EverydayInvestor (< 20)

Using the Texas Ratio and the Reggie Ratio to Identify Failing Banks

June 17, 2008 – Comments (6)

Disclosure: I am short SSBX, a company I analyze below.

Many of you are following the slow implosion of many bank stocks. No longer is the issue subprime loans, but construction loans and alt-a loans are coming back to bite banks. One of the most useful measures in analyzing ailing banks is the Texas Ratio. This was developed by Gerard Cassidy and other RBC analysts back during the late 1980s Texas bust. This ratio, when over 100%, is correlated with banks going bust and landing in FDIC receivership. See this Marketwatch article for a discussion of banks with high Texas Ratios.

According to Wikipedia, the Texas ratio is "calculated by dividing the value of the lender's non-performing loans by the sum of its tangible equity capital and loan loss reserves." I would amend that to include all non-performing assets, including REO. For most banks this would not change the ratio much.

To illustrate I will now calculate the Texas Ratio of Silver State Bancorp (SSBX), a company that Floridabuilder has previously criticized. We will use the most recent 10Q which gives us the data from March 31, 2008. As of that date, SSBX had total non-performing assets of $79.2 million (which is up an incredible 600% from $13.2m a year earlier). This number is in the notes to the financial statements--just use your browser to search for the term "non-performing" and you can find it quickly. We then need to sum up tangible stockholders equity and loan loss reserves. Stockholders' equity is $142.1 million (this is the second line to the bottom of the balance sheet), but we need to subtract any asset that is not tangible. For SSBX, that means subtracting the following:

Deferred taxes, net     13,534     
Other real estate owned     1,249
Goodwill     18,835
Intangible asset, net of amortization of $314 and $247, respectively     850
Prepaids and other assets     6,056       

We end up with tangible equity of $101.6 million. To this number we add the loan-loss reserves of $40.65 million (this is usually identified by a parenthetical note on the same line as loan assets -- "net of resevers of xxxx". We end up with a denominator for our Texas ratio of $142.3 million. Taking our NPAs of $79.2m and dividing by this we get .557 or 55.7%. This is the sign of a highly-stressed bank (for comparison, the Texas Ratio from a year ago was 9.1%). Both the absolute value of the Texas Ratio and the trend in the Texas Ratio are meaningful statistics. By both measures Silver State Bancorp is in, as Reggie Middleton would say, "deep doo-doo". However, Silver State just announced an equity rights offering for up to $40 million. I doubt that the company will be able to raise this much, but if it did, its Texas Ratio would fall to 43.4%. Even after the rights offering the bank would be highly stressed; therefore I believe such an equity raise to be wholly inadequate.

f course, there is more to analyzing failing banks than just Texas Ratios. The quality of loans matters too. I think it would be safe to bet against any regional bank with a Texas Ratio above 30% and total bad asset exposure of more than 150% is a candidate for FDIC receivership. By bad asset exposure, I mean construction loans (particularly residential construction), land development loans, subprime loans, option ARMs, HELs, HELOCs, and stated income loans. Exposure to the worst housing markets is desirable but not necessary. Very few regional banks have subprime or stated income loan exposure, so pay most attention to HELs, HELOCs, option ARMs, and construction loans. If you don't think HELOCs or HELs are that bad, take a look at the following chart of real-life San Diego foreclosures and the estimated recovery rate on all the HELs and HELOCs. The average estimated recovery rate: 0%. In the event of a falling prices and high loan to value ratios (the current housing situation), HELs and HELOCs invariably get wiped out. (By the way, I like that on that list of foreclosures there is a house on Goode street--my surname. If you really appreciate my blogging, feel free to buy it for me.)

If you sum up the total bad loans and divide by the tangible equity, you get what I would call the Reggie Ratio (as Reggie Middleton introduced me to this ratio; see this graph of this ratio at several stressed banks, discussed in this article ). This is a measure of the bank's risk. Silver State Bancorp has a Reggie Ratio of 1102%.

Etcetera: The Globe & Mail has an article detailing the Texas Ratios of large Canadian banks. None is higher than 10%, though, so dwot and her compadres need not worry. If you liked this article, please recommend it! I work for recs!

Disclosure: I am currently short SSBX. I am also short several other regional banks.

Rapper's Delight by The Sugarhill Gang

A free box of good chocolates to anyone who can write at least 3 minutes worth of lyrics to the above song to turn it into "Short Seller's Delight".