ANALYZING AND INVESTING IN COMMUNITY BANK STOCKS

236 Pages·2005·4.57 MB·English

by  Andrew Wilhelmy

ANALYZING
AND
INVESTING IN
COMMUNITY BANK STOCKS

David B. Moore

ANALYZING
AND
INVESTING IN
COMMUNITY BANK STOCKS

David B. Moore

Icarus Publishing

Copyright © 2005 by David B. Moore

All rights reserved under International and Pan-American Copyright Conventions.

CONTENTS

Introduction & Acknowledgements

Chapter 1: Introduction to Banks and Bank Investing 1

Chapter 2: The Balance Sheet 9
Appendix I: Common Borrowing Arrangements 17
Appendix II: Trust Preferred Securities 23

Chapter 3: The Income Statement 25

Chapter 4: Asset/Liability Structure 35

Chapter 5: Asset Quality and Reserve Coverage 43
Appendix III: Asset Quality and Economic Cycles 52

Chapter 6: Accounting Shenanigans 55
Appendix IV: Gain on Sale Accounting – A Primer 63

Chapter 7: Regulatory Environment 69
Appendix V: A Brief History of Major Banking Legislation 76

Chapter 8: Bank Acquisitions 101 81
Appendix VI: Understanding Reflexivity 98

Chapter 9: Valuing Bank Stocks 101
Appendix VII: A Valuation Conundrum – Book Value vs. Earnings 124

Chapter 10: Common Investment Strategies 127

Chapter 11: Case Studies 143
Research Reports: Community First Bankshares, Inc.
CNB Bancshares, Inc.
Hamilton Bancorp, Inc.
Appendix VIII: The Savings & Loan Crisis 205

Glossary of Terms 209

Footnotes 221

References 225

About the Author 227

INTRODUCTION & ACKNOWLEDGEMENTS

Although the audience for a book on investing in community bank stocks is limited by
the very nature of its somewhat narrow and obscure subject matter, I decided to write
one anyway. Why? Clearly I’m a glutton for punishment.

To describe community bank analysis as a dry topic would be an understatement, to say
the least. So, with that said, let me address a few issues about the book itself. First, this
is a book about community banks and thrifts, which I define as those depositories with less
than $15 billion in assets. If you want to know more about how to analyze larger banks
like Bank of America, JP Morgan or Northern Trust, you’re reading the wrong book.
Second, use of the terms “bank,” “institution” and “depository” throughout this book
also refers to thrifts (that is, Savings & Loans), unless specifically noted to the contrary.
Third, almost all of the italicized terms – where italics are not used for emphasis – are
either defined in the text or in the glossary. Finally, you will notice that there is no
chapter on a bank’s statement of cash flows. While all banks, obviously, have a cash
flow statement, I chose not to spend any time on this subject. Unlike most industrial
companies, banks don’t have meaningful amounts of depreciation and short-term
receivables. Consequently, unless a bank is engaging in accounting shenanigans (as
addressed in Chapter 6), its net income should be a close approximation of its operating
cash flow. And there’s no great mystery about a bank’s investment and financing cash
flows. So, rather than having a two-page chapter explaining the obvious, I just left
analysis of the cash flow statement out of the book altogether.

I encourage you to read the footnotes. I actually have little pride of authorship where
specific ideas are concerned. In many respects, this book is a compilation of both my
thoughts (primarily) and those of others (secondarily) on bank analysis. Consequently, I
have borrowed liberally, and at times verbatim, from others – I don’t believe in
reinventing the wheel. Rather than dot the book with quotation marks, however, I have
merely documented in the footnotes where such verbatim passages are located (along
with the corresponding footnote number in the body of the text, of course).

My goals in writing this book were to provide (1) a good introduction to bank stock
investing to someone somewhat familiar with accounting and investing, in general, and
(2) a source of reference for bank analysts that occasionally forget some of the minutiae
of the trade, like the proper risk-weighting for multi-family residential loans (50%, by the
way). Whether or not I’ve accomplished this goal is for you to decide.

I would like to thank the following for generously donating their time to offer helpful
comments and suggestions on early drafts of the book: Matt Allen, Stan Farrar, Kelly
Hinkle, Mark Merlo, Ian Nimmo, Troy Norlander, Chris Raffo, Steve Rippe, Hans
Schroeder, David Volk, Jim Volk and Joey Warmenhoven. Needless to say, any errors
or omissions can be attributed to these “editors,” as a group. Kidding, of course. I
would also like to thank Anamarta Laviaguerre for formatting assistance and Carol
i
Podesta for allowing me to reproduce in Chapter 11 three research reports I originally
wrote while employed by Podesta & Co.
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ANALYZING AND INVESTING IN COMMUNITY BANK STOCKS
Introduction to Banks and Bank Investing

CHAPTER 1
INTRODUCTION TO BANKS AND
BANK INVESTING

The Nature of Banking

At its core, the banking industry is relatively easy to understand. In its simplest form, the
business of banking entails yield curve arbitrage; that is, banks borrow at the short end of
the yield curve and lend at the long end. More specifically, banks take in funds, in the
form of deposits and borrowings, at one interest rate and lend those funds out or invest
them at (presumably) higher rates in the form of loans and investment securities.

In its more evolved form, the banking business entails the creation and distribution of a
wide array of credit-related (e.g., loans and lines of credit) and non-credit-related (e.g.,
cash management and trust administration) services to businesses and individuals. In
order to accomplish this task successfully, while providing an adequate return to
shareholders, a bank’s management must be adept at several different activities, including
marketing, pricing, risk management, operations and expense control, to name just a few.
In addition, bankers must be able to operate in a highly competitive, heavily regulated
environment, frequently competing against unregulated competition.1

A Financial Intermediary

Banks are financial intermediaries. By underwriting loans, banks transfer money deposited
by consumers, businesses and governments, as well as funds invested by shareholders,
and lend these funds to other consumers, businesses and governments for spending and
investment. Banks are also known as depositories because they hold deposits that are
insured against loss (up to $100,000 per depositor currently) by the Federal Deposit
Insurance Corporation (FDIC).

As financial intermediaries, banks serve three entities: depositors, borrowers and
shareholders. A bank that loses a significant portion of any one of these groups will not
remain in business for very long. Without depositors, a bank has no funds with which to
generate a profit through lending and investments. Without borrowers, there is no one
to lend to or invest in. (There are banks that invest solely in securities, as opposed to
underwriting loans, but such institutions are extremely rare.) And without shareholders,
there would be no funds with which to capitalize the bank.2

Excluding the bank itself, lending involves two primary parties: the suppliers of funds
(the depositors) and the users of funds (the borrowers). As intermediaries, banks
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ANALYZING AND INVESTING IN COMMUNITY BANK STOCKS
Introduction to Banks and Bank Investing

transfer money from those who wish to save to those who wish to borrow. It is
important to understand and appreciate the goals and objectives of these two parties.

Depositors’ Objectives

Depositors have three primary objectives: convenience, rate of return on deposited
funds and safety.

A major advantage most banks enjoy over other financial institutions that compete for
deposits is convenience, as depositors can reach a bank via telephone, computer, car or
on foot. Some banks provide courier services for commercial customers that make
frequent deposits. Furthermore, the over 9,000 banking institutions (with roughly
90,000 individual branches) spread around the country offer depositors the convenience
of location.

Banks also enjoy a competitive advantage in another area: they both solicit deposits from
and make loans to many of their business customers. Banks, for example, frequently
make loans to owners of businesses who already maintain deposit accounts at the bank
for covering operating expenses.3

For obvious reasons, depositors are sensitive to the rate of interest their deposits earn.
Bank customers want the highest rate of interest available for their deposited funds.
Today’s bank customer is much more likely to transfer funds and change financial
institutions in search of higher interest rates than were customers twenty years ago.4

It is imperative that banks maintain a reputation for fiscal soundness. Federal insurance
coverage (through the FDIC) on most types of deposits, federal and state regulatory
oversight and a record of fiscal prudence on the part of the banking industry all
contribute to depositor confidence in the safety of their funds.5

Borrowers’ Objectives

The borrowers’ primary objectives are favorable terms, service and advice.

To most borrowers, interest charged on a loan is a major consideration. Aside from
lowering the borrower’s cash expenses, a low interest rate is the equivalent of the bank
saying, “You’re a low risk.” As with the interest rate, the amortization schedule and
maturity date of the loan determine the amount of the monthly payments and,
consequently, whether the business or individual will be able to meet those payments. In
today’s competitive banking environment, many borrowers expect a long amortization
and maturity date. Most customers, however, are willing to pay higher interest rates for
these longer terms. In addition, to the greatest extent possible, borrowers want to
pledge the least amount of collateral possible and avoid personal guarantees.6

2