Father-son team builds bond-based business that catapults Iowa bank to the front of the industry

In the early 2000s, Treynor State Bank near Council Bluffs, Iowa was under attack. The bank was pressured to grow or sell as expenses increased and loan growth slowed. But selling was not Mick Guttau's style. A Vietnam War veteran and Cobra helicopter pilot, he had not forgotten his military training of more than 40 years earlier. "When the enemy shoots at you," said the chairman and CEO of the bank, "you turn into their fire." .TS Bank did turn into the fire. Guttau and his son, Josh Guttau, accepted two years without earnings, invested in a new bond-based business and beefed up the bank's traditional operations. Within five years, in the midst of the Great Recession, TS Bank became one of the most profitable banks in the nation; it remains at the head of the industry today..The difficulties of TS Bank in 2002 were not entirely of its own making. Since he bought the bank in 1978, Mick Guttau had grown it to $44 million in assets from $7.5 million. Guttau also had expanded to Macedonia, Iowa, in 2000, which brought the bank its second branch. The Treynor, Iowa-based bank proved so successful at serving the 992 people of Treynor and 247 people of Macedonia that by 2002 the bank served more than 94 percent of the households in its market. With only so many people in its footprint, the bank hit a wall. The bank's assets declined from 2001 to 2002, and Guttau fought to keep earnings positive.."We needed to step back and establish a new direction," Guttau said. "Our bank still ran on traditional concepts of banking. We still had the past mentality that people would come to the bank when they needed something.".While TS Bank complied with regulatory requirements for asset and liability management, Mick Guttau long lamented the bank's lack of strategy on that front. "If I had extra cash at the end of the day, I would pick up the phone and buy an Iowa municipal bond," he said. "And I'd do it without any analysis of the probability and severity of loss, or analysis of the return. It was a necessary evil; I had just enough time to buy the bond as clients waited for me in the lobby.".Then the new direction Mick Guttau sought came in 2003 when Josh Guttau joined the bank as its chief financial officer after earning a master's of business administration degree from Iowa State University; he also had three years of experience as the CFO for First National Bank of Omaha's wealth management group..Josh Guttau, Mick Guttau and the bank's board identified an opportunity in the bank's asset and liability management practices after attending an industry conference in early 2003. Debriefing after the American Bankers Association's National Conference for Community Bankers, an annual event for the bank's entire board, a board member talked about a breakout session he found interesting. "One board member brought up an example of a bank with what we call a 'wholesale banking business,' which means they invest in bonds in addition to making local loans," Mick Guttau said. "I remember Josh and I shot him down. We told him that we are a community bank, and that our business model is to bring in local deposits and make local loans.."But afterwards, the idea of a bond-based business intrigued me," he continued. "I thought it was beyond my ability. Then one day, Josh walks into my office and asks me if I had been thinking about that bank's wholesale strategy. It had been on both our minds, so we decided to have Josh look into it.".Josh Guttau's first step was to contact Tony Fahrenkrog, who was TS Bank's representative at the Federal Home Loan Bank of Des Moines. Fahrenkrog connected him with George Schniedermann, president of Frontier Bank, Rock Rapids, Iowa. "He gave me my first insights into investing in mortgage-backed security bonds and collateralized mortgage obligation bonds," Guttau said..Over the next year Josh Guttau embarked on an education campaign, hiring various asset-and-liability consultants to train him; the Federal Home Loan Bank of Des Moines' spring conference and the Sheshunoff Executive Development/Louisiana State University graduate school of banking were key sources of knowledge. Guttau also connected with bond brokers who specialized in the structure and risk of mortgage-backed securities and collateralized mortgage obligations..As Josh Guttau's knowledge increased, the Guttaus realized the bank's bond portfolio could be a profit center for the bank, just as its loan portfolio was. "We realized how much profit we could generate if we saw loans, municipal bonds, mortgage backed securities and corporate bonds as the same thing. They are all credit; they are all risk and reward," said Josh Guttau, the bank's president, CFO and chief risk officer. "This meant we needed to change our philosophy to create that business. We needed to become label blind when considering loans versus investments.".Label blind lending.With the potential of a wholesale banking business in mind, the Guttaus created a three-year plan in which the bank would go without earnings for 24 months as it built a bond-based business and invested in new branches and expanded staff. The father-son team served the plan to the FDIC and the state regulator in 2005. Mick Guttau and his wife Judy, the bank's board secretary, also raised $2 million in capital notes by pledging their bank stock..While the Guttaus saw regulators as a nuisance at first, the FDIC proved very helpful. Tyler Hosier, a capital markets examiner at the FDIC, was most influential. "He pushed us to put in the hours to develop ALCO policy, procedures and models," Josh Guttau said. "It took our sophistication to the next level.".Josh Guttau agreed with the regulator's high standards for proving the quality of a bond. "After the private mortgage debacle, risk weighting methodologies were suspect. Municipal bonds were predicted to have widespread failure and the insurance companies behind the bonds had received a ratings downgrade. We needed our own system of risk ratings," Guttau said. "We needed to be able to prove to a regulator that we had invested in good bonds.".In order to do so, Josh Guttau concluded he needed to know enough to underwrite municipal bonds himself. So, in 2006, he completed training in municipal bond underwriting from the National Federation of Municipal Analysts. "Interestingly enough, I found that Wall Street bankers, wealth management firms and brokers underwrite credit risk for municipal bonds; it is only community banks that do not underwrite them," he said..Josh Guttau then worked with the bank's risk analytics department to create a credit and risk model in Microsoft Excel for every type of bond the bank would pursue. The department's loan credit analyst built a risk rating model for two types of municipal bonds − revenue municipal bonds and general obligation municipal bonds. Another analyst with a background in corporate finance created a model for corporate bonds and Guttau developed a model for private-label mortgage-backed securities. The bank already had models for ag loans and commercial loans, which Guttau also built himself. These models reduced bonds to their mathematical bones and laid bare their risk and reward. "When we completed the models we could go back and forth between loans and bonds. We could literally put the risk and price of an ag loan or a commercial loan next to that of a corporate bond, a municipal bond and a mortgage-backed security," Guttau said..In particular, the bank's models calculate the way a bond's structure changes the bank's risk and earnings. "For example, most banks invest based on yield," Josh Guttau said. "But yield is not what you get when you buy a bond unless you hold it to maturity, and there is no optionality..We invest based on total return method, which is the bond's income plus the effect of changes in market value. This takes into account options, duration and other aspects of the investment's structure.".TS Bank put this concept to work right away. In 2006, the bank bought inverse leverage collateralized mortgage obligations. The structure of these bonds stipulated that the income of the bond would increase in a declining rate environment. For example, for one bond the bank purchased, if interest rates fell by 1 percent, the rate of the bank's bond would increase by 6 percent. "For a bond with 6 percent as the original rate, the rate jumped to 12 percent when market rates dropped by 1 percent. If rates dropped again, the effect combined," Mick Guttau said. "We made a lot of money off those.".A black swan.It was investments like these CMOs that catapulted TS Bank to the front of the industry in 2009..As rates fell between 2008 and 2009, the structure of these CMOs yielded part of TS Bank's $4 million in net income in 2009. However, the majority of the bank's record earnings came from its opportune investments in private mortgage-backed securities. .During the summer of 2008, Josh Guttau attended a course called the Bond Math University which was provided by a Chicago-based firm called Performance Trust, a firm which also sells bonds. By September 2008, the Guttaus decided to sell half the bank's bond portfolio in order to enter mortgage-backed security bonds.."On Friday, September 12, 2008, I finished the Excel sheet which identified the bonds we would sell in order to enter the private mortgage-backed securities," Josh Guttau said. "Then on Sunday the announcement came out that Lehman Brothers failed. They filed bankruptcy on Sept. 15. We called Performance Trust that day. On the following day, we sold half our bond portfolio and started buying mortgage-backed securities at 50 percent to 70 percent of their market value. If we had not changed our mentality to be label blind, we never would have touched private mortgage-backed securities," Guttau continued..In fact, it was TS Bank's policy not to buy a private mortgage-backed security at the time. The Guttaus called an audible because the price of the securities had shifted so significantly. "When we wrote our ALCO policy, we could only earn an additional 50 basis points on private mortgage-backed securities than we could from government guaranteed mortgage-backed pools. That just wasn't worth it," Josh Guttau explained. "But after the market meltdown our return was 5 percent to 10 percent higher than competing investments.".At the discounted prices, the risk side was equally attractive. "Performance Trust's analytics showed us that the prime and alt-A mortgage-backed securities were very cheap," Josh Guttau said. "So much so that if 75 percent of the underlying loans defaulted and we only collected 50 cents per $1 from the underlying collateral, only then would we lose our first invested dollar. It was a no-brainer. If we lost money, economic conditions would have gotten so severe that the bank was a goner anyway, as it likely would have been the end of the American financial system as we knew it.".The Guttaus expected to grow the bank by $30 million in assets by entering private mortgage-backed securities. Between September 2008 and September 2009 the bank doubled in size to $181 million in assets as management purposely grew funding for this strategy; they also saw a huge influx of local deposits as jittery clients pulled money from underperforming investments. By the end of 2009, the bank had a 33.4 percent return on equity and a 2.52 percent return on assets. These metrics put TS Bank in the top 100 banks in the country for ROA, regardless of asset size or geographic location. During the first six months of 2013, TS Bank earned 1.63 percent return on assets compared to the average of 1.10 percent for Iowa banks..Out of bondage.Today, TS Bank's wholesale banking business makes up about a third of the bank's $263 million in assets. The Guttaus have two reasons for keeping wholesale banking at less than 40 percent of the bank's assets. One reason is regulatory risk. The other is that the Guttaus are true community bankers. From the beginning, their strategy of wholesale banking focused on growing earnings and capital to be used to invest back into the bank's traditional operations..In the bank's climb to $263 million, the bank's growth has primarily come from its wealth management division, new branches and an expanded staff. However, the growth in each sector of the bank has been funded by earnings from the wholesale business. "Forward strategy expenses ran at 35 percent of total expenses at the height of our earnings. We are now pulling those back to between 10 percent and 20 percent to protect core earnings and not outgrow our capital growth rate," Josh Guttau said..In 2006, Josh Guttau described his understanding of economic conditions and bond rates in a newsletter distributed to staff and key prospects. "We succeeded in attracting one of those clients," Guttau said. "He learned of our expertise through the economic forecast. Then one day he walked in with an $8 million check. A week later he called wanting to wire $80 million to the bank. His family is one-fourth of the bank's assets in wealth management.".Today, the Guttaus have grown the bank's wealth management division to $290 million in assets under management. It had $10 million in assets in 2003. The division also brings $26 million of these assets in the form of deposits to the bank. "It is effectively our third-largest branch," Mick Guttau said. "We want to bring it over $1 billion in assets in 10 years.".Since 2003, TS Bank also has more than doubled its branch footprint. The bank opened its first location in Council Bluffs, Iowa, in 2005. It opened two more locations in Council Bluffs in the last year. Josh Guttau was the bank's 20th employee. The bank's staff now numbers 67 full-time employees..The bank's change in philosophy has made all this possible, Mick Guttau said. "If you look at the evolution of commerce, communities have always been built on roadways," said Mick Guttau, sharing the insight of a former board member who is also an economist. "The first communities were built on waterways. As technology progressed, the avenues of commerce became railroads and then highways. Today, the internet is a major avenue of commerce," he said. "We can now use it to attract the flow of capital into our community. We believe a community bank possesses a unique ability to pull outside capital, deposits, and investments into their community through a wholesale banking strategy. The game has changed entirely.".SIDEBAR: Guttau Returns to Vietnam.In July 2013, the Guttau family took Captain Michael "Mick" K. Guttau back to Vietnam for the first time in 42 years. The purpose of the two-week trip was to bring Guttau, this time with three generations of his family, to the exact coordinates where his life could have ended..March 2, 1971 was the day the 24-year-old Captain Guttau found himself in the fight of his life..Guttau was Air Mission Commander in Operation Lam Son 719 and piloted the lead Cobra Attack Helicopter of the mission. Operation Lam Son 719's objective was to disrupt the Ho Chi Mihn Trail; it was the last and greatest battle of the Vietnam War..For years, the trail allowed the North Vietnamese Army to transport goods and troops into South Vietnam under the complete cover of the jungle. This series of paths, roads, petroleum lines, and waterways dispersed across a 30-mile path allowed the NVA to receive supplies while bypassing much of the U.S. military's ground troops..Lam Son 719 launched in early February 1971. U.S. troops met with no opposition and pushed into Laos with ease. This gave the troops a false sense that the North Vietnamese were unprepared for the attack. Nothing could have been further from the truth..Guttau was preparing a key landing zone when the North Vietnamese began to attack. As Guttau maneuvered his chopper over Laos 60 miles from the Vietnam border, enemy gunners zeroed in on his helicopter. Guttau was barraged with rounds of anti-aircraft weaponry but he refused to abandon his mission. Literally turning into the fire, he nose-dived over the landing area to ignite the phosphorous he was using to clear the area. It worked, and he survived the attack..Guttau received the Distinguished Flying Cross for this brave maneuver which put down enemy fire and cleared the way for the operation's objective..The next 60 days proved to be a devastating time for American forces, with significant casualties suffered. Guttau said he sees the grace of God in his survival. When he returned from his mission on March 2, he exited the cockpit to take the routine tour around the aircraft with his mechanic to identify damage to the aircraft. Although he was at the heart of the most intense air combat of the Vietnam War, not a single fragment had penetrated his aircraft. On that day, the young Captain Guttau knew he had witnessed first-hand the glorious power of a supernatural being.