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Texas and other Bank Ratios: A continuation of Everydayinvestor's blog



June 17, 2008 – Comments (6) | RELATED TICKERS: KEY , CORS

I intended to initially do a response on Everyday's blog....just became too lengthy 

Michael.....I was meaning to do a blog on Texas ratio....but you beat me to it. Good - more people read your blog anyway. And I hope you dont mind a little bit of a hijack.

 Reggie Ratio

I am sure its great to come up with new measures - but this is just an exposure/leverage measure - really does not tell you much other than - relative exposure. Like generally if a bank is reporting a 9:1 leverage , if you see a number closer to 9 on Reggie then you know the bank did most of its business in this class of loans. Very difficult to see the number not highly correlated with the general leverage number, unless extreme circumstances.

Now the good stuff: My algorithmic addition to Michaels process

Main inputs ( You will need to do most of this - SSBX was a slam-dunk, a pity I did not know about its existence until much later. Most of the time - you'll find fuzzy answers, hence more information, the better in my opinion)

(1) Tangible Capital: Ditto
(2) NPA ( Total non-performing assets , not just loans as Everyday says) This is in essence most 90+days due consumer loans and "distressed/uncollectible" classified assets of commerical variety
(3) Loan Loss Reserves
(4) Tier 1 Capital and Tier II Capital Ratios( You will find them together in the Capital Adequacy section - do a search as Michael says)

If available ( They usually are)

(a) Delinquency (NPA/Total loans) by Category: Commercial ( This usually has the sub-heads of Construction, Land Development etc - also broken out), Residential (1-4 family), Home Equity.
(b) REO and Available for Sale Assets
(c) Growth in NPAs - do this , usually will have Mar 31,2007, Dec 31 2007 and Mar 31 2008 , right now. Create a QonQ growth rate. See where the slope of the curve is going - I dont need to say the interpretation - the Fools world is not so ahem foolish!


(1) Compute Texas Ratio.Actually no , this shouldn't be a 1st step - Texas is indicative only. So if you have a database of Texas ratios - I would simply sort by that and pick the worst offenders - unfortunately I dont know of any such source - so I am assuming you are doing Bank by bank - hence

1a. Compute Total NPA/Loan Loss Reserve ( ie a portion of the denominator used in Texas).

Why, you really can't assume the bank's a gonner - the regulators will start here - basically is the bank providing enough to cover for future potential losses.

Any number above 100% is interesting ...but you are really looking for a high 200%+ number here.

1b. There's a little bit more to NPAs : Here you need to break it down into NPL ( loans) and REO.NPLs are not sure shot loss. Only a % age of them will actually move into Loss ( and then into REO eventually). Post that - it all depends on the underlying value of the collateral - ie home/building or land value. THIS IS A VERY IMPORTANT DYNAMIC. Loans do not go into loss status overnight - due legal process ( foreclosure timelines vary by state - NJ it could take an eternity) takes time - time buys a lot for the bank.

This varies by the loan type/product also: Riskier products have higher propensity than other. Home Equity (HELOCs especially), Option ARMS will have high percentages. So also Commercial - you'll typically find very few loans in this category in NPA as compared to Total loans - but those that go - are in real trouble - because of concentrated exposure - like 10 loans all related to 1 troubled private builder , or 100 loans in 1 project in jeopardy of construction etc.

1c. Then you need to consider what the value of the asset is. As Michael says for Home Equity ( 2nd liens) - its close to zero ie 100% markdown. ( NOT 100% Loss) For Land - Florida says 20 cents to dollar ie 80% Markdown. For general Home - 50% mark possibly.

1d. Thus you get Net expected loss = Total NPL( You will need to extrapolate this based on the rate of growth computation you saw in the QonQ) * % of loans moving into Loss * % age Markdown + REO* % age Markdown ( SEE THE DIFFERENCE - anything held for sale or owned needs to be valued at market , no probabilistic uncertainty here - so anybody with a buldgeoning REO book has some real issues)

1e. This number at a minimum has to be at least 25% less than the Loss Reserves. OR THEY WILL BE ASKED TO BUILD UP TO THE NUMBER. This is what's happening today with RF,KEY,FITB - big regionals

2.  From the difference you can see how much of a variance it creates ( raising of the LLR to cover losses) to the Tier 1 and Tier 2 capital ratios - They have to maintain it ( anybody not doing - has given up ). IF THEY HAVEN"T RAISED CAPITAL YET : They have to, no choice. This is a simple immediate short - no bankruptcy required.

3. Chance of raising: Not everybody will be successful. SSBX 40 Million is a question mark. That means they are sunk. If they raise - and bring the ratios in order. Good for now.


4. ALL SAID: If you see (LLR - Net Expected Loss)/Tangible Equity Only ( ie no LLR here) >100% ( Basically a doubling of existing capital!) or really a high $ figure : That's your decision point. If they can't raise that much - well there's only 1 way to go.

Brings you to probably ask - what am I doing with all this theory. Very little - I only come to know of these candidates here at the fool - and most of the time - the opportunity is gone.  There have been a few exceptions though - and profitable ones.

Otherwise, of course , if you think shorting banks is easy money - you have no real problems/doubts.


6 Comments – Post Your Own

#1) On June 17, 2008 at 4:14 PM, anchak (99.91) wrote:

Error on 4. (Net Expected Loss - LLR)/Tangible

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#2) On June 17, 2008 at 4:22 PM, EverydayInvestor (< 20) wrote:

My blog post on the issue can be seen here. I am short SSBX and  several other regional banks. I'll reply with some insights later.

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#3) On June 17, 2008 at 4:51 PM, EverydayInvestor (< 20) wrote:

Anchak - good post. Some comments:

First, the Reggie Ratio is useful, as most small community banks and mid-size regional banks have avoided getting too high a percentage of these risky loans. I have looked at close to 100 bank balance sheets recently and most of them have less than 20% of loans in risky categories. So this ratio is not strongly correlated with leverage.

Of course this ratio is nothing more than a starting point. The key is to estimate what will happen to the loans. For some banks (such as SSBX), I do not have to do any complicated math. Defaults on 20% of its risky loans (considering that the recovery rate on defaults would be around 20%) would wipe out the bank's equity. I would not be surprised to see a default rate twice that or even more. There are several other banks in similar positions.

The point about shorting before likely capital raises makes sense. That would have gotten a nice profit on KEY. Me, I've never held a short for more than an 80% gain (poor me!), so I want to short a few to receivership. That being said I think you could short any bank over the next six months and stand an 80% chance of making money.

now a couple nitpicks:

1. If the Texas Ratio by definition uses NPA and not non-performing loans, then the Marketwatch article and Wikipedia (which cites Marketwatch) are wrong. I was just following those when I said Texas used NPL.

2. You say that 2nd loans receive 100% markdowns--not 100% losses. What is the distinction you are trying to make here? Are you trying to point out that it is not a 100% loss since interest had been received on the loan previously? If so, well, I guess I was technically incorrect in calling it a 100% loss.


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#4) On June 17, 2008 at 5:24 PM, anchak (99.91) wrote:

No didn't mean to correct anything......I agree with your structure - this is not an exact science....

1.the difference between loans and assets - is basically inclusion/exclusion of REOs. I agree with your view that you need to compute it based on all assets.

2. You need to get that there is an additional Probabilistic ( Uncertain) step from NPL into Loss ( typically REO for 1st Mortgages, Held for Sale ( scratch &dent) or MTM on 2nds). So if  70% of cases move into loss from NPLs and then The MTM on 2nds is 99% ( No equity) : Net loss is 70%*99%

Hope that makes sense!

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#5) On June 17, 2008 at 5:41 PM, EverydayInvestor (< 20) wrote:

Relating to point #2 above, the number I didn't include was the percentage of HELs or HELOCs going NPL ... which would then get multiplied by 99%.

Depending on how smart people are, I think future NPLs in HELs and HELOCs could be a lot higher than people think. If you are underwater on your 1st mortgage and are running low on money, the smart thing to do continue to pay that, but don't pay the second mortgage. The second mortgage holder cannot foreclose because doing so would wipe it out (after paying the first mortgage off). All the second mortgage holder can do is send nasty letters.

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#6) On June 17, 2008 at 8:35 PM, anchak (99.91) wrote: as I re-read my blog I kinda get why Everyday raised #1.....I actually was agreeing with him and not the classic Texas ratio ie you need to consider NPAs and not NPLs for the first pass of the ratio. You can compute it either way - and it IS incremental information - since

There is a distinction between NPLs and NPAs

(1) When a loan become NPL ( Non-performing): THERE IS USUALLY NO LOSS TAKEN. All that happens is the loan goes into Non-Accrual status ie no interest is recognized from that point onwards. You will find exceptions to this rule - where the 10q mentions NPLs in accrual status - this is unusual and really - a little fishy.

(2) Principal Markdown ( which is recognized on the income statement as Charge-Off/Write-Off) happens as it moves into Loss status and thence into REO. At this point as Everyday says - you get a double whammy from an income standpoint because all Interest accrued PRIOR to NPL status is also reversed - this is an negative income hit on Interest Expense.

I know this is nitty gritty - but is bank has $100 MM in NPLs today - to assume all 100 are going to loss is a misnomer. A big portion of them will ( for HELs and HELOCS this number would be in the high 70-80% depending on the originating product - lots of HELs are stated income)


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