Northeast Bancorp Using Cheap Leverage To Buy Distressed Mortgages

| About: Northeast Bancorp (NBN)
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Northeast Bancorp (NASDAQ:NBN) is a community bank primarily operating in Maine. Its business model pre-2010 involved taking in deposits, lending out vanilla commercial and residential mortgages, and providing insurance services. In 2010, an entity called FHB Formation LLC acquired the company and has done a few things: sold the bank's insurance division in order to increase the bank's equity (more specifically, the Tier 1 capital), started a loan purchasing program that buys mortgages at a discount, and recently issued more equity to further increase Tier 1 capital.

Some facts pulled from the most recent 10Q and a 10K (Note: I've adjusted all numbers for the recent stock offering):

  1. Tier 1 capital includes the common stock and preferred stock of the bank and is important because, by regulation, the bank is required to have 10% of its assets as Tier 1 capital.
  2. Currently, Northeast Bancorp has around $114 million of Tier 1 capital, post-raising $55 million through its public offering.
  3. After adjusting out the preferred shares, book value of equity is around $110 million.
  4. Northeast Bancorp's average cost of debt is 0.94%.
  5. Northeast Bancorp is allowed to invest 40% of its assets in its loan purchasing program, which is called LASG (Loan Asset Servicing Group).

Doing some number crunching, this means that Northeast Bancorp can increase its assets up to $1.14 billion by raising more deposits. It can use $456 million of these assets buying discounted mortgages.

Here are some other numbers, this time on insider buying:

  • The current CEO Richard Wayne, who was the CEO of FHB Formation LLC that acquired Northeast Bancorp, bought $1.5 million worth of Northeast Bancorp common shares in 2010 during the acquisition, and an additional $1 million worth of common shares during the recent share offering.
  • Claire Bean, CFO and COO, bought $1 million worth of shares during the FHB acquisition and bought another $500 thousand worth of shares during the recent share offering.
  • Heather Campion, CAO, bought $500 thousand worth of shares during the initial offering and $120 thousand worth more during the share offering.

It is important to note that none of these purchases were option exercises, and were purchased using the executives' own money.

These are the facts. Here is my interpretation: Northeast Bancorp will continue holding deposits and issuing loans, but the primary source of upside -- and why the current management bought into the company and continues to contribute capital to the firm -- is the loan purchasing program. The company now most resembles a hedge fund specializing in distressed debt more than anything else, and as such should be valued as one.

Publicly traded closed-end funds have traditionally traded at a 90% discount to net asset value (NAV). Book value of equity adjusted for intangible assets is a good measure of NAV for Northeast Bancorp because all tangible assets are financial (cash, mortgages, and securities). There are only $4.7 million net worth of intangibles on the books, so adjusted book value of common equity is around $105 million. Applying the 90% discount, a valuation of $94.5 million is arrived at for the market capitalization of the company, which translates to a valuation of ~$9.1 per share.

Anything below this price is worth buying, because the upside is much higher than $9.1 per share. Hedge funds/investment partnerships should be bought into if you believe the strategy they are applying will succeed. The three reasons why Northeast Bancorp's strategy will succeed, and potentially very drastically, is its cheap leverage, the multitude of distressed mortgages available, and its chief executive's experience in this field.

Northeast Bancorp has a huge interest rate advantage on hedge funds. For example, Fortress Investment Group currently has terms of Libor +4% interest rate on its debt. Compare this to Northeast Bancorp's 0.94% average cost of debt. This ridiculously low rate is the result of FDIC insurance, which effectively makes federal government the cosigner on all of Northeast Bancorp's depository debt, up to $250,000. This low risk of default drives the cost of Northeast Bancorp's debt down, while letting it leverage its assets to equity in a 10-to-1 ratio. This provides highly leveraged upside potential if the purchased loan portfolio performs well.

As for why distressed mortgages are available, read more here, here, and here. For those not familiar with distressed debt investing, here is a good primer. It's basically buying debt when it's sold at a discount. If investors are able to recover more from the loan than they bought it for, they make a profit.

Essentially, this area relies on the same principle behind all good investing: buying assets when the market sells them below their intrinsic value. Distressed investing requires careful analysis and also the ability to recover cash from the specific type of debt effectively. In this case, that means having experience with servicing mortgages well.

As for experience, this is CEO Richard Wayne's second turn at bat, having performed well in an earlier period with a similarly distressed loan environment:

In the early 1990s, Lazares and Wayne found the niche that would become Capital Crossing's identity. With banks going out of business, there were loans to be bought from regulators, such as the FDIC, that had taken over banks but weren't going to keep the assets.

I did some snooping to see what happened with Capital Crossing Bank, which was mentioned in the article. I found in an old SEC form:

Richard Wayne, Chief Executive Officer and Director, 57, co-founded Capital Crossing Bank (formerly known as Atlantic Bank) located in Boston, Massachusetts in 1988. He served as President and Co-Chief Executive Officer from 1991 until its sale in February 2007. Capital Crossing Bank, a national leader in the acquisition and management of loans secured by commercial and multifamily real estate and business assets, purchased loans with aggregate customer balances in excess of $2 billion. Capital Crossing went public in 1996 at a split adjusted share price of $3.375 and was sold in 2007 for $30 per share.

I was able to verify the sales price of $30 per share; $3.375 to $30 in 11 years is a CAGR of slightly more than 20%.

So far the strategy has paid off for Northeast Bancorp as well, with the return on the portfolio of purchased loans averaging around 15% (pulled from the 10Q). Northeast Bancorp is continuing to increase the size of both this portfolio and its capacity to loan out more through programs that increase the amount of deposits.

In conclusion, Northeast Bancorp's common stock offers asymmetric returns. In the worst case scenario, the expected value of the stock should be $9.1. In other scenarios, the stock is worth significantly more in the long run.

Disclosure: I am long NBN.