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Our track record of identifying opportunities to make money in bank stocks has resulted in significant profits (and avoidance of losses) for investors that have followed our work. In April 2010, we highlighted PCBC as the most extreme example of speculative capital chasing distressed banks. In June 2011, we exposed HMPR's temporary spike as a great short opportunity based on its unusual addition to the Russell 2000 index.

Both bank stocks declined by more than 75% following our articles. While the dramatic sell-off in financial stocks has created a few long opportunities, we believe that a significant short opportunity has arisen due in part to the actions of the Federal Reserve. Based on our work, investors do not yet understand the negative impact that the collapse in interest rates will have on certain banks. As a result, banks with large securities portfolios (especially those that have been large relative outperformers), are setting investors (and sellside analysts) up for major earnings disappointments.

We believe the largest dislocation between investor perception and a probable earnings collapse is Signature Bank (SBNY). SBNY has been one of the best performing bank stocks this year and has been rewarded with one of the most expensive earnings and price-to-tangible book multiples in the financial universe. We believe a nasty surprise awaits the complacent investor community that has been "hiding" in SBNY once it becomes clear that current estimates are wildly aggressive.

The math is simple and the numbers don't lie. SBNY has one of the largest allocations to residential mortgage backed securities (43% of assets) and one of the highest yields on their securities book (3.9%) among all publicly traded banks. RMBS yields have been DECIMATED by the collapse in the 10-year Treasury rate. In the first half of 2011, GSE mortgage securities were yielding between 3.75%-4%. Today, they are yielding LESS THAN 2.5%. SBNY's security portfolio yield is highly correlated to the Fannie Mae mortgage yield index that has collapsed - a fact that has been ignored by investors that will be blindsided by the earnings collapse. SBNY earnings will likely come under significant stress as it reinvests maturities and prepayments into dramatically lower yielding assets.

We believe that SBNY's premium valuation is at risk with the inevitable earnings collapse. Despite our burgeoning constructive stance towards banks, we view SBNY as a unique short opportunity - one that should underperform on a relative basis, as well as decline in absolute terms. Based on very optimistic asset growth and yield assumptions, we believe SBNY's earnings will decline by 5-10% in 2012 (versus expectations of 13% growth). If we use our generous EPS estimates AND give SBNY the benefit of a premium multiple, we still arrive at a $32 price target, or 35% downside from current levels. Under more draconian scenarios (such as greater NIM compression, higher refinance activity, limited growth, and/or credit issues), the shares could face even more downside.

Background on Signature Bank

Signature Bank has $13 billion of assets and is headquartered in New York City. Unlike so many high quality banks, it was recently founded in 2001 by a team of bankers from Republic National Bank, which was acquired by HSBC (HBC). The 2007 takeover of North Fork Bank by Capital One (COF) accelerated the pace of new bankers joining SBNY. The bank has built a solid deposit franchise, which has likely caused the strange complacency among investors. However, with interest rates near zero and a relatively flat yield curve, the inherent value in any deposit franchise has been greatly diminished. The securities portfolio has always been an outsized characteristic of SBNY. It represented over 60% of assets in 2004 and has been between 40%-50% of assets over the last five years.

RMBS constitutes $5.6 billion of the $6.3 billion securities portfolio. With the additions of the North Fork lending team, SBNY rapidly grew their commercial real estate portfolio at the height of the commercial real estate boom. To date, SBNY has not experienced a large degradation in credit. Interestingly, credit does not need to deteriorate, yet we believe investors still face greater than 30% downside based on obvious earnings risk. Beyond the earnings decline we discuss later, should the rapid and aggressive loan growth catch up with SBNY, the shares would likely face greater than 50% downside.

Security portfolio (in millions)

Held for Sale

Held to Maturity

RMBS - U.S. Govt Agency

40.5

RMBS - U.S. Govt Agency

3.8

RMBS - GSE

1,208.1

RMBS - GSE

23.7

CMO - U.S. Govt Agency

709.9

CMO - U.S. Govt Agency

100.4

CMO - GSE

2,485.0

CMO - GSE

312.3

Private mortgage securities

685.4

Private mortgage securities

9.7

Total RMBS Portfolio

5,129.0

Total RMBS Portfolio

449.9

CMBS

236.0

CMBS

7.3

Trust preferred and corp. debt

255.8

CDO

3.5

Pooled trust preferred

5.7

Other

35.7

CDO

4.0

Total HTM Security Portfolio

496.4

Other

160.7

Equities

15.3

Total HFS Security Portfolio

5,806.4

% assets

Total RMBS Portfolio

5,578.9

42.6%

Total Security Portfolio

6,302.9

48.2%

Why the Stock Outperformance is Unwarranted:

Asset sensitive banks have performed miserably since mid-year. We define asset sensitive banks as those with large C&I loan portfolios where loan yields are tied to LIBOR and Prime. The stocks of three larger C&I lenders, Comerica (CMA), PrivateBancorp (PVTB) and FirstMerit (FMER), have declined by 35%-45% since June 30th. This collapse in asset sensitive banks has been closely correlated to the collapse in the 10-year Treasury rate.

Both accelerated at the end of July with the downgrade of the US Government's AAA rating by S&P and took another leg down following the August 9th announcement by the Fed that they would "hold interest rates at ultralow levels at least through mid-2013." The most recent drop has been the result of anticipation of the Fed's "Operation Twist" announcement. We believe the drop in the 10-year is much worse for SBNY than it is for the asset sensitive banks. Despite this, SBNY has actually outperformed the KBW Bank Index by over 1050 basis points and the asset sensitive banks by 1800 to 2800 basis points since June 30th.

SBNY Has Significantly Outperformed Other Banks

6/30/11

9/23/11

%

Ticker

Price

Price

Change

Comerica

(CMA)

$34.57

$22.49

-34.9%

PrivateBancorp

(PVTB)

$13.80

$7.54

-45.4%

FirstMerit

(FMER)

$16.51

$10.54

-36.2%

KBW Bank Index / ETF

(KBE)

$23.99

$17.38

-27.6%

Signature Bank

(SBNY)

$57.20

$47.51

-16.9%

10 Year Treasury Yield

3.11%

1.83%

-41.2%

The decline in the 10-year and the Fed's promise to maintain low short term rates for an extended period of time is not, on its own, a negative for asset sensitive banks. LIBOR and Prime are about as low as they can go (the Fed cannot cut the fed funds rate below zero), so incremental margin pressure would not come from lower interest rates. An extended period of low short term rates does put a lid on asset sensitive banks as a higher fed fund rates is likely required for an expanding net interest margin.

As a result, analysts have reduced their estimates over the past month and the recovery to "normalized" earnings power of these banks has been pushed out. Also, competitive pressures in C&I and weak economic activity is expected to pressure loan growth (although this is likely the case in all loan categories).

While an extended period of low short term rates is delays a positive reversion trade for asset sensitive banks, it is not necessarily a reason to sell all asset sensitive banks. HOWEVER, declining 10-year yields (vs. stable yields at low levels) is undoubtedly a negative for banks with large securities portfolios. Banks with high security yields have been "over-earning" relative to today's reinvestment opportunity-set. As such, they face large earnings holes going forward as the "true" earnings growth rates are reset.

Our experience suggests that when earnings streams become impaired for secular reasons, multiples tend to collapse on these lower earnings, which is a "double whammy" to the stock price. As the table above highlights, the 10-year Treasury rate has declined 41%, or over 125 basis points, in the past two months to historic lows. For banks with large security portfolios, the mounting pressure is two fold: reinvestment risk on maturing securities and reinvestment risk on prepayments. The pressure will be most intense on portfolios with large weightings in residential mortgage banked securities.

SBNY Faces Massive Headwind

Of the 150 largest U.S. banks by market cap, SBNY has one of the highest concentrations of assets in RMBS securities at over 43%. By comparison, the top 150 banks in the U.S. hold on average only 10%-15% of their assets in RMBS according to SNL. We could find only four other banks with a higher percentage of assets (three of those four were only slightly higher). SBNY's security portfolio yield of 3.9% is also unsustainably high; ranking it in the top quartile of banks in the U.S.

However, since SBNY's last earnings report, RBMS security yields have been DECIMATED as they trade off a spread to the 10-year Treasury rate. To better illustrate the degree of the carnage, GSE mortgage securities were yielding between 3.75%-4% in the first half of 2011 (inline with SBNY's security yield). Today, they are yielding LESS THAN 2.5%. As the table below highlights, SBNY's securities portfolio yield is highly correlated to the Fannie Mae 30-year mortgage yield index. As that Index has completely collapsed, we believe SBNY's securities yield is also poised to collapse - a probability that has NOT been priced into the stock or reflected in analyst expectations (see chart here).

12/31/09

3/31/10

6/30/10

9/30/10

12/31/10

3/31/11

6/30/11

9/22/11

FNMA 30-Year Mortgage Index (MTGEFNCL)*

4.56%

4.51%

3.75%

3.39%

4.13%

4.30%

4.02%

2.78%

SBNY security portfolio yield

4.57%

4.35%

3.85%

4.09%

3.96%

3.83%

3.91%

?

*The index yield is based on par value. With securities trading at a 5% premium to par, this represents a 2.4%-2.5% yield.

Booming refinance activity should only accelerate the pressure on the securities yield as SBNY will be forced to reinvest current maturities AND payoffs into dramatically lower yielding assets. Also, should the Administration's plans to revamp the HARP program have any success, SBNY will see incremental pressure. Our understanding is that an enhanced program is expected to be announced shortly and will likely target 2-5 million high LTV mortgages for refinance. Prepayments could also hit book value at some point. SBNY is currently carrying their GSE, CMO and RMBS investments at a $114 million gain above par (this gain represents 10% of book value). If prepayments increase, SBNY could see this gain diminish as the securities pay off at par. Under this scenario, the bank could face disastrous earnings and book value pressure.

In the past, SBNY has tried to mitigate lower yields by extending duration. Adding duration with RMBS securites (almost their entire securities portfolio) offers little offset today. As mortgage rates drop precipitously, refinance activity will drive much shorter than expected durations. The only option SBNY has to mitigate the reinvestment risk is to DRAMATICALLY increase the credit risk of the portfolio (in theory, they could also buy exotic and risky mortgage securities, but we don't consider this likely). The only Fannie (FNMA.OB) / Freddie (FMCC.OB) / Ginnie securities or structures today that offer yields near SBNY's current yield are very risky and volatile securities like inverse IOs or inverse floaters. These markets are relatively small and illiquid (so difficult to put a lot of money to work) and given their inherent leverage and volatility, are undesirable investments for banks. Alternatively, they could add junk rated or subprime securities to the portfolio. If this occurred, we believe SBNY's premium valuation would come under pressure given the increased risk profile.

The securities portfolio is not the only factor that could stress the financial model. As business confidence wanes, loan demand will dry up. As banks stretch for loan growth, spreads are likely to tighten. As a result, we expect incremental pressure on loan growth and incremental pressure on asset yields in CRE. A recent high profile refinance provides an example of this competitive pressure. SBNY had a $31.5 million mortgage on a class A property in Manhattan that was paying them 6.5%. In July, HSBC refinanced the building with a loan at LIBOR + 250, or only 2.85%. SBNY will benefit from a one-time prepayment penalty, but at the expense of future earnings. Further, with their competition willing to write loans at rates 365 basis points below SBNY's current rate, their ability to find attractive, low risk, high yielding loans is greatly diminished.

Below is an estimated income statement for the next several quarters. We believe it includes relatively optimistic assumptions, such as $2 billion in balance sheet growth (in an environment with limited loan demand) and total cost of funds increasing by less than $5 million a quarter by the end of 2012 (so basically funding that $2 billion of growth at nearly zero cost--the FDIC insurance on new deposits alone would increase funding costs). We also assume there is a very gradual reduction in the yield of securities (so we do not assume HARP 2.0 is successful in driving refinance activity).

Our model also assumes the historically high correlation between the MTGEFNCL index and SBNY's yield completely breaks down (another generous assumption). The index and the yield have been within 17 basis points of each other for five of the previous seven quarters. We generously assume in our model that SBNY's yield leaps 75 to 85 basis points higher than the index. We are not sure how this can be accomplished, but it highlights the friendly inputs used in our base case earnings assumptions. We also assume very little degradation on the yield of the loan portfolio despite intense competition for loans in SBNY's markets and no incremental credit deterioration.

3Q10

4Q10

1Q11

2Q11

3Q11E

4Q11E

1Q12E

2Q12E

3Q12E

4Q12E

Ave loans

4.8

5.0

5.4

5.9

6.2

6.4

6.5

6.6

6.7

6.9

Ave securities portfolio

5.6

5.9

6.3

6.6

6.7

6.9

7.0

7.1

7.3

7.4

Ave earnings assets

10.4

10.9

11.7

12.5

13.0

13.2

13.5

13.7

14.0

14.3

% yoy asset growth

24.8%

21.4%

15.0%

10.4%

8.2%

8.2%

Yield on loans

5.78%

5.78%

5.61%

5.64%

5.60%

5.55%

5.50%

5.45%

5.30%

5.30%

Yield on securities

3.62%

3.59%

3.62%

3.71%

3.60%

3.50%

3.40%

3.25%

3.25%

3.25%

Interest on loans

69.3

72.3

76.0

82.6

87.2

88.2

89.1

90.1

89.4

91.1

Interest on securities

50.6

52.8

57.0

61.2

60.5

60.0

59.4

58.0

59.1

60.3

Cost of fund

31.4

31.0

29.2

29.4

30.8

31.5

32.1

32.7

33.4

34.1

NII

89.1

95.9

103.7

113.0

116.3

116.1

115.9

114.7

114.5

116.8

EPS excluding gains

$ 0.62

$ 0.72

$ 0.72

$ 0.82

$ 0.80

$ 0.80

$ 0.76

$ 0.75

$ 0.74

$ 0.76

Consensus EPS

$ 0.62

$ 0.72

$ 0.72

$ 0.82

$ 0.80

$ 0.84

$ 0.86

$ 0.91

$ 0.97

$ 1.02

Estimate revisions needed

-4.3%

-11.4%

-17.4%

-23.2%

-25.3%

Even with these unrealistically optimistic assumptions, we still calculate earnings that will decline over the next six quarters. Based on our generous assumptions, SBNY would conclude 2012 with earnings that would be 25% lower than current consensus estimates. If we again were overly generous and assigned SBNY an earnings multiple that was 47% higher than the KBW Bank Index's current multiple (11x vs.7.5x 2012 estimates), SBNY's stock price would be around $32 per share.

Despite all of these rosy assumptions and a massive relative premium multiple, we still get a stock price that would represent 35% downside from current levels. If SBNY were to trade inline with the bank group (let a lone if we adjusted the rosy earnings assumptions), the stock would trade below $24, or 50% lower. Incredibly, after all of the carnage in bank stocks, there are still a few that can be shorted (or sold) that can produce massive absolute and relative returns.

Disclosure: I am short SBNY.

Source: Signature Bank: An Obvious Financial Short