Subprime Red Flag in Pacific Capital Bancorp's 10Q?

Have you read through Pacific Capital Bancorp’s 10Q? I have, and in addition to more detail on the huge increase in non-performing loans and the woefully inadequate loss reserves, I found another red flag that I would like to bring to everyone’s attention:

Management is aware of one Collateralized Mortgage Obligation (“CMO”) security held in the AFS portfolio that has some sub-prime loans as the underlying collateral. The CMO currently has an investment rating of AAA and is fully collateralized. The Company has the ability and the intent to hold these securities until ultimate recovery.

I just cannot believe that after everything that has transpired with the subprime crisis, management would still like investors to believe that the AAA rating has anything to do with the value or the risk of the subprime CMO. The investment banks worked with the ratings agencies to give these subprime mortgage securities the illusion of investment grade. In fact much of the crisis was caused by naive investment managers believing that the AAA rating meant that the investment was safe.

The key words in this quote are “has the ability and the intent to hold these securities until ultimate recovery.” As soon as Pacific Capital Bancorp uttered these words, they were magically able to keep the CMO on the balance sheet at cost rather than ever having to mark to market.

I think this is definitely a red flag. The value of this CMO has probably eroded significantly since PCBC purchased it and by cherry-picking this issue to “hold until recovery” management is avoiding realizing losses.

This is just yet another fact that validates my opinion that management is being evasive and that they are making the earnings look much better than they really are. For the rest of the year the RAL/RT business will no longer offset the disaster underway with PCBC’s loan portfolio, so investors are likely to be much more critical of the results (speaking of the RAL/RT business, is that really a good business for a “neighborhood bank,” given that it smells like payday lending?) If you could put this short position in a box and put a “Do Not Open Until Xmas” tag on it, my guess is that you will have a single-digit stock as a nice Christmas present.

Disclosure: Author is short PCBC.

Comments

[thannagan]

1) Not all CMO's have been downgraded. If this one is still AAA, as the bank reports, then it's AAA. 2) It is not held as a "for sale" investment and does not have to be marked to market. 3) Even if your emotions are correct, and you are not just trying to rationalize your short, what's the amount involved? Is it material? 4) The RAL business is always a first quarter event. This is no surprise to anyone and actually performed better than estimates. 5) What is your support (ie:numbers) to say the loss reserve is too low? I'm not saying your conclusion is wrong, but in the spirit of this site, I'd like some hard analysis and less fear mongering.

[heynow]

It sounds to me like you are grasping at straws. In Q4 2007, PCBC recognized a loss on some securities that were marked-to-market. Wouldn't that demonstrate that they recognize losses when they need to?

[thebird]

The real story with this bank is the VERY WEAK MANAGEMENT who has destroyed what used to be top performing community bank and the leader in their markets. They no longer have a core competency or a viable strategy.