A California Bear And Bull Bank Stock Pair Trade

Includes: SIVB, WFC
by: The Wall Street Transcript

Looking for a long/short market neutral bank stock trade is a bit of work nowadays since it's difficult to find good short candidates. Most banks are still trading over 50% below their pre-crisis highs and well below even tangible book value. Its improbable that even if the economy stalls, bank stocks will fall another 50%. Of all the regions of the US, it seems that California would offer up some candidates for a wide variety of returns in this sector and therefore as a good sub sector for a long/short pair. The continuing crisis in state government funding there and the Stockton municipal bankruptcy should generate a high level of local financial stress.

Richard X. Bove, the Dean of Banking analysts in the United States for the last 45 years had positive things to say about a California bank in the Wall Street Transcript Investor's Guide to US Banking in an April 30, 2012 interview: "Wells Fargo (WFC) is much bigger. It is now a national bank. The company has emerged from the crisis in a stronger condition. Shockingly, the bank is actually in better condition in every way than before the crisis began."

In order to match that long call, a candidate from just down the road from Wells Fargo seems to fit the short bill: Silicon Valley Bank (SIVB). The bank's strategy is to follow the venture capital Gold Rush, adding a large scale effort to expand into the declining economies of China and Europe with a relatively expensive new start up effort.

For starters, the accounting in the latest 10Q is a bit weird to say the least. For example, the bank's business is centered on lending to small venture funded companies, which are risky by nature. It would seem conservative to run a large reserve against these loans, but not only does the bank not do this it also books enormous amounts of unrealized gains into its net income.

In fact, in the most recent 10Q for the quarter ending 3/31/12, Silicon Valley Bank reported "Equity Warrant Assets" of $71.4 million, a 40% gain in this Level 3 asset category of over $20 million from a year earlier. In case readers have forgotten, Level 3 assets in the banking world are those assets that the banks "mark to model", in other words, there is no market for these assets so the banks make up some formula to create balance sheet value for them. This note is of course buried on page 62 of the SEC filing.

However, the number of companies that the loans that these "equity warrants" are attached to went from 1164 to 1192 in that time period. So in other words, SIVB is booking $714k in new equity warrant value for every new venture capital loan they make? Since the net income for the whole bank in Q1 2012 was only $38.7 million it seems a bit excessive to have these warrants as the driver of net income. And when you consider that the bank has 7% of total assets in Level 3 assets, or over $814 million in Level 3 assets as of 3/31/12, it seems a much riskier asset mix than its other regional California banking peers.

Another odd asset class is to be found in SIVB's "consumer loans secured by real estate". What's odd about that? Isn't it common for banks to have residential mortgage assets? Well sure, but at Silicon Valley Bank, their 3/31/12 portfolio of $542.5 million in loans secured by real estate includes $101.6 million in "loans to eligible employees". That's almost 19% of the entire portfolio! To put that in perspective, if Wells Fargo had the equivalent amount of its residential mortgages to "eligible employees" the number there would be $720 billion out of Wells Fargo's $1.8 trillion residential mortgage loan servicing portfolio.

Another interesting tidbit in the Silicon Valley Bank Q1 2012 filing is the note buried on page 39 about their China banking J.V. This interesting banking venture received funding of $79.7 million in December of 2010. Unfortunately for shareholders the management of this venture are still "continuing to prepare the joint venture bank for opening" a year and a half later. And who is managing this tardy venture? The former CEO of the company Ken Wilcox, who stepped down from his leadership position with the bank in April of 2011. The 2011 proxy statement gives some interesting detail on this arrangement.

According to the proxy, given "the importance of Mr. Wilcox's responsibilities in China", Silicon Valley's board "decided to maintain Mr. Wilcox's total target compensation at 2010 levels" which includes a $1 million base salary plus a number of other cash compensation "bonus targets" but so as not to be excessive the board "set an internal guideline of $4.0 million" as the maximum annual compensation. That $4.0 million excludes Mr. Wilcox's temporary "relocation expenses" of course, which totaled only $782,386 in 2011. Nice work if you can get it.

It seems that SIVB is a stock worth looking further into for investors - if you're interested in a short candidate for a long/short banking pair that is.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.