The Trouble With Regional Banks

Jan. 14, 2011 11:11 AM ETKRE, ASB, RF, ZION36 Comments
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By Mike McDermott

The mortgage market is one giant twisted mess…

I’m sure that statement doesn’t come as a surprise to anyone who has been paying attention for the last 36 months. But just in case you thought things were starting to get better, let me set the record straight:

The mortgage market is STILL one giant twisted mess!

Consider the most recent legal development from Massachusetts. In what appears to be the final verdict for US Bank vs Ibanez, the state court ruled that if a bank can’t prove that it owns a mortgage, then it cannot foreclose on a home.

That sounds like common sense, but considering the paperwork fiasco laced with fraudulent activity, it may be difficult for many of the nation’s banks to actually prove ownership of individual mortgages. In the case of US Bank vs Ibanez, the bank apparently still has the right to pursue repayment for the loan. But without mortgage rights, this becomes an unsecured loan which is obviously much more difficult to collect. From The Wall Street Journal:

The Massachusetts ruling is especially significant… the decision suggests foreclosure-related problems aren’t merely procedural, as banks have argued. Rather, documentation issues may call into question the actual ownership of billions of dollars of mortgages bundled into securities and sold to investors.

From a consumer perspective, this is actually quite sobering. Residents who are currently living in a home and unable to pay their mortgage may very well be able to avoid foreclosure. But anyone who stepped in and bought a foreclosure over the past two years may be in jeopardy of losing their investment.

If the court precedent set in Massachusetts is adopted or simply becomes influential in other states, the seemingly clear-cut issues of ownership will become grey – a giant tangled mess that could be very expensive and time consuming to unravel.

Banks Bear the Brunt of the Risk

From the perspective of financial institutions, the news couldn’t be any worse. Mortgage loans are traditionally made with the property deed as collateral. Not too many banks would be willing to offer a middle-class citizen a $200,000 loan without a legitimate piece of property as a guarantee.

Today, not only are the values of these properties significantly below peak levels (and most-often below the original loan value), they may now be out of reach when it comes to foreclosure proceedings. Washington has proposed many different solutions in an attempt to allow borrowers to continue to live in their homes, but this new court development has the potential to circumvent property rights as we currently know them

Of course the Massachusetts verdict may be an extreme when it comes to treatment of mortgage documentation. But rising conflicts with mortgage documentation, issues of ownership, fraudulent underwriting activities and securitization are certain to slow down the foreclosure process. This means banks will have to continue to sit on nonperforming loans or write them off as worthless (damaging balance sheets in the process).

Unfortunately, the verdict out of Massachusetts could easily ignite a self-reinforcing loop where consumers abstain from paying mortgages, understanding that the foreclosure process will be severely delayed – or even cancelled outright. All the way back in June we discussed the potential for “strategic default,” or consumers willingly choosing not to pay mortgages on underwater properties for strategic reasons (rather than because of a hardship).

If banks are forced to accelerate write-downs of non-performing loans, capital ratios will be affected. As a result, depositors and lenders to the bank perceive more risk and require higher collateral or higher rates. Increased costs of funding and liquidity crises may very well return to financial markets in 2011 – and regional banks with fewer political liaisons and less access to government capital will likely be the primary victims.

Rebounding Financials, and Regional Risk

During the past several weeks, the financial sector has seen quite a rebound. Investors are becoming more comfortable with bank stocks, and a good bit of this optimism stems from a settlement agreement involving mortgage put-backs.

According to the Wall Street Journal, Bank of America (BAC) agreed to pay Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) almost $3 billion to cover bad mortgages originated by the bank and sold to the GSE’s. It sounds like a tough break until you read Barry Ritholtz’ assertion that this payment covers all future claims on $127 billion in loans sold by Countrywide through 2008.

Investors quickly realized that the major banks are essentially getting away with a simple “slap on the wrist” instead of what could have been a much more crippling punishment. In turn, financial stocks of all shapes and sizes were bid higher – including the regional banks.

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But this good news really doesn’t apply to the regional banks who are not struggling under the weight of fraud issues, as much as they are struggling with souring loans still on their books.

On January 7th when the US Bank vs Ibanez verdict was announced, regional banks began to falter (see chart).

Given the magnitude of both residential and commercial real estate lending in this area, the regional banks look vulnerable as a group.

Regional banks don’t typically have high-power proprietary trading desks or large fee-based services like investment banking or ultra-private wealth management. So with loan delinquencies still a significant challenge, and the right to foreclose now potentially off the table, many of these banks could drop significantly – and even face insolvency.

Employment Adds Additional Risk

Regional bank loan risk is compounded by a weak employment environment. Last week, the non-farm payroll report failed to meet expectations, and while the unemployment rate actually dropped to 9.4%, the improvement was due to a statistical decline in the labor force, not because of an actual increase in jobs.

According to the American Bankers Association, the difficult employment environment continues to support high levels of delinquent loans. From Bloomberg:

Overall delinquencies across eight loan categories rose to 3.01 percent of all accounts in the three months ended Sept. 30 from 3 percent in the preceding quarter, the ABA said today in its Consumer Credit Delinquency Bulletin. Most of the increase was attributable to delinquencies on home-equity lines, auto loans and credit cards…

Until we see employment pick back up, and the housing / mortgage issues unwinding, regional banks will see little improvement in their balance sheets. From a trading perspective, it appears the January 7th verdict will turn out to be a key turning point for the sector – offering short opportunities for nimble traders.

Below are three regional banks that look particularly attractive (for bears) today:

Associated Banc-Corp (ASBC)

Midwest bank struggling to improve the quality of its loan portfolio.

Significant loan sales may have simply liquidated best (marketable) loans while keeping problems in-house.

Charge-offs increased in the last quarter, a red flag for recovery.

Stock multiple leaves plenty of room for disappointment.

Associated Banc-Corp operates in Wisconsin, Minnesota and Illinois; and has been working hard to restructure its troubled loan portfolio.

The company boasts $23 billion in assets, $12 billion in loans and a healthy deposit base of $17 billion. But like most regional banks, ASBC has been struggling with non-performing loans and high delinquency rates.

Management has been working aggressively to contract the company’s balance sheet, with total loans down 24% from the fourth quarter of 2008. ASBC has been actively selling bonds to whittle down its exposure level – while at the same time, taking significant charge-offs to its portfolio each quarter.

The lower level of loan exposure may give the company less “face-value risk” as these loans are transferred to third parties, but whenever a financial company divests assets to manage risk, there is the question of which assets are actually sold.

Typically, one of two approaches are taken. Either the company divests its strongest assets at reasonable prices (leaving the remaining in-house loan book even more vulnerable), or the problem loans are sold – but at a significantly reduced price.

(Click to enlarge)

Time will tell whether the remaining loans on ASBC’s books are of high-quality or not, but a rise in charge-offs in the third quarter raises suspicions.

ASBC will report earnings on Thursday, January 20th after the close. Investors will be listening carefully to hear what management has to say about the credit quality of the loan portfolio.

As noted in the graphic, non-performing loans have declined from a peak of 9.1% of the book to 6.6% over the last two quarters. Commercial real estate makes up the largest portion of non-performing loans – a segment that has been much slower to improve than the bank’s exposure to construction loans.

If non-performing loans do not continue to improve, analysts could begin to question their earnings and equity assumptions for the year ahead.

From a valuation standpoint, ASBC is trading at a healthy “growth stock” multiple. The consensus expectation is for the bank to generate EPS of $0.60 in 2011 – a significant improvement from red ink in 2009 and 2010. Investors are paying more than 24 times earnings for this turnaround story, and yet regional banks like ASBC still face significant risks to their asset base.

So far this year, ASBC stock is off about 7% after testing its recovery high on January 3. Last week, the stock sliced below the 20 EMA and should continue to weaken as the sector contemplates the ramifications of the Massachusetts verdict.

ASBC could easily test the low side of its 2010 range (near $12.00) and if the foreclosure mess continues to gather momentum, ASBC could break below $10.00 like it did during the height of the financial crisis.

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Regions Financial Corporation (RF)

Problem loans are coming to the surface just as fast as the company can sell them.

Deleveraging consumer creates challenges for new loan production.

Stock is trading at 0.5 times book – but appears to be a value trap.

To give the Regions Financial management team fair credit, executives know they have a problem…

(Click to enlarge)

Regions has been aggressively disposing of its problem assets for a number of quarters now, with a full $1.04 billion of these loans sold in the third quarter alone.

The mid-tier banking institution is headquartered in Birmingham Alabama, and has captured significant market share throughout the Southeast.

Since this region (no pun intended) has been well known for its real estate rise and fall, Regions has its hands full with a portfolio of loans that have continued to weaken.

Despite the aggressive sales of troubled loans, Regions has seen little improvement in the level of non-performing loans. This indicates that new problems continue to arise as consumers and businesses struggle to keep up with payment schedules.

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Similar to Associated Banc-Corp, I am concerned that the asset sales could represent the company’s strongest loans – and so while needed capital is raised, and the headline loan values decline, the quality of remaining loans may be below investors’ expectations.

From a valuation perspective, there are two very different ways of looking at this company. From an earnings perspective, an investment in RF has very little merit. Regions lost $1.27 per share in 2009 and lost $0.77 in 2010. The consensus expectations for 2011 are for the company to barely break even and generate four cents per share.

Alternatively, long-term investors could look at the company’s book value which gives a very different picture. RF is currently trading at just 0.5 times the reported book value per share – meaning you can pick up $1.00 of assets for every $0.50 you invest in the company.

The problem is that the value of these assets are highly suspect. I can’t tell you how many analysts made the same argument for Lehman Brothers and Bear Stearns just a few quarters ago.

The stock has rallied with the financial sector and is now sitting just below resistance in the low $7.00 area. Traders haven’t pushed the stock down with the regional bank group quite yet (possibly waiting for the January 25 earnings announcement), but a drop below $6.90 would get my attention.

If RF begins to weaken ahead of the earnings announcement, and the regional bank area confirms the bearish action, RF could be an excellent short candidate with plenty of room for profits before hitting support near $5.20.

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Zions Bancorp (ZION)

Significant portion of the bank’s loans are non-performing.

Charge offs represent a material portion of loan values quarter after quarter.

Loan levels continue to drop despite billions of new originations.

Zions Bancorp operates in the western US states – a particularly troubled area when it comes to jobs, real estate, and loan quality.

Like many regional banks, Zion has been actively disposing of assets, selling troubled loans and writing off assets regularly each quarter. The level of these charge offs has become quite disturbing as the company has written off nearly 7.5% of its loan values in the first three quarters of this year alone.

For the last five quarters, the company’s non-performing assets (more than 90-days delinquent) have hovered around the 6% mark despite aggressive dispositions.

(Click to enlarge)

Management appears to believe that the company can underwrite new loans that are better quality than the current assets because the firm is actively lending out capital with nearly $2.5 billion in new originations last quarter.

Despite the aggressive lending practices, ZION has experienced declines in its gross level of loans - due primarily to charge-offs and selling distressed assets at a discounted price.

After losing $6.13 per share in 2009 and another $2.21 (expected) in 2010, analysts expect ZION to post a positive year in 2011 with EPS of $0.40

The company reports fourth quarter earnings on January 24th and investors will be anxiously awaiting further information on the company’s loan quality and prospects for the coming year.

With employment still struggling to recover, and California’s economy in sad shape, it’s difficult to see how management could instill much hope of sustained recovery.

A quick word of caution here… ZION has very high short interest, meaning there is significant capital shorting this name. Traditionally, traders wish to avoid shorting stocks that are already crowded because there is a higher risk of a short-squeeze – with all bearish traders hitting the exits at the same time.

I view the situation a little differently, noting that so many are short this stock for a reason. ZION carries a significant amount of risk and while I respect the possibility of a short squeeze, I also respect the analysis that is behind the building of these short positions.

In this case, I would suggest picking a spot to short the name after some positive action has shaken the weak bearish holders out. The late December ramp could serve as an example, and now a drop below $23 or $24 could lead to aggressive pressing by short sellers.

With risks to the company’s loan portfolio, economic strain in western states, and an uncertain earnings environment, ZION should be an excellent regional bank short.

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Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.

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