Separating the Banking Wheat from the Chaff

No one cares when, each Friday, the Federal Deposit Insurance Corporation (FDIC) closes a small bank here and there. The local paper runs an item, but otherwise bank closures are non-events. The regulators from the FDIC, state banking authorities, along with the local police, lock the doors of the retail branches, wrapping them in yellow tape. FDIC investigators interrogate senior management.

A transition team working for the bank takes over the deposits. Temporary signs and a staff are ready to open Monday morning: It’s like nothing happened. Of course your money is safe. It never went anywhere. Your account number will change, but your money is still here. Your ATM card will still work at thousands of locations. Go ahead and write checks. You’ll forget the name of the failed bank in no time.

Smart bankers are running the place now.

Since the FDIC insures deposits, bank customers pay little attention to the financial goings on at their bank. There is no need. For instance customers of Security Exchange Bank in Marietta, Georgia likely weren’t concerned when the locally owned and operated bank piled into real estate loans made on property in the local market. A market that was red-hot post 9/11. From the year 2000 to 2008 Security Exchange grew its loan portfolio from zero to nearly $200 million, with the majority of those loans being real estate secured.

When the real estate market crashed in 2008, the greater Atlanta market (including Marietta) was hit especially hard. Those money-good loans that Security Exchange made in the boom, where suddenly bad in the bust. A measure of a bank’s problems is reflected in its “troubled asset Ratio” or “Texas Ratio,” calculated by dividing the amount of a bank’s delinquent loans and foreclosed property by its capital plus loan loss reserves.

The rule of thumb is that a bank should be very concerned if their Texas Ratio hits 50%. And it used to be that any bank with a troubled asset ratio over 100% would be closed by regulators any Friday.

At the end of September 2008, Security Exchange Bank’s Texas Ratio was over 56%. Six months later in March 2009, that ratio had grown to nearly 146%. One would have thought the little bank’s days were numbered. But Security Exchange lived on, presumably under the watchful eye of banking regulators. At the end of 2010, troubled assets were 558% of capital plus loan-loss reserves.

Still no yellow tape. At the end of last year Security’s Texas Ratio was over 1000%. Ten times what was previously a light-out condition. Still no closure. Did banking authorities think the bank’s fortunes were going to miraculously turn around?

At the end of this year’s first quarter Security Exchange’s Troubled Asset Ratio hit an astronomical 1209%. Finally, the bank saw its last day on June 15th, when the Department of Financial Institutions for the state of Georgia closed the bank with the assets turned over to the FDIC for disposal. The deposit insurer, as is typical, already had a buyer in Fidelity Southern Corporation.

Fidelity assumed all of Security Exchange’s deposits and also agreed to purchase all of the loans subject to a loss-sharing arrangement with the FDIC that covers 68% of the loan book. These loss-sharing agreements limit the downside for purchasers like Fidelity Southern. It’s also reasoned that bankers in the private sector will do a better job of collecting than FDIC bureaucrats would.

But one wonders what made the FDIC and Georgia regulators wait so long to pull the plug. Bank failures have slowed considerably. This shouldn’t be a manpower problem.

What hasn’t abated is the elevated number of banks on the FDIC’s super secret problem list. After jumping from 76 at the end of 2007 to 252 at the end of 2008 to a high of 888 at the end of the March 2011, the number has stayed stubbornly high, with 772 still on the list at the end of March of this year.

More than 280 banks have been closed since the end of 2009, yet the number of problem banks has increased by 70 since then. The problem banks aren’t getting any healthier, and more banks are getting sicker.

Michael Rapoport reported for the Wall Street Journal earlier this year,

Regulators say they aren’t deliberately keeping troubled banks around longer. The improving economy, stumbling or not, means the banks are deteriorating more slowly, the regulators say, so they are getting more time before failure to raise capital and fix their problems on their own.

“If we believe there’s a realistic chance…we’re more willing to let them get that capital raise,” said Kris Whittaker, deputy comptroller for special supervision at the Office of the Comptroller of the Currency, one of the main federal bank regulators. “This is a judgment that we have to make.”

Well there you have it. The authorities must have felt Security Exchange Bank had a shot at rehabilitating itself.

But according to the WSJ’s analysis of the banks that failed in 2011, 66% of these banks were “significantly undercapitalized” for at least six months before they failed. This compared with only 29% of 2010 failures. The median capital level for failed banks in 2011 was 25% less than those that failed the year prior.

The Journal cites the example of Decatur First Bank in (where else) Georgia. By the time regulators seized the $184 million asset bank, it had burned through all but $895,000 of its capital. That’s half a percent.

If the free market were at work here, depositors would close down an ailing fractional reserve bank in minutes by lining up to retrieve their deposits. But modern banking is anything but a free market. Banks and government are joined at the hip. Everyone knows about Too-Big-To Fail, but closing down the small fry seems to be left to regulatory whim.

Regulators say the law doesn’t require them to shut down a bank until its capital level falls below 2%. A money losing bank can limp along at 50 to 1 leverage, as long as it has a source to inject just enough capital to keep the regulators at bay.

For instance, the Bank of Las Vegas has managed to stay open keeping its capital ratio just above the we-don’t-have-to-close-you 2% level, with capital injections from parent company Capitol Bancorp Limited (CBCR).

Bank of Las Vegas lost $1.3 million in the first quarter and only maintains a capital ratio over 2% because Capitol Bancorp down streamed $549,000 to its Vegas affiliate.

Bank of Las Vegas’s portfolio of foreclosed real estate, Other Real Estate Owned (OREO), totals $21.7 million, more than 3 times the amount of capital the bank has on its books. And with few buyers in the market, bank management will have to hold its breath every time they re-appraise their OREO properties, with regulators demanding write-downs to appraised value minus closing costs. Also, Nevada law requires banks to write down 10% of the value of an OREO property each year.

After moving $4.1 million in loans into non-accrual in the first quarter, non-accrual loans totaled $54.3 million. Add the bank’s OREO to that and you have troubled assets of $76 million. Bank of Las Vegas had $6.3 million in capital at quarter end and a loan loss reserve of $12.3.

The Texas ratio for Bank of Las Vegas is 410%. That’s four times what used to be lights out territory.

Capitol Bancorp’s latest move, announced earlier this month, is to move Bank of Las Vegas, along with other affiliate banks Indiana Community Bank, Sunrise Bank of Albuquerque and Sunrise Bank of Arizona under Michigan Commerce Bancorp, a wholly owned subsidiary.

American Banker reports that all of these banks are just basis points above the 2% capital threshold at the end of the first quarter. So the idea is to take five critically wounded banks that cannot attract additional capital on their own, roll them together and the bigger under-capitalized entity will be worthy of investment?

American banker reports, “The move is largely organizational, but the company said in a Securities and Exchange Commission filing that it would help capital raising efforts. It did not, however, say how.”

The parent company–Capitol Bancorp Limited–is itself attempting a restructure. CBCR is asking holders of company debt to exchange their debt securities for both common and preferred stock in the company.

Like many bank holding companies, CBCR feasted on what is known as trust preferred securities to bolster capital levels during the boom. Trust preferred is debt, but the terms are so favorable to the debtor that banking regulators allowed banks to call it capital for regulatory purposes.

The catch is that these securities contain provisions requiring that the bank obtain trust preferred owner approval before raising capital that would be senior to the trust preferred shares in a liquidation. Most times, troubled banks, desperately in need of additional capital, must retire the trust preferred with the new capital, which defeats the purpose: The trust preferred holders don’t agree to the capital injection and in turn the bank fails.

However, CBCR has already managed to convert a large amount of trust preferred into equity. And as Capitol’s Chairman and CEO, Joseph D. Reid states, “…the initiatives have been structured carefully to include the opportunity to preserve Capitol’s substantial deferred federal tax asset (which Capitol estimates at $142.6 million as of March 31, 2012), and state tax deferred asset, which can provide a measurable benefit to all shareholders going forward.”

Capitol’s plan is following two tracks: An out-of-court restructuring and an in-court restructuring. Each track includes additional capital to be raised to bring its affiliate banks to well-capitalized status in exchange for 47% of the restructured CBCR.

At 3/31/12, the company had 41 million shares. If the restructuring happens, those 41 million shareholders will own 53% of the company, with the trust preferred and unsecured note holders owning the other 47% or approximately 36 million shares. With a total of 77 million shares, the deferred federal tax asset would amount to $1.84 per share.

Shares of CBCR are currently trading at 11 cents. The market recognizes that threading this restructuring needle is going to be tough, and besides, after it’s all said and done, CBCR will still sport a negative equity position in a business that with Dodd-Frank is fraught with expensive regulatory potholes to navigate.

But how much might a going concern pay for those tax benefits with a few branches and loans to go with it?

Ex-banker Chris Mayer points out in the current issue of Mayer’s Special Situations that the end of small banks in the United States is close at hand. Old time bankers and the owners of community banks have decided that running a financial institution has become a government job of following the rules instead of making business decisions. And they are saying “no thanks.”

But with banks going away, there is opportunity and Chris has identified a handful of S & Ls- turned-commercial banks that are ripe for takeover. Special Situation subscribers that following Chris’s advice already have solid gains with his picks, but the best is yet to come as the industry consolidates.

Caution: There is a big difference between the winners and losers in the small banking arena. You don’t want to be caught hoping for a windfall holding a bank’s stock that only survives because the FDIC is hoping for a greater fool to come along.

Lots of banks will be bought, but it’s a buyers market. Let a banking expert like Chris show you the way to profits in the banking minefield.


Doug French

The Daily Reckoning