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Regional and Local Banks Continue to Show Economic Stress

May 13, 2009 | About:
Inoculated Investor

Inoculated Investor

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At the Markel (MKL) annual meeting, EVP/CIO Gayner concluded the Q&A session with the comment that the entire market is a banking stock right now. For investors who have been long since mid-March, this could be interpreted as a great thing. As banks have doubled and in some cases tripled off of their previous lows, the entire market has followed suit. However, that is not what Gayner was referencing. His point was that the market is levered to the health of the financial industry. He specifically said that nothing works in this country unless the banking system is functioning properly. He ended the meeting on a cautiously optimistic note by saying that the financial world will get back to normal but that it would certainly take some time.

I have been following the regional banks closely since October 2007 when my boss asked me to find some good shorts in the space based on companies' real estate exposures. As it turned out you could have been short just about any one of them and made a ton of money. Now, with the economy showing some meager signs of turning around, the short thesis on the regional banks is not as clear. Despite the impressive run up in share prices recently, many of the stocks are still down a lot from their previous highs. Plus, the government looks to be content with throwing as much money at the situation as possible with the hope of papering over legitimate solvency issues.

However, my suggestion is that you pay very little attention to the noise coming out of Washington regarding the banks and the stress tests. Yes, these large banks own something like 2/3rds of the nations banking assets, but they have so many different segments and businesses it is really hard to glean a lot of useful information about the state of the economy by looking at these banking behemoths. From my perspective, the loan books of regional and local banks are a much better proxy for what is really going on with businesses and consumers. These banks are really in the trenches and the stress in their loan books should be indicative of the stress on the broader economy.

Unfortunately, among the banks whose recent Q1 filings I have reviewed, the situation continues to be pretty terrible. Now, what is my basis for that conclusion? I am going to steal a page out of the perma-bulls playbook and talk about second derivatives. Before you think that the recent rally has driven me mad, hear me out. Banks have to report a number of different categories of troubled loans. In banks' initial quarterly filings with the SEC, the focus has traditionally been on providing detail on non-performing loans, forcing more discerning investors to have to wait for the FFIEC call report to get more granularity about troubled loans. However, as a result of all the balance sheet scrutiny, banks have started reporting more specific data on all troubled loans.

Take Western Alliance Bancorporation (WAL) for example. WAL is a $4B bank with branches in California, Nevada, and Arizona, states which have been devastated by the housing slump. I think it is logical to assume that the warm weather states that were the first to experience the real estate stress will likely be the first ones to show signs of improvement. So, WAL is a very good bank to examine if you are searching for an indication of recovery in the housing market. Well, so far no luck on that front. Non-performing loans increased from $58.3M in Q4 2008 to $98.7M in Q1 2009. However, that is to be expected to some extent and is not what troubles me the most. Specifically, loans 90 days past due and still accruing increased from $11.5M to $53.2M in the same period. These are loans that have potential to go bad but technically aren't quite there yet. Amazingly, the number of these loans increased by close to 5 times between Q4 and Q1.

Ideally, what you would like to see is a deceleration of new potential problem loans (here is the 2nd derivative part) and a low roll rate percentage, meaning that only a few of these potentially bad loans are rolling into non-performing loans. In terms of WAL, ZION, CYN and RF (just to name a few), that has blatantly not been the case. In fact, we have actually seen an acceleration of new problem loans and roll rates that appear to be quite high. This does not bode well for the banks when it comes to future loan losses and the need for more robust reserves. If WAL were to have $1 of reserves for each dollar of dodgy (technical term) loans, the company's tangible common equity to tangible asset (TCE/TA) ratio would fall from 4.7% to about 2%. Not what I would call "well capitalized."

So, if Mr. Gayner from Markel is right and the market is levered to the health of the banking system, then the market is in for a serious shock if the data I have examined is indicative at all of the current state of bank's balance sheets. The market could continue to rally, but in my opinion that would only mean it has decoupled further from the economic reality. Accordingly, if you are long right now and have not been hedging or taking down your equity exposure a little, my advice is to be very careful out there.

Inoculated Investor

inoculatedinvestor.blogspot.com

About the author:

Inoculated Investor

My name is Ben C. and I am 2nd year MBA candidate at the Anderson School of Business at the University of California- Los Angeles. I have a BS in Economics from the Wharton School of Business at the University of Pennsylvania. Before coming to Anderson I worked as a generalist equity research analyst for Right Wall Capital, a long-short equity hedge fund located in New York City. Prior to working at Right Wall I worked as an analyst at Blue Ram Capital, another long-short equity hedge fund located in Rye Brook, NY. This past summer, I worked for West Coast Asset Management as a research analyst. West Coast, which was co-founded by Kinko’s founder Paul Orfalea, is run by well-known value investors Lance Helfert and Atticus Lowe.



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