Happy Thanksgiving!

Today's news:

A "substantial majority" of policymakers at the Federal Reserve's meeting early this month agreed it would "likely soon be appropriate" to slow the pace of interest rate hikes as debate broadened over the implications of the U.S. central bank's rapid tightening of monetary policy, according to the minutes from the session. The readout of the Nov. 1-2 meeting, at which the Fed raised its policy rate by three-quarters of a percentage point for the fourth straight time, showed officials were largely satisfied they could move rates in smaller, more deliberate steps as the economy adjusted to more expensive credit and concerns about "overshooting" seemed to increase.

From Scott Grannis:

Thanks to today's release of the November 2nd FOMC meeting minutes, we know that the Fed has "pivoted" as expected; they are backing off of their aggressive tightening agenda. Instead of hiking rates another 75 bps at their December 14th meeting, we are likely to see only a 50 bps hike, to 4.5%, and that could well be the last hike of this tightening cycle—which would make it the shortest tightening cycle on record (less than one year). And they might not even raise rates at all in December—that would be my preference. For more than two years I have been one of a handful of economists keeping an eye on the rapid growth of the M2 money supply. Initially I warned that it portended much higher inflation than the market was expecting. But since May of this year I have argued that inflation pressures have peaked: "Many factors have contributed to this: growth in the M2 money supply has been essentially zero since late last year; the stimulus checks have ceased; the dollar has been very strong; commodity prices have been very weak; and soaring interest rates have brought the housing market to its knees. All of these developments mean that the supply of money and the demand to hold it have come back to some semblance of balance." To sum it up, I think the Fed has gotten policy back on track, so there's no need to do more. In fact, the October M2 release showed even more of a slowdown than previously, thus underscoring the need to avoid further tightening.

Just Published: Issue 42 of the Oddball Stocks Newsletter

We just published Issue 42 of the Oddball Stocks Newsletter. If you are a subscriber, it should be in your inbox right now. If not, you can sign up right here.

Remember that we have made some back Issues of the Newsletter available à la carte, so you can try those before you sign up for a subscription. 

The past two years' back Issues are available for $139 per copy. (Links for purchase: Issues 32, 33, 34, 35, 36, 37, 38, 39, and 40.)

Our older Issues (19-31) are available for $99 per copy. (Links for purchase: Issues 19, 20, 21, 22, 23, 24, 25, 26, 27, 28, 29, 30, and 31.)

We also published a Highlights Issue in February 2020. The Highlights Issue is available here for purchase for only $59 as a single Issue. If you have been curious about the Newsletter, the Highlights Issue is the perfect opportunity to try about two Issues worth of content (much of which is still topical and interesting) at a low cost.

Also, we tweet regularly from the @stocksoddball account on Twitter so be sure to follow us there.

Bank Balance Sheets: “Risk-Free Return or Return-Free Risk?”

[Our Oddball Stocks Newsletter guest writer Catahoula (@CatahoulaValue, previously) writes in with thoughts about banks' results this earnings season.]

“At recent prices, bonds offer such low yields that an investor who buys them for their supposed safety is like a smoker who thinks he can protect himself against lung cancer by smoking low-tar cigarettes.” - Benjamin Graham, The Intelligent Investor

Back in business school, the term “Risk Free Return” signified what an investor could earn on an investment with zero risk. U.S. Treasury obligations were regarded as a proxy for “zero risk” pertaining to a “return of capital.” In other words, with a U.S. Treasury, you will get your money back at maturity in almost every conceivable circumstance. Therefore, there is no “credit risk.”

However, another key risk was left out altogether: Inflation leading to higher interest rates, or “market risk”. The Consumer Price Index (CPI) grew at an annualized 9% rate from 1972 to 1983, but inflation has remained largely dormant for the last four decades. After the U.S. gained an upper hand on inflation by the late-1980s, average inflation rate rocked along at ~2.2% average thereafter. Before the pandemic, from 2009 to 2019, the U.S. had an even smaller average inflation rate at just 1.8% annually.   

Many bankers have never experienced this new kind of rising price environment. Inflation is a risk to bank bond portfolios, not only due to falling asset values from “market risk,” but what we see as an emerging threat: “liquidity risk.” If interest rates continue rising—and bonds continue falling—banks holding high quality bonds until maturity may not experience credit losses, as many intend to hold bonds to maturity. However, they are now experiencing sharply higher funding costs.

We are reviewing bank earnings releases in advance of our upcoming Issue 42 of the Oddball Stocks Newsletter, which will be published next month. Based on the last 40 years, everyone is especially attuned to credit. With good reason! In the book Ten Lessons Bankers Never Learn, Courtney Dufries says there are many things which can kill a bank, but in Lesson #7: “It’s almost always bad loans.”

Share prices at the largest U.S. money center banks have dropped considerably, making them a much better bargain, but is credit quality an issue? Any cracks? Elevated delinquencies? Adverse classifications? Nope! Although rate- and market-sensitive businesses (mortgage and investment banking) are weaker, this is a revenue problem, and is not credit-related. JPMorgan Chase and Bank of America are doing well. Citigroup posted fine results, but a major shift in strategy brings execution risk. Wells Fargo still has number of regulatory consent orders outstanding, including the $2 Trillion cap on assets.

Further down the asset-sized stack, there’s several mid-sized banks that boosted provision expenses, such as M&T Bank Corp (MTB) and Comerica (CMA), but not in a concerning fashion. We trust that MTB will get their arms around the People’s United Financial acquisition. CMA is well-managed and especially asset-sensitive, with any weakness cushioned by higher NIM and lower expense ratios.

One of the most interesting pre-announcements was Provident Bancorp (PVBC), which sees a “likely loss” for Q322. The holding company for BankProv announced that they are repossessing crypto-currency mining rigs in exchange for the forgiveness of a $28 million loan. However, the bank has not entered into an agreement for the resale of the collateral. Falling Bitcoin hits crypto mining revenue, while electricity costs are soaring. Thus, these rigs are not likely to fetch what they once would.   

“Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars’ worth of groceries. Today, a five-year-old can do it.” – Henny Youngman

Inflation is an invisible monster. Fixed income investments such as annuities, pensions and bonds suffer when the “cost of living” rises. At least stocks provide some opportunity to protect against the loss of purchasing power. In an inflationary environment, although operating expenses are higher, a company can boost its revenues accordingly, maintaining or even increasing profits. This in turn supports increases in dividends and, in turn, higher share prices.  

But very few banks own equities. In the entire history of credit, there’s never been a bond issuer who has paid back more than was due. Many banks which stretched two-three years ago for longer duration bonds—even U.S. Treasuries and government-guaranteed Mortgage-Backed Securities—have bond portfolios which are starting to resemble “Return-Free Risk” rather than “Risk-Free Return”.

Why? Deposit costs are soaring! A short primer on Federal Funds: As customers deposit money at banks, those deposits provide them with funds required for extending loans to their customers. Federal Funds are excess reserves held by banks, over and above the regulatory reserve requirements of the Federal Reserve Bank. The current Federal Funds target rate is 3.00% to 3.25%, which is set as a range between an upper and lower limit, but the actual rate is set by the inter-bank lending market.

Banks borrow or lend their excess funds to each other on an overnight basis, since some banks have too many reserves and others have too little. This is an overnight loan, so banks maintain credit lines with many other institutions. If amounts are continually borrowed—credit lines are tapped out--counter-parties may get nervous and refuse to lend, even overnight. To balance its books, a bank is then forced to approach the Federal Reserve discount window, which is perceived as a lender of last resort.

Since Federal Funds are a large, short duration source of funds, they introduce significant stress to a bank balance sheet. Thus, banks typically try to stretch maturity of their liabilities with longer duration products. Enter the Certificate of Deposit. Even with Federal Funds in the low 3.00% range, banks are now offering 4.5% one-year CDs—the highest interest rates on CDs in years--through brokerage firms. But CDs can be volatile if too many leave at once.

The most stable funding source for banks is core deposits, which include demand deposit and savings accounts. “Demand deposits” seem counter intuitive as a stable funding source, because their  designation implies that they can be gone in an instant, which they can. But many DDA accounts added together on a bank balance sheet are especially stable (unless the bank itself is in danger).  

If the core deposits are in small retail accounts (which typically happens at money center banks), this is even better as a funding source because the bank doesn’t face the risk that several large depositors imperil its liquidity by walking away all at once.

We look at the current state of the industry: very few credit problems, with Federal Funds and other funding costs rising rapidly, as starting to resemble the late 1970s and early 1980s, when higher interest rates impaired the financial structure of savings and loans who had balance sheets composed of long-term assets and short-term liabilities.

Back then, regulators arranged mergers between failing thrifts and solvent ones (they often resembled “shotgun marriages”) to reduce the cost of resolution to the deposit insurance fund. In these mergers, the acquiring financial institution was allowed to employ the purchase accounting method, which had been rarely used in the thrift industry prior to 1980. Purchase accounting treats the difference between the purchase price and the fair market value of the acquired bank as “goodwill”.  

Under Generally Accepted Accounting Principles (GAAP), “goodwill” was the amortized over its useful life, which could be up to a maximum of 40 years. For regulatory purposes, the full amount of goodwill created by mergers (“supervisory goodwill”) was counted as capital before the FIRREA was enacted in August 1989. Therefore, the purchase accounting method enabled solvent thrifts to acquire failing ones without raising capital.  

Unfortunately, “goodwill” often had to be written off. Thrifts, emboldened with new capital, engaged in aggressive risk taking that ranged far afield from their traditional one-to-four family homes of a savings and loan. Large acquisition and development lot developments loans, speculative home construction, special use facilities such as water parks etc.—all caused large losses.

In the present day, higher long-term interest rates have caused unrealized bond losses on bank balance sheets if they are “marked to market”. You get different reactions from an accountant, regulator, or investor. If an accountant deems a bank to be a trader, they force the institution to immediately recognize bond losses as a hit to both the income statement and retained earnings. This is rare.

Otherwise, accountants treat unrealized losses lightly, providing two options under GAAP: “Held to Maturity” (HTM) and “Available for Sale” (AFS). Neither is recognized on the income statement. HTM merely shows up in the statement footnotes. AFS deducts losses as an adjustment both to asset values and to retained earnings through Accumulated Other Comprehensive Adjustment (AOCI).

The regulators acknowledge that bonds are scheduled to pay 100 cents on the dollar at maturity, unless
there’s a credit-related impairment. The unrealized gains and losses from interest rates converge towards zero as the bond maturity approaches. Therefore, regulators don’t consider bond portfolio market losses as a hit to regulatory capital--there’s no threat to solvency. No harm, no foul?

As an investor, if you take a similar view as an accountant or regulator, you should realize that “De Nile” is not just a river in Egypt. As a crypto meme recently wagged: “If I lost all the currency in my wallet, but I have the same amount of cash in my bank account, am I really in the hole at all?” Investors generally step past denial and realize that the bond market value losses are real.

Indeed, many banks which stretched for yield are starting to have AOCI losses represent a substantial part of their equity capital, and in some extreme cases the AOCI loss now exceeds total bank equity altogether. This puts a bank in a pickle. It is at the mercy of the highest marginal deposit costs in the marketplace, because it literally cannot afford to sell bonds to raise cash. Meet “liquidity risk”.

In the Savings and Loan Crisis, their effort to attract more deposits by offering higher interest rates resulted in higher cost liabilities that were not able to be covered by the lower interest rates at which they had loaned money. As a result, one-third of S&Ls became insolvent. We wonder what would happen if the regulators ever required financial institutions to adjust capital for market losses.

On Twitter is CorpusColossus (@CorpusCol), who really knows banks and had two terrific tweets on this subject:


We will be writing more about this in the upcoming Issue of the Oddball Stocks Newsletter.

What are the interest rate increases doing to banks?

In the most recent Issue of the Oddball Stocks Newsletter, our guest writer "SomethingClever" (on Twitter) wrote about the effect that the increase in the ten year bond yield has had on banks:

At the end of 2021, all US banks held about $4.3 trillion of AFS securities and $2.1 trillion of HTM securities. The cumulative mark between the fair value and amortized cost on those bonds was negative $9 billion, which equates to a -0.1% mark. As of June 30th however, that mark ballooned to negative $475 billion or -7.3%, with over half of that mark hidden in the HTM bonds.

Now, you may be reading this and thinking to yourself that a 7.3% loss does not sound so bad in the grand scheme of things. In fact, there are plenty of bond funds out there with worse track records this year-to-date. But what is needed to round this picture out is that banks typically run leverage at 10:1, meaning they hold 10% of their assets in equity, and on the left-hand side of the balance sheet securities usually represent anywhere from 20-30% of assets. This means that any loss on a securities portfolio owned by a bank has a 2-3x multiplier on its impact to its equity. Thus, despite the fact that the 10yr yield has yet to even scrape the levels it was at leading up to the global financial crisis (GFC), banks have taken marks that are triggering TCE ratios last seen during the 2008 downturn.

This is something that we have been talking about in the Newsletter for a long time. In our Issue 19 (back in March 2018), we wrote some "Thoughts on Small Banks and Interest Rates":

During last year's (2017) annual report season, we looked at 33 different tiny banks with an average market capitalization of $55 million. Most of these are not SEC filing and many provide their financial statements only to shareholders.

What we found last year was that the small bank stocks had become quite expensive. The 33 banks had a combined market capitalization of $1.8 billion compared with a book value of $1.5 billion – they traded at 1.2 times book value. Another way to look at valuation is earnings: the banks earned a combined $110 million, so they traded at 16 times earnings.

At that earnings multiple the banks were cheaper than the S&P 500 which traded at 25 times. But these banks, which are very small and mostly rural, have different risk-reward characteristics than the S&P 500. From their base of $1.5 billion of book equity, they have levered up over nine-fold to own $14 billion worth of assets. Looking at each of the 33 annual reports revealed that the majority of them have chosen to boost income by buying long duration fixed income securities. It was common for them to have invested multiples of their equity in low yielding government debt with significant duration.

Imagine a bank with twice its equity in ten year treasury bonds. These will fall in value by about 9% if the yield on the ten year treasury increases by 1%. The leverage of owning twice as much ten year bonds as it has in equity magnifies the loss twofold, so book value would fall by 18 percent. Given the six percent average earning yield on the 33 banks that have reported earnings to us so far, this small interest rate move would wipe out three years of earnings. And this does not even consider the diminution in value that the loan portfolio would experience. (Although this would not show up as a loss in the financial statements, since the loans are not revalued higher or lower based on interest rate changes the way trading securities like government bonds are.)

Of course, the rising interest rate scenario we are talking about is no longer purely a hypothetical. The yield on ten year treasuries rose from a low of 1.37% in June 2016 to its current level of 2.85%. It will be very interesting to see what kind of damage this did to the small banks' equity in 2017 annual reports. (Of course, they will still report positive net income, because changes in bond portfolio values hit the balance sheet through Other Comprehensive Income.) [...]

What we see with small bank stocks is that the situation has inverted over the course of the recovery since 2009. In the beginning they were trading at big discounts to book value and the risk-reward tradeoff of their bond investments was much better. Now that bond yields are lower they are leveraging up and buying more. And meanwhile they are trading at a premium to book value.

Our experience with these small banks is that the people running them are the dumb money. When they are so sanguine about interest rate risk that they respond to falling yields by leveraging up a couple more turns to maintain the same interest income, it seems like the final innings of the bond bull market.

It is debatable whether the great bull market in bonds (which started in Autumn 1981) ended two years ago (summer 2020), but what we do know is that the small increase in rates off of the bottom has caused big losses for banks that were heavily invested in bonds. In his guest piece, SomethingClever wrote,

For the first time since 3Q17, and really the first time in earnest in over a decade, there are banks with negative equity capital, which admittedly is a hard thing to conceptualize. As of June 30th, there are 9 bank subsidiaries with negative equity capital. Going back quarterly, the last time there was a bank in this shape was in the third quarter of 2017: Farmers and Merchants State Bank of Argonia. Going back further on a quarterly basis, there have been 197 instances of banks ending the quarter in a negative equity position since 2000. Narrowing this down, it’s really only 151 banks in total because some banks during the crisis were in this position for multiple quarters. Of these 151 banks, 139 no longer exist, either they were acquired or absorbed by FDIC and sold off.

Excluding the 9 banks that ended June 30th of this year with negative equity, only 3 banks out of 142 made it through and still exist independently today. That is an appallingly low base rate of survival, but of course those banks had negative capital because of credit impairments, while this recent crop has negative capital because of “temporary” losses on securities that most expect to be paid in full at maturity.

In addition to the 9 banks with negative equity that were mentioned in the article (all of which were private and not OTC-listed), we also had a list of public banks that lost more than a third of their equity in the first half of 2022. Some of these have probably been pushed into negative equity with the interest rate move during the third quarter, including - almost certainly - Mauch Chunk Trust Financial Corp. (MCHT) in Jim Thorpe, PA. 

This paragraph was in their second quarter of 2022 letter to shareholders:

Total shareholders’ equity capital on June 30, 2022, was $838 thousand, $46.7 million less than 2021. Lower equity capital this year is the result of a $50.5 million increase in accumulated other comprehensive loss associated with the change in the value of the securities portfolio resulting from an increase in the level of interest rates. This decrease was partially offset by an increase in retain earnings of $4 million. MCTFC’s capital remains well above the regulatory minimum requirements to be considered well capitalized.

MCHT is an interesting case study. At the beginning of the year it had $49 million of equity, $624 million of assets, $367 million of securities ($199 million due after 10 years) and a $40 million market cap (0.83x book).

As of June 30th, it had only $838k of equity and a $27 million market cap (33x book). They earned $1.4 million (excluding securities losses) in Q2 so that is under 5 times annualized earnings - assuming that their deposit cost doesn't go up.

Their deposits are almost all interest bearing. Interest expense was $394k in Q1 and rose to $503k in Q2. (Cost of funds 26 bps in Q1 vs 34bps in Q2.)

Interesting to think that with a further increase in funding cost of probably less than a percent, they would no longer be profitable.

Once is Chance, Twice is a Coincidence, Three Times is a Pattern

About nine months ago, Oddball Stocks Newsletter guest writer Catahoula wrote an article entitled “Put Yourself in My Shoes” on Five "Teenage" OTC-listed banks that were trading between 0.75x and 1.25x Tangible Book Value, with an efficiency ratio under 55%, net interest margin greater than 300 basis points, and were between 10 to 20 years old (hence, "teenagers").  

Today, we sat up and took notice when the third of those five banks, Centric Financial Corporation (CFCX) announced a merger with First Commonwealth (FCF) in an all-stock transaction valued at approximately $16.20 per share.

Over the years, we've grown fond of Centric, a solid bank that has flourished under Patti Husic, President and CEO. CFCX  was founded in 2007, making it a teenager at 15 years old. Centric Bank has principal executive offices in Enola, Pennsylvania. This is the Harrisburg area about 110 miles away from Philadelphia. A major hiccup along the way occurred about a year ago when the bank suffered a $5.1 million fraud in 3Q21. Though mighty unpalatable, one loan fraud is a business risk in banking.  

CFCX has sometimes traded 85% of tangible book value, which is confounding. If you compare Centric (CFCX), which trades on OTC, with Bank of the James (BOTJ) a similarly-sized bank on the NASDAQ, Centric is more efficient and profitable. But there's sometimes been a valuation difference of thirty percent of tangible book value between otherwise comparable public and private (OTC-listed) banks! 

We find this really fascinating because these paired comparisons of similarly-sized banks demonstrate a discount that arises purely by virtue of being OTC-listed instead of public. If the Oddball Stocks Newsletter stands for anything, it is for harvesting this OTC valuation discount.

We asked Catahoula why he thought that so many of the teenage banks he mentioned have merged.  He said that a bank in its second decade often faces increasing pressures. The board and executives have tapped out their contacts in the immediate community for business. They contemplate growth through expansion, but they are not as familiar with neighboring towns. Sometimes they are reluctant to acquire acquire another bank. He also said that capital management becomes more important. As profits accumulate, banks may face pressure to pay a dividend or buyback stock.

Often, early investors look for a a cash-out of their initial investment before two decades have elapsed.  Banks initially listed on the OTC Markets usually intend to graduate to the major exchanges, hoping to uplist to NASDAQ, and ultimately the NYSE. Uplisting supports expansion of the shareholder base to include institutional investors, with a goal of eventually becoming included in the Russell 2000 or 3000 indexes.  

Whether increased valuation comes from a buyout or uplisting to a major exchange, at Oddball Stocks we like to eat steak for the price of hamburger. We will continue to bring you small, non-public companies and banks trading in the obscure corners of the market. If you are interested in the two remaining teenage banks that Catahoula identified, be sure to check out Issue 37 of the Oddball Stocks Newsletter.

Just Published: Issue 41 of the Oddball Stocks Newsletter

We just published Issue 41 of the Oddball Stocks Newsletter. If you are a subscriber, it should be in your inbox right now. If not, you can sign up right here.

Remember that we have made some back Issues of the Newsletter available à la carte, so you can try those before you sign up for a subscription. 

The past two years' back Issues are available for $139 per copy. (Links for purchase: Issues 32, 33, 34, 35, 36, 37, 38, 39, and 40.)

Our older Issues (19-31) are available for $99 per copy. (Links for purchase: Issues 19, 20, 21, 22, 23, 24, 25, 26, 27, 28, 29, 30, and 31.)

We also published a Highlights Issue in February 2020. The Highlights Issue is available here for purchase for only $59 as a single Issue. If you have been curious about the Newsletter, the Highlights Issue is the perfect opportunity to try about two Issues worth of content (much of which is still topical and interesting) at a low cost.

Also, we tweet regularly from the @stocksoddball account on Twitter so be sure to follow us there.

Second of Catahoula's Five "Teenage" Banks Acquired

In November 2021, our guest writer Catahoula wrote a guest piece in the Oddball Stocks Newsletter entitled: Guest Piece: “Put Yourself in My Shoes” by “Catahoula” on Five Teenage OTC Banks. (That Issue #37 of the Newsletter is available à la carte.) He writes in with an update,

--

In February, Peak Financial in Idaho (IDFB) got taken out. Last week, Integrated Financial Holdings (IFHI) announced a nice merger. MVBF is tech-forward and fintech-sensitive. It's an all-stock acquisition, so I might consider hanging around. IFHI built a nice platform for government guaranteed loans at West Town Bank. 

From my November 2021 article in Issue 37, there are three remaining teenage banks -- CFCX, USMT and CMRB. In 2Q22, CMRB's operating results continued to flag due to increased salary and bonus expenses. As "Ronbo" on Twitter summarized: 


All of the long-time holders (myself included) were unhappy about the deterioration in the operating results. I sold out my full position. As "Our Bank" on Twitter said: 


Although I no longer have a dog in this hunt, if CMRB can't find its footing, in my opinion it will be increasingly vulnerable to acquisition. The board owns ~20% and former CEO Herb Schnieder had 2.5% or so (the last proxy before he departed). As I mentioned in the article:

"When I look at the opportunity set among OTC banks, I identified five that have reached their second decade. I believe they are either set on a path to acquisition or a profitable long-term niche."

--

Be sure to check out Issue 37 of the Oddball Stocks Newsletter and read Catahoula's piece on the three remaining "teenage" banks.