The "Texas Ratio" and FirstFed Financial

There was a great article on bank failures written by Alistair Barr several days ago over at MarketWatch.  While the whole article was of interest, I found the section describing Gerard Cassidy’s “Texas Ratio” to be especially interesting.  Cassidy, who is at RBC Capital Markets, developed the ratio during the 1980s while covering a large number of banks out of Texas. 

With the help of a booming economy, the region gave birth to a number of successful banks all of which rapidly expanded their balance sheets in the hopes of making large amounts of money.  When the price of oil collapsed in the mid 1980s the banks quickly ran into trouble as their loans quickly deteriorated in quality.  According to Cassidy, the “Texas Ratio” acts as an early warning system for banks that are in trouble.  In the early 1990s, the ratio proved its usefulness by identifying many of the banks that got into trouble in New England.

The MarketWatch article defines the “Texas Ratio” as the following:

The ratio is calculated by dividing a bank's non-performing loans, including those 90 days delinquent, by the company's tangible equity capital plus money set aside for future loan losses.

The current situation in California is very similar to the situation that occurred in Texas in the 1980s.  Over the last decade or so, the economy in California has been driven in a large degree by the construction industry and the prospect of ever-rising home prices.  In Texas, the economy in the 1980s was dependent on the oil industry and the ever-rising price of oil.  The stock price of Texas banks in the early 1980’s was very similar to the stock price of Californian Banks following the dramatic reduction in interest rates by the Federal Reserve in the first part of this decade. 

The banks in both time periods experienced a significant expansion in their market capitalization, driven by a surging economy and rapidly expanding balance sheets.  The rapid expansion of the balance sheets of many of the Californian banks has gotten them in trouble, just as Texas banks in the 1980s.  While many of the Californian bank stocks have declined, I believe that they have much further to fall.

While I was not aware of the “Texas Ratio” until the MarketWatch article, I immediately put it to test on several of the Californian banks.  What I found was slightly horrifying and goes along well with my belief that Californian banks are in terrible shape, which I have wrote previously about here.

One bank that is in especially poor shape is FirstFed Financial Corp. (FED).  For the period ended 12/31/07, FirstFed Financial had non-performing loans of $180 million and loans less then 90 days delinquent of $236 million.  This gives you a total of $416 million.  The next step in determining the “Texas Ratio” is to divide $416 million by the bank’s equity capital and its allowance for future loan losses.  FirstFed Financial as of 12/31/07, had an equity base of $654 million and $127 million in loan loss allowances for a total of $781 million.  If you divide $416 million by $781 million you can find the “Texas Ratio.”  For the period ending 12/31/07, First Fed Financial had a “Texas Ratio” of 53%. 

Now let's compare this to FirstFed Financial’s “Texas Ratio” on 3/31/08.  The company had non-performing loans of $395 million and loans less then 90 days delinquent of $273 million, for a total of $668 million dollars.  Now turning to look at the bottom numbers, FirstFed Financial had shareholders equity of $586 million and $233 million in loan loss allowances.   These numbers give you a “Texas Ratio” of 82%, a substantial increase from the previous quarter, and a sure sign that the bank is being put under tremendous stress. 

When making these calculations it is important to do a little research.  It is incredibly difficult to find the exact figure of loans that are less then 90 days delinquent.  Most banks, unlike FirstFed Financial that to its credit has done a good job of disclosing issues to its shareholders, fail to disclose the number and dollar figure of these loans.  The non-performing loans that show up in the quarterly reports are by and large only those that are more then 90 days delinquent.  In order to come up with the less then 90 day figure you must go to the FFIEC website and input the name of the bank (not the publicly traded holding company), I discussed the FFEIC website in greater detail in my First Marblehead article which can be found here.

However, the situation in California today is slightly different then the situation in Texas during the 1980s.  That is why I believe that a “California Ratio” needs to be created.  While I am not sure what it should be, I do know that it needs to include two things, both of which are exemplified in FirstFed Financial.  First, it needs to include the real estate owned as the banks are quickly accumulating foreclosed homes, which are incredibly hard to value and are worth nowhere near the value of the mortgage taken out on them.  As of 3/31/08, FirstFed Financial had over $45 million dollars of real estate on its books, and, in my opinion, this should be subtracted from the equity portion of the balance sheet, or at the very least, discounted. 

Another key issue for the Californian banks is the number of impaired loans that they have.  If I understand the term correctly, one way a loan can be impaired is if the collateral behind the loan no longer supports the loan.  For example, a house that has not yet been foreclosed on, but is worth far below the mortgage still being paid on by the homeowners can be considered an impaired loan.  In the period ended on 3/31/07, FirstFed Financial had $131 million of impaired loans and I would imagine that in any new “California Ratio” would need to have these taken into account, as they are surly a harbinger of the future level of non-performing loans.

In valuing FirstFed Financial by the “Texas Ratio,” we see that currently 82% of its shareholders equity has been impaired and will likely be lost.  However, if we use any type of “California Ratio” that limits the value on the asset side provided by the real estate owned portfolio as well as that of the impaired loans we can see that shareholder equity at FirstFed Financial has been eliminated, giving the stock price a value of zero. 

For Further Review:

• FirstFed Financial's 10-Q

Disclosure: None

Comments

[paulmars]

FED is dead.
Rode it all the way down from the $50s...puts are still a good buy for the final descent.

[E Nuff Sed]

Great analysis. I was unfortunately long and have lost a few thousands. I was not aware of the "texas ratio" analysis. The short interest on FED is substantial, indicating that many sophisticated market players feel as the paulmars does above that FED is dead.

However is real estate has been re-possessed it has to be valued at market prices as per FASB so writing them off (or devaluing them) further is unnecessary. Therefore I am not sure of your "california ratio" analysis.

Interestingly there is a lot of insider buying, which would suggest that insiders are more confident than you are. As usual time will tell.

[SantaMonica Owl]

First Fed says that it stopped doing subprime lending (or at least the worst forms of it) in the summer of 2006. If accurate, First Fed logically should have fewer forthcoming quarters of pain than some of its competitors that didn't pull back until the summer of 2007. Anyone have more detailed information about this?