US Banks: The Good, the Bad, and the Ugly

Includes: BBX, COF, WMIH
by: Christopher Whalen

We turn away from the GSE mess to focus on the diversity of results in the Q2 numbers for the US banking sector. While overall the financial result for the US banking population is poor, some recognizable names such as Well Fargo (NYSE:WFC), US Bancorp (NYSE:USB) and BB&T (NYSE:BBT) continue to perform strongly. In fact, as of the first quarter of 2008, IRA's analysis to support research on credit conditions suggests that just eight percent of US bank units display evidence of stress and should be the focus of an initial round of industry remediation work.

When we roll out the beta version of our credit conditions index with the Q2 regulatory dataset, subscribers to The IRA Bank Monitor will be able to display specific institutions and groups of banks based upon relative credit stress factors. What our observations suggest is that the vast majority of US banks are not evidencing extreme stress in terms of lending capacity and, for example, are far below average risk when viewed based upon metrics such as ratios of Economic Capital to Tier One Risk Based Capital.

Thus while the financial media tries to whip up public panic by publishing scare stories about a few highly visible, specific institutions, the reality is that the vast majority of US commercial banks are relatively stable - even if they are under growing earnings stress due to macro economic factors. Some analysts publish lists of doomed institutions for the pleasure and profit of their hedge fund clients, but we prefer to ponder what adjustments need be made to get the system back into balance and thereby restore investor confidence. Seeking to deliberately destroy the depository institutions which underpin our society hardly seems a good use of time, but some people call this work.

Let's take three actual examples styled after the Clint Eastwood film The Good, The Bad and the Ugly, to illustrate that not everybody is losing money in the banking world, but also that telling truth from spin remains as difficult as ever.

The Bad: BankAtlantic

Take the litigation announced this week between BankAtlantic Bancorp (NYSE:BBX) and Ladenburg Thalmann & Co. [LTS] and its veteran bank analyst Richard Bove. BBX owns about 100% of BankAtlantic, a federal savings bank (FDIC Certificate #30559) located in Fort Lauderdale, FL. In February of this year, BBX completed the sale of Ryan Beck Holdings to Stifel Financial Corp (NYSE:SF).

BBX claims that Bove's July 14, 2008 analysis, entitled "Who is Next?", erroneously included the bank's parent and a related holding company, BFC Financial (BFCF), among a list of troubled banking instititutions. "While Bove's report purports to consider which banks might fail, he failed to examine the health of the banks and thrifts in his report,'' BankAtlantic Chairman Alan Levan said in the statement. "He only examined holding company data which, in at least our case, is meaningless information.''

Looking at the financial data submitted by BankAtlantic to federal regulators in Q1 2008, the bank does seem to evidence mounting signs of stress in its loan portfolio. The bank was in loss in Q1 and reported $35 million in defaults during that period for an annualized run rate of over 300bp. But with 8.7% capital to total assets at the bank level as of Q1, BankAtlantic hardly seems like an emergency situation -- at least for now.

Subscribers to The IRA Bank Monitor, click here to view the QuickSheet for BankAtlantic for Q1 2008. Note the significant drop in the efficiency ratio in Q1 vs 2007, bucking the industry trend toward higher expenses.

Gene Stearns, lawyer for BBX, accuses Bove of mixing apples and oranges in looking at the financials of BankAtlantic's parent companies instead of the bank itself. Specifically, Stearns accuses Bove of wrongly using the financial data for the two upstream holding company vehicles, which own direct and indirect stakes in BankAtlantic and conduct significant other non-banking activities, to make comparisons regarding ratios of non-performing loans to total loans and total assets.

"Bove's `Danger Zone' was above 5 percent of non-performing loans to total loans and above 40 percent of non-performing loans to total common equity plus reserves,'' BBX said in the statement. "BankAtlantic's numbers are not even close.''

Click here to view the bank unit loan loss summary demo for BankAtlantic from The IRA Bank Monitor.

As you can see, the total non-accrual loans calculated for BankAtlantic as of Q1 ($57.6 million) by The IRA Bank Monitor, using "as filed" data from the FDIC, is 1.24% of total loans and leases ($4.624 billion). Total assets non-accrual and all past due for BankAtlantic totaled $101.6 million at March 31, 2008 or about 2% of total loans and leases. Not a very pretty picture, but not the end of the world either.

Stearns continues: "Had [Bove] used the FDIC data for BankAtlantic, he would have seen a well capitalized institution with problem loan ratios far better than the average bank or thrift." Of note, while Stearns concedes that all commercial banks operating in FL are likely to see loss rates rise in 2008, he argues that the rate of change in loan loss rates in FL is already slowing.

A Ladenburg spokesman told The IRA that the firm will fight the "meritless" lawsuit by BBX, but would not comment on BBX's specific allegations that Bove's analysis was flawed by the use of non-bank data in including BBX and BFCF on Bove's list.

The dispute between BBX and Bove illustrates, for us at least, why any analysis of US banking firms must begin with an inspection of bank level data from the FDIC. Only by comparing banks with other banks, we believe, are analysts able to properly perform peer comparisons when it comes to bank performance and credit factors. This is why IRA calculates a "bank only" rollup of BHCs to facilitate "apples to apples" comparisons with unitary banks.

The other analytical issue highlighted by BBX's lawsuit, in our view, is the question of mixing financial data from regulatory and other sources. One of the standing work rules at IRA is that each data source must be kept discrete and, wherever possible, maintained and displayed for users in "as filed" format. Thus the data obtained electronically from the FDIC and used in The IRA Bank Monitor and the Bank Benchmark tool on the American Banker web site is not altered from the "as filed" format used by the FDIC.

To that point, Stearns tells The IRA that BBX has contacted a data vendor that they believe was employed by Bove in performing his analysis and, further, that said data vendor admitted an error may have been made in integrating the regulatory and SEC data filings. If the vended data used by Bove was flawed as BBX attorney Stearns claims, then that data may have biased the analysis.

The IRA hopes that Dick Bove and LTS will respond directly to the assertions made by BBX. We're ready to listen as and when they start talking.

The Good: CapitalOne (NYSE:COF)

If we told you about a $30 billion asset national bank which reported 900bp or 9% annualized charge-offs in Q1 2008 and a lending return of nearly 16% or almost two standard deviations above the peer mean, you might suppose that this bank is in trouble. And you might be wrong.

In Q1 2008, the credit card unit of CapitalOne Financial boasted an ROA of 8%, an ROE of 50%, and a bank unit efficiency ratio of 43%. And all that with a default rate that is 2 SDs above peer. During the same period, COF did 2% ROA and ROE of almost 11%.

By the way, the Exposure at Default or "EAD" for Capital One Bank [USA], NA is 1,100% or roughly 10x the EAD for most large banks, which is normal in the credit card business. This is a fancy way of saying that the unused lines of this bank are $11 for every $1 currently drawn.

On a consolidated basis, COF's subsidiary banks generate less spectacular returns on the group's $132 billion in total assets than does the credit card unit alone. But remember that the card unit maintains 14% capital to total assets.

Could the comparison between Capital One Bank [USA] and COF illustrate why banks are not bank holding companies? When compared with COF, does a peer ROA of 5% and ROE of 31% for the Capital One Bank [USA] credit card unit peers ring any cow bells?

Subscribers to The IRA Bank Monitor, click here to view the bank unit profile for Capital One Bank (NYSE:USA).

Speaking of credit card default rates, it might interest readers of The IRA to know that on July 2, 2008, the Office of the Comptroller of the Currency released a "Statement of Objectives" for a "Data Analytics Reporting Tool." The solicitation, CC-08-HQ-R-0059, envisions the collection of monthly footings from credit card issuers such as COF, as well as enhanced reporting for Basel II and an expansion of reporting for Shared National Credits to a quarterly cycle.

So you see, we weren't barking mad when we wrote earlier about the impending modernization of "SNC" as it's known inside regulatory circles. See our comment in GARP Risk Review ("Regulatory Hazards: Basel II, Shared National Credits and Market Risk").

Q: What do the objectives in this bank data collection task from OCC suggest? What do you suppose a mandate for monthly collection of privileged general ledger data from the top credit card issuer banks implies in terms of the next worry bead?

To give you some perspective on the world of credit cards, Capital One Bank [USA]'s default experience translates into just a "B" bond equivalent rating, but there are issuers that operate far above these loss rates. The likes of GE Money Bank, a unit of General Electric (NYSE:GE), reported 800bp of run rate default in Q1, while the credit card portfolio at Washington Mutual (NYSE:WM) fell below 600bp, a significant improvement over the 1,000 bp of default reported in 2007.

The Ugly: Washington Mutual

WM was another bank lucky enough to be listed in Bove's report and just announced a second quarter 2008 net loss of $3.33 billion as it significantly increased its loan loss reserves by $3.74 billion to $8.46 billion. Total net charge-offs rose to $2.17 billion from $1.37 billion in Q1 2008. Nonperforming assets grew to 3.62 percent of total assets at June 30 from 2.87 percent at the end of the first quarter

The Q2 WM results puts the run rate (annualized) charge offs well over 350bp. The issue that comes to mind, obviously, is whether the rate of change is going to slow or continue to gallop along at current rates. WM indicates in its press release that it expects peak provisioning to occur in 2008, but that could also mean a pile of further losses and another capital raise faces existing shareholders.

Subscribers to The IRA Bank Monitor, click here to view the bank tear sheet for Washington Mutual Bank.

The thing which is striking to us about WM is the extent to which its loss rate is diverging from that the mortgage peer group. Part of the effect comes from the subprime credit card portfolio, as we've noted before this. But the fact is that the real estate lending book was throwing off 200bp of defaults in Q1, according to WM's regulatory filings vs. less than 100bp for the peer group.

Even if you impute a 100% increase in the peer default experience in Q2 to say 180bp of gross defaults, that still leaves WM a significant outlier in terms of overall loan loss rates. The bank's C&I book for example, which is thankfully less than 1% of total loans, reported 800bp of loss in Q1 2008. The changes needed to bring WM's book of business back into alignment with industry/industry risk norms is considerable and may require both symbolic and substantive management changes. But with the close of the Countrywide transaction by Bank of America (NYSE:BAC), WM is now the top of the agenda for the hedge fund mafia.

Stock Position: None.

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