I am wary of regional banks for good reason. KeyCorp came out with a disastrous earnings report yesterday and was promptly whacked by the market. The regionals have way to much exposure to commercial real estate (CRE) and construction loans. And in the next leg down of this downturn, that is where losses may be centered.
This past weekend, Barron’s published an interview with Hedge Fund manager Sy Jacobs about his thoughts on financial stocks. You will see, he also is skeptical of banking stocks and sees more trouble ahead. The article begins:
Three years ago, Hedge-Fund manager Sy Jacobs told Barron’s that serious trouble was brewing in the housing market, predicting that “the bursting of the housing bubble [would] be a dominant theme for investing in financial stocks in the next decade.” He was right. Jacobs, 47, is the founder of New York’s JAM Asset Management, which runs two funds, both focused on financial stocks and closed to new investors. The larger entity, JAM Partners, follows a market-neutral, long-short strategy and has close to $300 million in assets. As of May 21, the fund’s year-to-date total return, net of fees, was 9.6%, versus a 4.5% loss for the S&P 500. Its annualized return since inception in 1995 (through April 30) was 16.6%, compared with 9.9% for the S&P.
He talks specifically about the CRE and construction loan exposure, where I am worried.
In a recent letter to your investment partners, you noted that you were very concerned about the health of construction loans. Could you elaborate on that concern for us?
I spent a week recently in California, visiting some troubled, or soon-to-be-troubled, banks. With home sales down so much, construction lending is becoming a problem. You have a lot of developers and home builders stuck with homes that aren’t moving. And they are sitting on lots that have loans against them. Subprime is such a small piece of the banking industry, but construction lending is a core product. If the housing market stays weak for much longer — and it seems to be getting weaker — construction-loan losses are going to be a big problem.
After the brutal real-estate recession that occurred in the early 1990s, there was a sense that banks had finally learned their lesson and would be much better fortified for the next downturn. I take it you don’t think that’s true.
I take a pretty cynical view of whether bankers have gotten smarter. We’ve had a real-estate bull market ever since the early 1990s. I think you are going to see the same thing again. The number of banks that get taken over by the FDIC and disappear may not be as high as it was in the late-1980s and early 1990s because there is strength in the energy patch now. But real-estate lending institutions are the bulk of the community-bank world, and I think you are going to see a lot of banks disappear.
The article goes on to ask Jacobs about his picks in the financial sector (questions from Barron’s in italics, answers from Jacobs then follow):
You’re a fundamental stockpicker, but are there any interesting trends you see in the financials?
One of our themes on the long side is that local plain-vanilla, over-capitalized community banks, especially thrifts, are in a position to gain back market share in the lending business. And they have real deposit franchises that they can fund themselves with. They have been losing market share to the Countrywide Financials [CFC]of the world for a generation. Now, though, they are going to gain a lot of that market share back, because they suddenly have a funding advantage, relative to the larger financial firms that have been securitizing their loans. That market has been discredited. We’re long lots of micro-cap ways to play this, but they’re too illiquid to mention here.
How about a different short holding?
Hudson City Bancorp [HCBK], which is based in New Jersey. The shares have gained about 60% from their July ’07 lows and now trade at 21 times ’08 estimates and two times tangible book. They have a wholesale funding and asset-generation strategy, which allows them to keep expenses low.
Fair enough. Let’s discuss some of your holdings, starting on the short side.
The first one is Wells Fargo [WFC], trading at 12 times ’08 estimates and 2.7 times tangible book; the group trades at less than two times book. The Wells Fargo name has a storied past and gets the Warren Buffett halo effect because he owns a lot of the shares. But if you look back at the last real-estate recession in the early 1990s, the Wells Fargo side, focused on California, had a lot of credit problems in the real-estate area, and the stock underperformed during that period. The Norwest side, which has more exposure to the Midwest, still has a lot of consumer-credit exposure. Of particular concern is the bank’s portfolio of home-equity loans.
What’s the big worry there?
Home-equity line of credit (HELOC] is 16% of their portfolio. More than a third of their HELOC exposure is in California, which is now developing very badly on the home-price and employment fronts. And delinquencies and losses are already rising pretty sharply. But they also have a big unfunded exposure to the undrawn lines of credit. Also, despite their reputation for being conservative, their loan-loss reserve at the end of March was lower than their annualized charge-off rate for the first quarter. Given the prospects for rising losses that we see, that’s not conservative. We think they will disappoint this year and next and, as a result, their premium multiple will go down.
Wells Fargo, however, is known a
s a well-run bank. One example of that is the company’s reputation for being very effective at cross-selling its products.
We’re most concerned with their exposure to home-equity loans at the top of a real-estate bubble. Remember that home-equity lines of credit sit on top of first mortgages. So if home prices depreciate, which is what is happening now, and a home goes into foreclosure, the home-equity line often gets wiped out. The first mortgage holder can get most of their money back, but the home-equity line absorbs all of the loss.
Let’s move on to another short position.
BB&T [BBT], which operates in the Southeast. The stock trades at 11 times ’08 earnings and 2.5 times tangible book. It’s bounced about 30% off its lows in January. They’ve gotten a pass because, to some extent, their core Carolina and Virginia real-estate markets were among the last to roll into home-price depreciation. So their non-performing assets are still low. But we listened to the Toll Brothers [TOL] conference [call] recently. [Chairman and Chief Executive] Robert Toll graded the markets they operate in and he gave Charlotte an F-minus for current home-building conditions and Raleigh a C-minus. We’re also concerned that they have 4% of their portfolio in Alt-A mortgages, which are between prime and subprime, and 20% in construction loans.
Long story, short: financials are a place where fortunes will be made and lost in this market.
See also: Other posts under the label ‘regional banks.’