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ANALYZING AND INVESTING IN COMMUNITY BANK STOCKS PDF

236 Pages·2005·4.57 MB·English
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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. ii 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 1 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

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CONTENTS Introduction & Acknowledgements Chapter 1: Introduction to Banks and Bank Investing
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