pressure over the last several years, reacting both to the financial crisis and the ensuing great recession, events that historically have been especially hard on bank stock valuations. For the most part, valuations have not recovered – since the start

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of the economic downturn, the SNL Bank and Thrift index is down 62.3%, while the smaller banks are down 60%. The largest banks in the country, with market caps greater than $10 billion, are down 81% from their peak. In addition, the industry median price-to-book value has declined from approximately 174% at the end of 2006 to 75% at present. Conversely, sellers may be holding out for better times when they could fetch 2.5 to 3 times book value. You can see with the value destruction caused in the market that seller expectations are too high. The bid/ask spread needs to adjust as equities have adjusted over the last several years. Establishing the Right Credit Mark – The wide bid/ask spread between buyers and sellers is in part driven by what the credit mark should be. While sellers have put aside reserves (which now cannot be transferred under FASB 141r), buyers take a fresh look and re-mark the portfolio based on their own set of assumptions. Buyers will take a conservative approach to make sure they identified all the impairments and mark them accordingly. Sellers either believe their marks are appropriate for the risk or they are in denial about the real mark to mark value of their loan books. We believe the answer falls somewhere in the middle. Nonetheless, this is a major impediment when delivering a price that the seller can accept. Social Issues – The social issues are an important consideration when discussing potential mergers and acquisitions. The phrase most often used in this sector is “banks are sold not bought,” which refers to the fact that boards and managements make the decision to sell rather than reacting to either a hostile situation or overtures from other banks. That is not to say that good bank managers are not talking all the time to potential sellers, rather that the ultimate decision to pull the trigger resides with the board and/or management. It is difficult to handicap this, as many management teams are entrenched and happy to have a job even as their institutions are producing an insufficient ROE for shareholders. In fact, there are many undercapitalized and underperforming banks that clearly are not acting in the best interests of their shareholders. Most bank board members are successful business people in their own rights, yet are often guided by managers that are not always aligned with shareholders. We strongly suspect that as more bank boards realize that the industry will not move back to peak profitability or peak pricing, more will decide to find a partner.

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The Banking Landscape

The above chart illustrates the landscape of private and public U.S. banking institutions. A review of the opportunity set shows that the majority of banks are small community banks with assets of less than $500 million. Of that, roughly 1,100 are publicly traded companies with market caps below $250 million, and a combined $85 billion capitalization (table on p. 19).

# of Institutions Assets ($ Billions) Total Industry Banks & Thrifts 7,040 100% 18,460 100% Private 5,799 82% 2,512 14% Public 1,241 18% 15,948 86%

# of Institutions Assets ($ Billions) Public Banks & Thrifts 1,241 100% 15,948 100% Public Banks 992 80% 15,317 96% Public Thrifts 249 20% 632 4%

# of Institutions Assets ($ Billions) Public Thrifts 249 100% 632 100% Fully Public 196 79% 593 94% MHCs 53 21% 39 6%


5,714

646400

76 154

0

2,000

4,000

6,000

$0 to $500 Mil $500 Mil to $1 Bil $1 Bil to $3 Bil $3 Bil to 5 Bil $5+ Bil

U.S. Banking System CompositionNumber of Banks by Asset Size


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As noted below, nearly 764 companies are trading at less than book value, reflecting investor appetite for liquidity coupled with the current economic environment and company-specific issues. As previously stated, new capital requirements and banks’ lack of access to the public markets, will contribute significantly to the increase in consolidation. As the below chart shows, 413 companies or 54% of the public banks trading below tangible book value, are experiencing substandard capital levels and/or elevated asset quality issues.

Summary of Potential Market Opportunity SNL Micro-Cap Bank & Thrift Index

993 Companies with:

--A Median Market Cap of $ 20.6 Million

--An Average Market Cap of $ 39.3 Million

--For a Total Index Market Cap of $ 39.0 Billion

SNL Small-Cap Bank & Thrift Index

98 Companies with:




SNL Micro-Cap and Small Cap Bank & Thrift Indices

1,091 Companies with:




Sources: SNL Financial LC & FJ Capital Research Data as of February 3, 2012

Public Banks 1,180 100.0%

P/TBV >= 100% as of close on 2/3/2012 352 29.8%

P/TBV < 100% as of close on 2/3/2012 764 64.7%

P/TBV is not available or not meaningful 64 5.4%

P/TBV < 100% 764 100.0%

TCE > 6% AND NPAs/Assets < or = 4% 472 61.8%

TCE > 6% 990 129.6%

NPAs <= 4% 747 97.8%

TCE < 6% AND NPAs/Assets > or = 4% 122 16.0%

TCE < 6% 179 23.4%

NPAs >= 4% 413 54.1%

No TCE data available 11 1.4%

No NPA data available 20 2.6%

Public Banks: Current Valuation and Credit Summary

Sources: SNL Financial LC & FJ Capital Research Data as of February 3, 2012

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Update on FDIC-Assisted Transactions The financial crisis of late 2007 sparked a resurgence in bank failures. As shown below, the real estate bust led to an unprecedented number of failures in the early 1990s. The trough phase of the most recent cycle has seen some very large institutions fail, yet the absolute number of failures remains well below the peak created in the prior real estate crash. Companies with strong balance sheets have taken advantage of this cycle to prudently grow their franchises. Often, multiple bidders try to grow their franchises with the help of government stop-loss guarantees. The below chart shows that while the U.S. economic recovery still has a long way to go, the pace of FDIC-assisted transactions has slowed, coupled with much more competitive pricing.

In the second half of 2010, Sheila Bair, former head of the FDIC, highlighted that there were 829 banks on the FDIC’s “Problem List” at June 30, 2010. She also declared the market near a peak in failures and said that this cycle will produce far less bank failures than the mid 1990s cycle. At September 30, 2011, the number of problem banks was 844, down 5% from the recent high of 888 banks at March 31, 2011. Based on FJ Capital’s research and SNL Financial LC data, we count 415 banks with Texas ratios [nonperforming assets/(tangible common equity + loan loss reserves)] greater than 100 percent, a typical sign of potential failure. The five states with the highest numbers of banks with Texas ratios above 100% are: Georgia (63 banks), Florida (43 banks), Illinois (42 banks), Minnesota (29 banks) and Missouri (23 banks).

555

485

279

118

194

229 2 3 8 8 5 7 3 3 0 0 3

25

115

147

90

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

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2004

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2006

2007

2008

2009

2010

2011

Number of FDIC Assisted Deals (1990-2011)


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About FJ Capital Management, LLC This paper was written by FJ Capital Management Co-Founder, Managing Member and CIO, Martin Friedman, and FJ Capital Management Managing Director, Scott Cottrell, who have a combined 35-plus years of capital markets experience, much of this time spent following and analyzing small- and mid- capitalization financial institutions. A special thanks goes out to Mutian Yang, who helped significantly in data collection and presentation. Prior to founding FJ Capital in 2007, Mr. Friedman served nine years as director of research at Friedman, Billings, Ramsey Group, a major financial services firm publicly traded on the New York Stock Exchange, where he built the 13th largest U.S. sell side research organization, with 140 professionals encompassing eight industry sectors. Previously, Mr. Friedman was a senior research analyst focused on the financial services industry covering small- and mid- cap banks and thrifts. Mr. Friedman has been analyzing and investing in this sector for over 20 years. Mr. Friedman currently serves on the board of Access National Bank (ANCX), an $800 million asset community bank headquartered in Reston, VA. Prior to joining FJ Capital, Mr. Cottrell served as a research analyst at FBR covering small- and mid- cap banks and thrifts. Mr. Cottrell has approximately 15 years of banking industry experience for firms that include Wells Fargo, National City Bank and Servus Financial Corp. He is a CPA and earned his MBA from Georgetown University. FJ Capital Management is a fundamentally driven investment management firm founded in 2007 that analyzes and invests in publicly traded U.S. community and regional banks through alternative strategies. The firm utilizes proprietary fundamental research to uncover value disparities in the small- and mid-cap bank sector and seeks to take advantage of these disparities by building core positions with longer term holding periods. The firm also seeks to generate attractive, risk-adjusted investment returns by uncovering opportunities with identifiable, near-term catalysts. For more on FJ Capital or to further explore opportunities in the bank sector, please visit www.fjcapital.com or contact: Andrew Jose FJ Capital Management O: 703.875.8378 1313 Dolley Madison Blvd., M: 703.408.0394 Suite 306 [email protected] McLean, VA 22101 www.fjcapital.com Important Disclosures: This White Paper is provided for informational purposes only, does not constitute investment advice and should not be relied upon as such. It is neither an advertisement for investment advisory services nor an offer to sell or solicitation of an offer to buy securities. The information presented in this White Paper has been developed internally and/or obtained from resources believed to be reliable; however, FJ Capital Management does not guarantee the accuracy, adequacy or completeness of such information. References to securities or asset classes do not constitute recommendations to purchase or sell any specific securities or asset classes.

Long Term M&A Cycle Creates Opportunity In Banking Industry..

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