The last articles I have posted on this site have been bearish towards equities and bonds, and I have been very critical of financial institutions in this current economic environment. In this article, I’d like to talk about my favorite bank, and why you should not buy their shares in the near future.
Dime Community Bancshares , Inc. (DCOM) is the parent company for the Dime Savings Bank of Williamsburgh, founded in 1864 and headquartered in Brooklyn, New York. The company has $3.74 billion in consolidated assets as of June 30, 2008, and has 22 branches located throughout Brooklyn, Queens, the Bronx and Nassau County, New York. For those of you who have a penchant for a huge mega-bank, this would be a good point for you to stop reading this article and go back to watching your stock holdings decline.
If you ever have the opportunity to take the train over the Williamsburg bridge from Manhattan to Brooklyn, you can see the historic domed Bank of Williamsburgh as the train pulls into the Marcy Avenue station. However, you can’t transact business in that beautiful edifice because the bank sold that property long ago. There is another beautiful branch building, again in the classic sturdy Romanesque style which was sold to WaMu several years ago. You see, the bank threw off the old trappings of excess and prosperity for an extremely humble profile. That humble profile helped it get through the worst of the credit crisis and they reported net earnings of $8.4 million, or 26 cents per diluted share for the quarter ending June 30, 2008 compared to $6.0 million per diluted share, for the quarter ending March 31, 2008 and $5.6 million, or 17 cents per diluted share for the quarter ending June 30, 2007.
Just to get things in perspective – during a period of time where almost all banks reported net losses for the past 4 quarters, this small bank has reported steady positive earnings and expects earning in the next quarter between 24 and 26 cents per share. You can look at the stock price and see that the stock price has rose 5 percent in the past year while I have watched the mega banks plummet into the basement.
So how did they do it? Very simple. The bank has been committed to portfolio lending. Instead of underwriting loans, warehousing them to six months and sending them off to a CMO trust or another servicers, each loan that the bank has underwritten has received careful scrutiny from their credit committee. The New York City metropolitan area has also seen home prices remain relatively high, with an exception of poorer areas in Brooklyn and Queens where the larger subprime lenders feasted and now reap a harvest of sorrow.
Finally, low interest rates from the Federal government to shore up the big boys allowed the bank to stop trying to compete with internet banks for deposits in high yield CDs giving them a bigger lending margin. In their July 23, 2008 earnings report, the bank alluded to adding a new branch on Montague Street, which means that perhaps JPMorgan Chase will give up the lease in their landmark building for the Little Bank that Could. If you take the time to read through the earnings report and balance sheet, you will be very impressed with a bank which runs extremely lean and runs its business as a conservative, portfolio based lending institution.
So should we buy? To quote Lee Corso, former football coach and co-host of ESPN’s College GameDay, “Not so fast, my friend!” There are many reasons to hold off on investing money in this solid, well run bank which have everything to do with external factors outside the bank’s control.
First, the bank purchased $83 million in mortgaged-backed securities during the June 2008 quarter, using available liquidity from deposit inflows that occurred late in the March 2008 quarter. The earnings report states that these securities were short-term, fixed rate agency obligations, all possessing the highest possible credit rating. In other words, the bank took on CMOs which cost ten times their profit in this quarter. In my opinion, there is no amount of yield on these securities which would warrant purchasing any CMO. Dime Savings Bank has the luxury of owning loans in a part of the country which has largely escaped the massive devaluations that Miami, Las Vegas and California have suffered. I have no idea which properties are used as securities for these obligations or which entity insured them. It just doesn't make sense that if you have one of the strongest housing markets in the United States why you would reach out and take on more risk outside of your backyard. And who is going to pony up if there are defaults? Ambac? XL Capital? MBIA?
In my humble opinion, the risk is too great even with Paulson and his cronies bailing out anyone in a bespoke suit with their hand out. There has been much debate over which are “good” or “bad” CMOs, but if Cadwalader, Wickersham and Taft fires 95 attorneys in the secured mortgage bond underwriting division because no one is asking for them anymore, there is no reason to buy them at all. On a balance sheet which is refreshingly transparent down to each individual loan, the vague nature of the maturity, origination and indemnity of these CMOs should give anyone pause.
Second, while New York City’s property values have remained high, there is no guarantee that they will stay high or that the credit crunch will contribute to their decline. I have had clients purchase properties in the Bronx for $750,000 and a year later, negotiate short sales for $250,000. Those are isolated incidents and certainly not the norm, but for a small operation such as DCOM, a few large writedowns could be devastating.
Next, it is important to note that most small banks hold shares of stocks of other small banks to signal confidence in the system as a whole. Other small regional banks who have not been as foresighted as DCOM are experiencing writedowns after experimenting with CMOs and subprime lending. As those banks falter, the value of their securities on DCOMs balance sheet may fall as well. This means that even if Dime Savings Bank does great, it’s holdings in its less prudent colleagues may drag down the balance sheet as a whole. With only $8.4 million in profit off of a balance sheet of $3.74 billion, there is just a small margin for error.
Finally, while the Fed has gone to great lengths to provide a liquidity backdrop to every company with a squawk box and a Bloomberg Terminal, there is still the chance that the Fed may raise rates if commodity prices rise again or if inflation continues to rise, especially as the winter approaches, where home sales historically fall and home heating oil bills cause homeowners to cut back on discretionary spending. It may very well be that the Fed is forced to raise rates at some point. Dime Savings Bank will not be able to reap the benefits of wide margins from the discount window to loan origination and will be forced to compete for more deposits through higher CD and interest accounts, lowering their profit margins. A lame duck presidency will not provide any clarity towards Fed action until the pain is palpable. Dime Savings Bank's forward expectations toward the next quarter’s earnings assumes rates will remain the same. As investors, it is too risky to share that assumption if we are looking for a meaningful ROI.
DCOM could be the flagship success story of the current small lender industry. For many years, investors have been lulled into a false sense of security as banks grew in size and securitized anonymous loans through the internet, sold off to unsuspecting investors with limiting recourse. The pain of the financial sector is the direct result of this get-rich-quick mentality. Dime Savings Banks commitment to portfolio lending in a stable housing market combined with brick-and-mortar retail banking is a refreshing alternative to the reckless business practices of the bigger banking conglomerates. If the government has the temerity to raise rates and drop inflation, a 5 % increase YOY for a bank investment is a normal and prudent rate of return. However, until national home prices stabilize and the reckless banks are culled from the herd, we’re better off watching from the sidelines until the dust clears.
Disclosure: Author holds SKF