Regional Banks: Defining the California Ratio

Valuing regional banks is a difficult task during even the best of times.  During times such as these it becomes a crapshoot.  This is especially true in areas like California where banks find themselves straddled with homes they don’t want and loans that have become under collateralized do to the fall in housing prices.  In addition to experiencing these issues, banks are also facing the typical run of the mill issues related to a weakening economy.  In areas like California, this has created a perfect storm for state’s community and regional banks. 

The survivors of this storm will be able to dominate a market that in good times, with relatively light competition, could potentially produce phenomenal returns.  As a result, it is important to pick the winners as the losers will surly be absorbed by the strongest banks, taken over by the Federal Reserve or be forced to sit out of the next upswing in the market as a result of a weak balance sheet that has been damaged by the current crisis in the housing and credit markets.   Hedge funds and other smart investors have already begun to look at many of the California banks.  The news last week that Jana Partners has taken a 9.9% stake in FirstFed Financial (FED) is but one example of many more deals to come.  Not all of these investments will be prosperous as these banks still have substantial issues.  To begin investing in these banks it will be important to be able to assign adequate value to the companies you are examining.  One way to do this is to use financial ratios that show the banks remaining available equity after accounting for troubled loans.

I talked about one such ratio last week in my article on the Texas Ratio, which can be found here.  The bank that I used to exemplify the ratio was surprisingly enough FirstFed Financial.  The Texas Ratio, as I discussed in the article linked to above, was developed by Gerard Cassidy of RBC Capital Markets in the 1980s.  Cassidy defines the calculation of 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.”

In the case of FirstFed Financial, the bank had a Texas Ratio of 82% at the end of the most recent quarter, leaving just 18% of equity unimpaired in anyway.  In my opinion this is just enough of a cushion to get yourself in trouble as it is too early in the cycle for a bank to be in such a poor position.  The Texas Ratio while being a great early warning system for banks that are in trouble can be refined in my opinion to account for the current situation in California.  These refinements will in my opinion make it a better, more fool proof, tool for measuring the health of banks in California and those in other areas where banks may find themselves swamped by rapidly declining housing prices. 

In looking at many Californian banks, it is clear that they all face many of the same problems.  The vast majority of the banks in question have seen their real estate owned portfolios surge as a result of increased foreclosures.  The real estate is carried on the balance sheet of the banks as an asset, the value of these properties though is questionable and most likely far less then what was originally assigned to them by the bank.  The other asset on the bank’s balance sheet that has ballooned is the number of impaired loans.  The number of these loans has soared as banks reassess the value of the collateral behind their loans.

In creating a new California Ratio to supplement the Texas Ratio, these two issues must be addressed.  Discounting the value of the banks real estate owned portfolio and that of its impaired loans will allow for a much more accurate ratio capable of signaling out troubled banks faster then the Texas Ratio.  The use of this ratio should allow you to sort through the Californian banks faster, in search of one that will make it into the next cycle.  In my opinion, you can define the calculation for the California Ratio as the following:

Calculate the California Ratio by dividing the bank’s non-performing loans (including those less than 90 days delinquent) by the company’s tangible equity capital and the money set aside for future loan losses.  The tangible equity capital should be marked down to account for a reduction in value for the bank’s real estate owned portfolio and its impaired loans.  The bank’s real estate owned portfolio should be marked down to 50% of its stated value while the bank’s impaired loans should be carried at 80% of their stated value.

The California Ratio should allow investors to more properly value the banks that they are examining.  In carrying the real estate owned portfolio at half its stated value you are accounting for the costs of foreclosure and housing price declines since the loans were issued.  The reduction of the value assigned to the bank’s impaired loans will allow you to build into your estimates the damage that will come about to the banks capital base as it should allow you to see future loan losses and foreclosures before they are officially booked on the banks balance sheet. 

For Further Review:

Statement of Ownership in FirstFed Financial by Jana Partners 

Disclosure: None

Comments

[Tim Plaehn]

How about a chart showing the CA ratio of some of the CA regional banks?