Tom Brown on loss reserve adequacy
by PlanMaestro
Several questions on this issue. I have nothing to add.
For instance, the two most misleading measures of loss reserve adequacy are 1) the ratio of loss reserves to nonperforming assets, and 2) the ratio of reserves to nonperforming loan percentages. Sure enough, these two metrics are the favorites of many analysts and journalists.
Why are the numbers misleading? First, they are overly mechanistic. The reserve is built through backward-looking formulas that take into account the institution’s loan mix, its loan grades, and its historic loss rate by loan type for all of its loans, not just the nonperforming loans.
Second, any additional writedown or loss on the disposition of OREO does not come out of the loan loss reserve. Instead it shows up as an expense. Remember the titles: “loan loss reserve” and “other real estate owned.” Once a bank possesses the property or other collateral, that property is no longer a loan. It’s an asset. Any further value decline, therefore, cannot come out of the loan loss reserve.
Variant Perceptions 
Thanks Plan! Great post! I have been confused about how loss from OREO goes.
Thanks, well said.
Brown’s article highlights an absolutely crucial point–judging the value of a bank with troubled assets requires an analyst to assess the conservatism (or liberality) of management’s marks. That’s some difficult and time-consuming work.
I know a few Michigan banks well that appear cheap, but whose management has consistently overestimated the ultimate recovery on their NPAs. Intuition (or my unquenchable pessimism?) pushes me to believe that recovery on the remaining NPAs will likely be even worse.
Could you share some specifics cases WideMoat? Michigan intrigues me.
Two uglies I’ve followed are MCBC and FBC.
One decent one that got snapped up this year was Byron Bank, previously owned by Oak Financial, now Chemical Bank (CHFC).
Not sure what Einhorn sees in FBC. Sure, after everyone went broke they are one of the few mortgage originators standing. But after two dilutions I am more in the “show me” camp. MCBC looks quite horrible.
Have you checked FBMI and CRBC?
I’ve looked at CRBC. According to my notes, their 30-89 days past due is trending down significantly YOY, but their provision for loan losses in Q110 was still very high.
Pre-tax, pre-provision earnings for TTM looks about 110-120m, so a market cap of 310m looks cheap if its loan book firms up from here.
At current prices though, WFC is less than 3.5x PTPP earnings, and has stronger non-interest income (relative to non-interest expense), and much lower cost of funds (about 0.8% at 3/31/10, vs CRBC’s around 1.9%).
Thanks WideMoat. Interesting point about WFC, I should give them another look. I noticed that their Texas ratio was still going higher but might just be a sign of conservative accounting and they are an earnings machine with that cost of funds. I have a higher PTPP earnings for CRBC, more in the order of $140M so have to check that.
I think for CRBC, the key question is how long they will keep burning cash in the current pace. Right now in their first quarter of 2010, they burned 90,000k, so that is 360,000k per year. With 1,244,000k equity at present, they can only last another two years at the most. If 30-89 days delinquency quickly drops to a much lower level, like 1%, then they will be much safer than right now.
Zehua, not sure what you mean. CRBC had $32m in cash from operations in Q1 2010
Plan, I mean the reduction in equity.
Yes, it does have 32M cash from operations, but it has to set aside a large sum of money for provision for loan losses, and I would assume this sum of cash for provision will be burned later, so I would assume free cash flow minus provision for loan losses to be their real cash flow, if their provision is estimated accurately.
Got it. Last Q there was one time hit from their disposal of housing mortgage related NPLs that impacted equity. At the same time this Q there will be probably a one time positive event from the sell of a subsidiary for a profit.
Hi Plan, why do you think CRBC took the “one time hit” for their home mortgage disposal? I see that each quarter they have to provide a large sum of money for provisions.
They had concerns of another housing leg down, so they decided to get rid of that issue once and for all
What is the potential for a bank with 3.5x PTPP? I think it will only be a two-begger, right?
Banks historically have low PEs around 12-13 during “normal” economic conditions, so WFC would at most be a two begger at current 3.5x PTPP. What do you think?
I guess the easy out (albeit an honest one) is that it depends on the capital allocation and the sense of urgency going forward. Also, when one decides to sell.
I know that a good capital allocator could do some special things, even with a bank, at 3.5x PTPP earnings.
Don’t take my words to suggest that I find WFC the best value in the market right now. But it does serve as a useful mark to measure opportunity cost, particularly vs other banks.
Good points
A guest in Zero hedge tackles the FBC situation. Looks very risky to me
http://www.zerohedge.com/article/flagstar-bank-good-bad-ugly
well, that’s interesting. so when a property gets repossessed it then gets carried as an asset at some value and the loss reserves get dinged by the diff between the loan and that value — do i have it right? and that value is a finger in the air value, or based on comps, or how is it determined?
My understanding is that most use appraisers. One way to see how conservative is the accounting is to follow the OREO losses or gains
So if OREO sales constantly gets losses, then it must be an aggressive accounting, right?
Or a terrible economy