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A few months back, I wrote an article detailing how I thought K-Fed Bancorp’s (KFED) loan loss provisions looked to be absurdly low in comparison with most other banks. While most banks were allowing loan loss provisions of 1-2 percent earlier this summer (before the credit crunch and the big jump in delinquencies), KFED’s allowance for loan losses amounted to just 0.6 percent of the portfolio. This looked to me to be suspiciously low, and with KFED’s Annual Report being filed on September 13th for the year ended June 30th, 2007, we can get a better glimpse into KFED’s books. So without further ado, let’s start digging.

Description of the company

KFED is a small bank based in Corvina, California, which is east of Los Angeles and centered in the inland empire area of Riverside and San Bernardino. The bank was originally Kaiser Permanente’s Credit Union, and was converted into an open bank in 1999. The company functions as a standard savings and loan, and originates primarily real estate loans (90% of the overall loan portfolio) as well as auto loans. In addition, the company also purchases mortgages from third parties for its loan portfolio.

Market details

KFED operates in the heart of what is clearly one of the worst housing markets in the country right now. The inland empire to the east of Los Angeles has been one of the most brutal markets in the country, and recent evidence indicates that the situation continues to worsen. According to The Press Enterprise, “San Bernardino County had 5,253 [foreclosure] filings last month, up 196 percent from 1,776 filings in September 2006, while Riverside County recorded 6,766 filings, up 282 percent from 1772 a year earlier.” As detailed in the article, LA County is not doing much better, and represents further problems for KFED’s local operating area. Moreover, prices are expect to continue to fall in the coming months, so the housing crisis in the inland empire is likely to worsen.

The housing market woes have clearly had an impact on the local banking sector, as evidenced by the large increases in provisions for loan losses in the third quarter for PFF Bancorp (PFB), which reported earnings on October 22nd. PFB is a larger bank operating in the exact same geographic area as KFED, and although they have more exposure to new construction in their loan portfolio, PFB also reported a huge jump in non-accruing loans for residential real estate (which more than doubled year over year). The need for increased loan loss provisions drove PFB to a third quarter loss, and sent the shares down some 25 percent in the wake of earnings. KFED looks susceptible to the same type of writedown, and with a higher valuation, we could well see a drop of equal or greater magnitude when the company reports earnings in early November.

Portfolio details

As I stated in my introduction, what first drew my attention to KFED several months ago was the fact that they had only made allowances for loan losses of 0.6 percent of the total loan portfolio. This number appears to be very low for any bank, but especially low for a bank operating in the inland empire where the housing downturn has been felt especially hard. The number raises even more eyebrows when one looks at the composition of KFED’s loan portfolio. The data below is taken directly from the company’s recent Annual Report filed September 13th, 2007.

KFED’s total loan portfolio is $699.1 million, and consists primarily of real estate (90.5% of the portfolio) and auto loans (7.5% of the portfolio). One to four family homes comprise 67 percent of the portfolio, whereas commercial real estate comprises 11% of the portfolio and multi-family homes comprise another 12.5 percent of the portfolio.

As far as the interest rate position of the portfolio, fixed rate real estate comprises 49.7 percent of the portfolio, whereas adjustable rate real estate comprises 40.8 percent of the total portfolio. The majority of KFED’s adjustable rate mortgages were originated in the last three years, and carry a fixed term for three years before readjustment. Given that rates are substantially higher today then they were in 2005 (when the majority of these mortgages were written), these loans appear to have substantial risk when rates are reset to significantly higher rates.

Reading further down, the report starts to become more interesting. Approximately 83 percent of the company’s one to four family home loans are purchased from third party mortgage originators, meaning that KFED has very limited control of the underwriting standards for these loans. Moreover, the entire mortgage portfolio consists of mortgages in California, which, as we all know, is one of the top states in the country for delinquencies. Not encouraging.

If that were all, the company would probably not be in great shape going forward. But it gets worse. The kicker for the company is the inclusion of interest only and non-documentation loans in the portfolio, and their place in the portfolio is substantial. Interest only loans in the portfolio amount to $100.4 million, or 14.3 percent of the overall portfolio. For those unfamiliar with interest only loans, these loans require the borrower to pay only interest for a fixed period (usually 3,5, or 7 years) before the loan payment resets to include payment of principle as well. Moreover, non-documentation loans (so called Alt-A loans) accounted for $118.8 million, or 17 percent of the overall loan portfolio. These loans are extended without verifying income and other details about the borrower, thus making them significantly more risky.

Not surprisingly, interest only loans became the loan of choice for home ‘flippers’ during the housing boom, and many people took out interest only loans at the top of the bubble with the intent of selling their house before the loan resets. A significant portion of those borrowers will not be able to pay for their mortgage when the loan resets, and therefore, defaults are likely to follow. Moreover, Alt-A borrowers typically used the loans to buy houses beyond their means as home prices soared in the housing bubble, and therefore, these mortgages also have a sharply elevated risk of default. For instance, while the nationwide rate of default has been rising to about 5 percent in recent months, the default rate on the riskiest mortgages (subprime) hovers at around 15 percent. While I can’t find the exact data for Alt-A and interest only default rates, it is likely to be around 10% nationwide at present, and will more than likely rise as home prices continue to fall.

Overall, KFED’s loan portfolio has some serious shortcomings. With over 40 percent of the portfolio in ARM’s and some 31 percent in less than prime loans, the portfolio is likely to experience a substantial rise in defaults in the coming months. I don’t know how the company has so far managed to make provisions for loan losses accounting to just 0.6 percent of the portfolio, but after looking at the company’s loan portfolio, I do know that this tiny provision is unlikely to be sufficient going forward. With some $219 million in interest only and Alt-A California loans on the books, we are likely to see some substantial losses as default rates rise. The company’s loan portfolio looks vulnerable to tens of millions of dollars in losses, and that does not bode well for the bank’s earnings going forward.

Valuation

Additionally, while the company looks very vulnerable to loan losses, it also remains an expensive stock. The company is trading at 40 times trailing earnings, which are likely to be higher than earnings going forward if loan losses begin to rise. In addition, the company is trading at 2 times book value, which would be about right in good times, but is substantially higher than the current valuation of most banks given the housing and credit crisis. Moreover, given the fact that the book is probably worth substantially less due to the excessively low allowance for loan losses at present, the company is more than likely trading at substantially more than 2 times book value. That is a very significant premium being afforded to KFED as compared with most small banks, and the premium is especially surprising given the geographic risk inherent in KFED’s mortgage portfolio. Finally, while the stock does have a yield of approximately 3% (which still isn’t all that high as compared to many banks at present), a quick read of the company’s annual report reveals that the company paid out 112% of its earnings in the form of dividends last year. Clearly, that is not a sustainable trend. While KFED’s cash position is sufficient to continue paying that dividend for several quarters, the dividend is not sustainable over the long term if the company’s operating performance does not improve. As I detailed above, the likely increase in provisions for loan losses hints that operating performance is more than likely going to decline over the next several quarters, and if that happens, the dividend will likely have to be decreased.

Other details

While KFED has substantial operating challenges ahead of it, it may also have other problems. On September 18th, the company announced in an 8K filing that the chairman of the audit committee (Frank Nicewicz) for the company had resigned. While the company stated in the filing that “to their knowledge” the resignation was not in response to any disagreement about the company’s operations or practices, I am skeptical as to whether that is in fact the case. The fact that the company’s provision for loan losses is incredibly low at 0.6 percent makes me wonder whether there is not more to this story. I am just speculating here, but isn’t it possible that the company has improperly accounted for loan losses in the past, and as conditions worsen, the company can no longer hide these losses? We can’t know for sure, but I don’t think it is out of the question going forward.

In addition, the company has yet to appoint a new chairman for the audit committee, despite the fact that their 8K indicated that they expected to find a replacement within 30 days of the filing. The filing was made on September 18th, so we are now beyond the 30 day window the company indicated for finding a replacement. The company is not compliant with Nasdaq listing requirements as a result of the absence, so the lengthy delay in finding a new chairman does not inspire confidence.

Summary

KFED looks like it is about to become victim to the expectations of Wall Street. It is fairly easy to understand why the company has gotten into trouble. Since reorganizing as a mutual holding company in 2003 and coming public in 2004, the company’s loan portfolio has expanded by nearly 100 percent despite much slower growth in the company’s deposit base. KFED used leverage and bought high interest mortgages (ie, interest only mortgages and Alt-A) to try to increase earnings and boost the stock price. While this worked while the housing market was booming in 2005 and 2006, the company is likely to pay the price as the housing recession continues to deepen.

Overall, KFED has some serious challenges ahead regarding its loan portfolio, and the stock continues to be priced at a premium in comparison with the rest of the banking sector. Geographically, the company is operating in one of the worst housing markets in the country, and this eventually has to trickle down in the form of higher delinquency rates on mortgage loans. In addition, the turmoil regarding the company’s chairman of the audit committee may foretell accounting and legal problems related to previous earnings reports, which could further pressure the stock. For all of these reasons, I hold a moderate short position in the stock, and believe the stock has the potential for a significant decline in the near future.

Disclosure: Author holds a short position in KFED

Source: K-Fed Bancorp: Loan Loss Provisions Likely to Rise