Thoughts on Banks with Negative Equity

Banks that invested deposits in long term bonds have lost a lot of money as interest rates have risen. (Not just banks, but also other leveraged institutions like insurers.) This is a topic we have been following closely over at the Oddball Stocks Newsletter. For example, in Issue 43 we said:

We cannot help observing that most bankers have completely fumbled the incredible opportunity that they were given, by the government and by the fickle markets, in the wake of the pandemic.

Banks are nothing more than ultra-leveraged vehicles for investing in fixed income assets. At the same time that their own shares were trading at big discounts to liquidation value and private market or takeover value, their assets (loans and securities) were worth all-time, world-historically high valuations. (That is captured in the record low U.S. ten year bond yield of around 50 basis points in 2020.) A discrepancy where pessimism existed simultaneously with record optimism regarding the same assets.

Yet how many (or how few) bankers took serious advantage of that discrepancy? Remember, last Issue in our “Cheap Cyclicals” commentary, we talked about the importance of looking for “markets that aren't talking to each other” to find opportunity. Banks, as we said, are leveraged fixed income investors. And on one hand, the market was very depressed about banks, while at the same time very enthusiastic, even manic, about the fixed income investments that banks own: the loans and securities.

But what banker, anywhere, took action by selling off his expensive assets, deleveraging, and buying back his own cheap shares? Sure, many small banks (ones that we wrote about) bought back perhaps ten percent of their outstanding shares. But none of them treated this as the career-making, potentially transformative opportunity that it was. (Except, arguably, the banks that did their shareholders a favor and sold out, since the market price for takeovers was far higher than that for fractional interests in banks.) [...]

The last time we had very high inflation in the United States there were not many alternatives for idle cash. One could invest in Treasury bonds, but it was not just a few clicks, it was an involved process and required one to be able to buy in size. One could also purchase gold, but again, it was something physical that needed to be stored. There were no money market funds. You could not buy high-yielding Certificates of Deposit in a Fidelity account with one click. With these high barriers people just sucked it up and kept their cash in the bank.

Fast forward to now: frustrated customers have many alternatives. From TreasuryDirect, to purchasing Treasury bonds directly via online platforms, to easy and convenient money market funds with checkwriting ability. Why keep cash at a bank earning 0% when one can keep cash in a money market fund earning 3.5% and functionally have the exact same experience as the bank account?

That’s exactly what is starting to happen, that is the wildcard of this banking equation. If our example bank experiences a small amount of deposit flight they will be able to handle that with cash on hand. But let’s presume that 20% of their deposits leave for greener pastures. The bank doesn’t have enough cash on hand to handle this. They would need to some of sell their securities, locking in a permanent loss and tangible hit to their regulatory capital.

In our example above the bank could sell securities, handle the deposit outflow, and survive. But not all banks would be able to do this. As you will see in one of this Issue's guest pieces, there are now 30 banks reporting negative equity. There are also 246 banks with equity equal to less than 5% of their assets. For any of these, any deposit outflows are going to result in a situation where they’re either raising capital at a dilutive price, or potentially going out of business or being “taken under” by a competitor.

Where things can also get really bad is if rates continue to increase, further depressing security values. Every positive tick in rates means a further gap between what depositors are getting paid and where market rates are, as well as a further downtick in the value of securities purchased at the top of the market. This is actually such a threat to the banking system and economy that it implies that the Federal Reserve might not be able to tighten much further.

In Issues 41 and 43 of the Newsletter, we published lists of banks that had negative equity (taking into account securities losses) or were getting close. Silicon Valley Bank was actually one that was flagged as having negative equity in Issue 43.

Note that we first raised this as a concern on Credit Bubble Stocks almost eight years ago in our review of the book Panic. Sometimes things take a very long time to happen!

If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. In the 2000s that was mortgages, at other times it has been other investments like railroads.

Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest delusion.

It seems like there are three possibilities for how this will play out, starting Sunday night.

First would be if the Fed keeps tightening and nothing is done for the SIVB depositors. In that case, everyone is going to build mark-to-market balance sheet models for all banks in the country to see who has the worst combinations of negative equity and uninsured deposits that are at risk of running. These models could mark not only the banks' securities investments to markets but also the loans that were originated when rates were much lower. Quite a few banks would have negative equity if they were forced to liquidate all of their securities and loans. (A mortgage originated at 3% has lost a lot of value with mortgage rates now at 7%.)

These lists will circulate on Twitter and these banks will have runs - people will move their deposits to "too big to fail" banks or to brokerage accounts where they can buy Treasuries directly. Not only is that safer, but they also go from earning nearly zero to 5%. (And deposit flight gets all the more likely if the Fed keeps raising rates further, since the gap between low interest bank deposits and money market yields widens.) No one is going to tolerate keeping money on deposit for free and at risk of impairment. These runs would result in further failures. Things get very messy indeed if banks' $50-$100 billion loan portfolios are being put up for fire sale every week. Social media (like finance Twitter) means that these runs can happen in a day. This is already starting to happen as of Saturday, with lines outside of First Republic Bank branches in California, and people on Twitter crowdsourcing research into weak banks.

Second possibility would be various measures aimed at calming bank depositors' concerns. On Saturday night, there has been talk of an FDIC fund to backstop deposits at failed banks. Also, from 2009-2010, the FDIC insurance on transactional accounts was temporarily uncapped: the Temporary Liquidity Guarantee Program. Something like that could be done again.

Ultimately, though, it seems unlikely that this will stop until the Fed stops tightening. Continued interest rate increases have been widening the gap between what bank deposits pay and what customers could earn by buying Treasuries directly. At some point, the dam would just burst and deposits would get converted to direct Treasury investments, never to return. Also, higher interest rates have already basically wiped out the equity in commercial real estate (just look at a stock chart of an office REIT like BXP or VNO), and if the rates increase further, these properties will start getting handed back to the banks.

But once the Fed pauses, then no one will think that their bank deposits are at risk because of the interest-rate related decreases in value of assets which are still performing. Banks can then continue to earn their way out of their liquidation value hole, as they had been doing and as has normally happened at various points in past economic cycles.

However, the caveat here is that inflation will come back. They have to give up on trying to get it back down using monetary policy. Maybe they raise taxes, maybe they put a sumptuary goods tax on Ferarris and private jet flights. Maybe they stop printing money to send to Ukraine. There are all kinds of fiscal and regulatory things that could be attempted. Inflation would have been better over the past two years if we had more sawmills and oil refineries and fewer cryptocurrency startups.

But they will have to eat some big CPI prints without being able to jawbone about tightening unless they want a banking crisis.

Small Bank Annual Report Season

We get a lot of small bank annual reports in the mail at Credit Bubble Stocks. Two came in today so let's just do a kind of deeper read of the annual reports and think about their businesses and valuations.

First up is Dacotah Banks, Inc. (DBIN) which came in today.

• At $32 per share the market capitalization is $358 million, which is 1.3x the book value of $274 million.  
• Bank earned $17.5 million for a P/E of 20 times. Return on equity was 6.5% in 2017 and 9.1% in 2016.
• Only $233 million of debt securities. Of these, only $25.3 million have more than five years to maturity. This is much more conservative than we have seen at a lot of other banks. Also, of the $1.9 billion of loans only $230 million has a maturity or next repricing of greater than five years.
• Loans for agricultural purposes comprised approximately 46% of total loans. A similar amount are commercial and commercial real estate loans. Not much consumer or residential lending. 
• They have $47 million of premises and equipment. But, they have 32 locations across the Dakotas and rural western Minnesota. So the total book value per store is only $1.5 million.
• They have $1.9 billion of loans and $2.1 billion of deposits. So, another way to look at the locations is that each one is responsible for about $60 million worth of loan and deposit business.
• Interest expense in 2017 was $10.4 million on $2.1 billion of liabilities. That's a funding cost of only 50 basis points! Interest received on loans was $94 million, which is a 4.9% coupon. The result is a net interest margin that's been steady around 4% the past four years.
• They have some impressive non-interest income as well. For example, $4.8 million of insurance commissions.
• They paid $735,000 to the FDIC in 2017 on the $2.1 billion of deposits. Andy Redleaf says that "mispriced deposit insurance" is one of the main reasons why a man should own a bank.
• From their proxy statement, their bylaws provide for cumulative voting, which is cool. They also included the minutes of the previous year's annual meeting, which you never see. However, no disclosure in the proxy of who the largest shareholders are or how much management/directors own.

Next up is WC Bancorp (WFCB).

• At $9.85 per share the market capitalization is $25 million, which is 0.89x the book value of $28.4 million. Notice that this one is a tenth the size of Dacotah.
• Bank lost $116,000 in 2017 vs making $109,000 in 2016. So no net income over previous two years.
• This is a mutual conversion: "WCF Bancorp, is a Iowa-chartered corporation organized in 2016 to be the successor to Webster City Federal Bancorp (the Old Bancorp), a federal corporation, upon completion of the secondstep conversion of WCF Financial, M.H.C. (the MHC) from a mutual holding company to a stock holding company form of organization. The MHC was the former mutual holding company for the Old Bancorp prior to the completion of the second-step conversion. Upon consummation of the second-step conversion, the MHC and the Old Bancorp ceased to exist. The second-step conversion was completed on July 13, 2016 at which time the Company sold 2,139,231 shares of its common stock (including 171,138 shares purchased by WCF Financial Bank's (the Bank) employee stock ownership plan) at $8.00 per share for gross proceeds of $17.1 million. Expenses related to the stock offering totaled $1.7 million and were netted against proceeds. As a part of the second-step conversion, each of the outstanding shares of common stock of Old Bancorp held by persons other than the MHC converted into 0.8115 shares of Company common stock with cash paid in lieu of fractional shares. As a result, a total of 2,561,542 shares were issued in the second-step conversion."
• A fund called Firefly Value Partners in New York owns 8%. The ESOP owns 6.7%. Directors and management own less than 1%!
• Interest expense on $88 million of deposits was 68 basis points.
• The loan portfolio is 81% 1-4 family residential.
• The securities portfolio is $43 million, which is 1.5 times their equity. Of this, about $17 million is more than five year maturity.

Neither one seems attractively priced. However, Dacotah is a better business and better positioned for rising interest rates.

Moldbug On Fractional Reserve Banking

Great Moldbug post on "maturity transformation," aka the fractional reserve banking scam:

Our financial system is not a new operating system. It is a very old operating system. Worse, there is only one of them: the whole world runs the Anglo-American banking system, more or less as described by Walter Bagehot in Lombard Street (1873). Lombard Street is our Windows. There is no Mac. There is no Linux. Our experts in finance are not experts in finance. They are experts in Lombard Street finance. Asking them to imagine an alternative is like asking a Windows programmer to imagine OS X - except that Windows isn't 314 years old. [...]

The end goal is to phase out this lending-counterfeiter business, and construct a new financial system - the motorcycle - in which lending is really, truly private, and financial intermediaries match their maturities. If Bobby needs money for three weeks, he asks you for a three-week loan. He does not ask you for a one-week loan and then get a surreptitious, covert, informal three-week loan from the Fed's "technology, called a printing press."

In any such financial system, we would see the true yield curve, the graph of interest rates at every maturity, uncontaminated by maturity mismatching. My suspicion is that at least at first, long-term rates would be quite high. Which means lower house prices. In the spirit of portfolio neutrality, USG might want to print some more money and kick it back to homeowners, such as, of course, myself...

It probably would not be possible to get 30 year loans to buy real estate in a free market system where you had to borrow the money from an actual investor. It would be more like 5-10 year money. And if you take a look at what housing finance was like 100 years ago, I think that is pretty much how it was.

The current system results in subsidization of residential real estate. It leads to an allocation of capital to houses that is much larger than you would see under a free market system. This system also creates a lot of financial intermediation "jobs". The herding behavior of these bankers seems really non-free-market.

It's interesting that the comment thread on that post in September 2008 was much more intelligent than any other blog I can think of. I think it's really hard for most people to grapple with the existence of a flawed (crooked) system that benefits the elite and will therefore be kept around, with modifications and tinkering, to the extent possible.

Stilwell Letter to HopFed Bancorp, Inc.

Second, any fool can grow a bank substantially in asset size over 16 years. The fact that you equate asset size to “enhancing long-term shareholder value”—as opposed to per share book value or per share earnings or return on equity or return on assets is perhaps why you don’t understand what a truly poor job Mr. Peck has been doing.

Nate Tobik: "Getting Rich With Small Banks"

WSJ: "The Demise of the Small American Bank"

Today's WSJ:

"[D]odd-Frank, a law intended to take on the systemic risk of 'too-big-to-fail' banks, is multiplying the problem. 'The big banks that are too big to fail are bigger now than ever, but the regulations have trickled down to the smaller banks that didn’t cause the financial crisis' Mr. Hill says. As a result, community banks are disappearing. 'When I started my first bank in the 1970s there were 24,000 banks in America,' he says. 'There are now 7,000 banks. It may soon be 500 or even fewer.' [...]

He laments that the Community Reinvestment Act, a catalyst of the 2008 subprime mortgage crisis, still hasn’t been repealed. 'We are literally required to make loans that we know are going to fail.'"

A correspondent writes, "It's driven in part by politics and regulation and in part due to technological change and market competition. I say the latter only because different tech platforms are allowing traditional roles of banks to be decentralized across time and space (payment platforms, loan intermediation, escrowing, etc)."

Note that this is actually bullish for cheap small banks: those trading below the value they would receive in a merger, and especially those trading below book value.

Nate Tobik Discusses Banking at the Fairfax Shareholder Dinner

"Why Your Bank Is Going To Be Worth A Lot of Money"

Article:

"The new bank application department at the FDIC was a little slow in 2014. Before the recession, it was common for the FDIC to get 250 applications per year and approve 159 of those. In 2014, only Primary Bank (in organization) filed an application (still pending). Part of the issue is that if you are crazy enough to want to start a bank you are probably too dysfunctional to handle the management of a bank. Given average ROE below the cost of capital, tight margins, low interest rates, tough competition and too many banks, it is no wonder why more bankers have not applied."

"The Post Office Should Just Become a Bank"

The postal service, with public trust earned over generations and 35,000 outlets in the best real estate in practically every city in America (in fact, the report notes, 59 percent of all post offices are in “bank deserts” with only one bank branch or less), is well-positioned to deliver simple financial services. In fact, it did for over 50 years. Begun in 1911, the Postal Savings System allowed Americans to deposit cash with certain branch post offices, at 2 percent interest.

The banks in this country are not free market institutions, anyway. The majority of their capital (deposits) is government subsidized. Through the miracle of fractional reserve banking they are also allowed to make fraudulent promises to repay to their depositors.

If lending is going to be a creature of the state, you may as well split the huge rents between customers and the government. The P.O. bank idea is sound.

Of course, the ideal, honest solution is to get the government out of lending entirely. If you want to make 30 year loans you really ought to have a committed source of funds for that time period. 

Excellent Essay: "Banks - Expensive at Every Price"

"We're not in the habit of making heretical statements, but we believe banks are not an appropriate investment at any price for the thoughtful value investor." [pdf]

- Value Investment Institute, March 2011