Why the Odds Favor TARP Bank Investors

by: Kerrisdale Capital Management

SNL Financial recently reported “91 Institutions Defer May’s TARP Dividend”. The implication is that banks can’t make TARP payments, but this doesn’t seem to be the case for every bank on the list. Some banks aren’t being allowed to pay dividends by regulators even though it’s not likely to put the banks in jeopardy. For some banks, not paying dividends might make sense, especially if the preferreds are non-cumulative or if they’ve borrowed money (or have other preferred shares) yielding more than 5%.

What makes the TARP situation confusing is that funds can be viewed as a bank’s saving grace or a terrible headache depending on whether you’re a regulator, management, or a shareholder. For a short background on how to analyze banks and understand TARP, we recommend our readers check out our Primer on Banks before continuing.

From the regulators’ point of view, preferred shares represent equity and increase bank stability. But the benefits only go so far. From speaking with management teams, we learned that some banks were “advised” to take TARP funds even though they really didn’t need it. In the case of Commerce National Bank, regulators suggested the bank accept TARP money, but then wouldn’t let the bank pay dividends despite a healthy capital structure. Regulators cited negative retained earnings as a concern (not negative shareholder equity). However, a few months later, regulators allowed the bank to fully repay TARP in one lump-sum. Commerce National wasn’t deemed financially stable enough to pay a 5% dividend, but repaying TARP wasn’t a problem? This doesn’t make sense, and we’re sure government intervention has created other “inefficiencies” as well.

For shareholders, there are two good reasons to skip TARP payments. From the shareholders point of view, TARP isn’t equity, it’s debt yielding 5%. If the bank is paying more than 5% on any of its capital (preferreds included), it makes financial sense to keep TARP in the financial structure. Also, some TARP preferred shares are non-cumulative, meaning missed dividends don’t have to be repaid. After 6 missed dividends, regulators appoint two directors to the board, limiting how long interest-free TARP can last. But in the cases where TARP preferreds are non-cumulative, there’s no incentive to pay until the six quarters are up.

From management’s point of view, TARP funds can potentially be a nightmare, bringing limits to executive compensation, increased oversight, increased reporting requirements, as well as reputational risk when depositors think TARP is a sign of weakness. The compensation limits explain why the big banks repaid TARP asap, but unless a bank has an unusually high cost of capital, it’s difficult to imagine why a management team would want TARP.

With an understanding of whose interests lie where, we can run some simple screens on the list of 91 dividend transgressors to see if there might be any decent banks. We looked at what percent of capital is comprised of TARP, the regulatory capital ratios, loss allowances, Q1 annualized charge-offs, net interest spreads, net non-interest expenses, and deposit growth. The banks that screened best on these metrics are presented below: (Click to enlarge)

For comparison purposes, we can compare these banks to the top-ranking banks in a study put together by Linus Wilson and Yan Wu that attempted to predict which TARP recipients will be most likely to repay TARP funds. The analysis can be downloaded here, and we look at the top 5 picks below: (Click to enlarge)

We can see from this that there are some key differences. The TARP recipients in the Wilson-Wu study have less TARP in their capital structure, are better capitalized, and are generally much larger resulting in a lower average non-interest expense ratio as economies of scale take effect. That being said, the difference in quality is more than reflected in the market valuation.

Our seven dividend transgressors have combined interest earning assets totaling $17 billion, compared to $125 billion for the healthy group of five. However, the dividend transgressors have a market capitalization of $450 million compared to the healthy group of five’s market capitalization of $17 billion. If the transgressors were equivalently valued, they would be worth $2.4 billion.

This means that if investors bought a basket of these dividend transgressors, 5 would have to fail for every 1 of the higher ranked current TARP holders for the valuation discrepancy to make sense. We have no doubt that some of the dividend transgressors will go bankrupt, and some of the better ones we’ve isolated above may also go bankrupt. But an 81% failure rate seems high, even for a basket of generally weak companies.

Investors should also keep in mind that TARP recipients were initially isolated because of their relative financial strength. Of the 227 banks that have failed since 2009, only a handful (somewhere in the range of 5) have been TARP recipients. For anyone who wants to check that, the list of TARP recipients can be found here. The list of failed banks can be found here. So despite the general pessimism, the odds seem to be in favor of TARP bank investors.

Disclosure: No positions