Predicting Community Banks Failure

Community Banks of Colorado was taken over by the FDIC and remaining assets were given to Bank Midwest, out of Kansas City, MO, itself owned by National Bank Holdings Corporation, chaired by Timothy Laney, an alumnus of Bank of America and, more recently, Regions Bank. Taxpayers will protect most depositors. Only shareholders and savers with money in excess of the current $250,000 FDIC limit could face losses. A review of Community Banks’ declining financials shows that the takeover was entirely predictable.

The lack of research about local banking institutions leaves many large depositors worried about whether their bank will be the next to fail. Regulators don’t like to make rankings public so that they don’t cause a run on a troubled institution.

As a result, savers may be overly anxious about keeping their savings in a local bank, depriving local lenders of resources that could be invested in the community to create jobs. Instead, money flows toward “too big to fail” institutions who are increasingly investing in government bonds – funding the big government juggernaut – but leaving local job creators without sufficient expansion capital. While big banks increase fees to make up for their lack of interest income with a host of new fees, including the appropriately-named new Durbin fee on debit card transactions, smaller institutions are prevented by the regulators from making loans in the areas they know best, to local investors who are best suited to take over management of the millions of homes across the country that sit in foreclosure portfolios.

Finding objective information is difficult, but relying on rumors just increases the level of anxiety. Several local banks have been the subject of rumors in the past year, including Community Banks.

Large depositors with concerns about their deposit institution should do the research for themselves on the Federal Financial Institutions Examination Council web site. (https://cdr.ffiec.gov/public/) The site makes it easy to view or download data for individual institutions.

In our research for a local foundation client, we focus on a few key statistics to keep the analysis manageable. The first ratio we review is the Tier One Leverage Capitalization which measures the amount of investor money at risk before losses would impact depositors with savings above the FDIC guarantee levels. Most of the local institutions have nearly 10% in tier one capital. As of June 30, Community Banks of Colorado’s capital ratio had declined to only 1.66%, meaning another 2% in bad loans was all it took to wipe out the equity.

We also look at the total past due loans and leases. At Community Banks of Colorado, there was another 11.31% in past due loans as of mid-summer, so it shouldn’t have been a big shock when the equity was wiped out. In our review, we concluded that only one of the remaining twelve institutions is “under water” in the sense that its past due loan percentage is greater than its current tier one capitalization. In all of the other banks, even if every past due loan went bad, there would still be equity left to protect depositors from future losses.

In our review of thirteen local institutions, Community Banks was far and away the most likely institution to fail. Unfortunately, as tight regulatory policies force banks to walk away from more and more borrowers, forcing additional foreclosures, these numbers do change over time so you need to perform the analysis on an ongoing basis.

The benefit of performing this research, which only takes about an hour to complete, is that depositors can make an informed decision before allowing a local bank to keep deposits in excess of the FDIC lending limits. The data is reliable, compiled by the bank regulators who are paid to look over the shoulder of the industry. And while it isn’t exactly kept in an easily understood format, analysts who identify a few key ratios can make sense of the mountain of data that is available.

 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Occupy Wall Street Turns Ugly

Drunken youth cruise around Wall Street looking to pillage, but unlike the MBA’s who have been doing this for years under the blue chip label of Goldman Sachs, this time the mob is looking to tear down capitalism, although they’re not certain what will replace it. Like the flash mobs in London who were looking for extreme thrills rather than making shrewd and considered philosophical judgments, the Occupy Wall Street mob is defined as much by the company they keep as by the actions they take, which thus far have included rioting against the rule of law, blockading bridges, and hoisting thought provoking signs that say things like, “eat the rich.” It’s almost disgusting enough to make me want to take the side of the Goldman bankers.

But the protesters have gone too far, this time. Amidst the protests, arrests, and accusations, they appear to be consorting with Hoofy the Bear. Bear markets are typically defined by a 20 percent decline. Looking at this market, year-to-date (not from the April high), the S&P 500 was down -7.4% at the start of trading Friday. The NASDAQ had declined -5.5%. However, other markets were already well into bear market territory at this point. Mexico and France are each down -18%. Germany is -20%. Large China companies have fallen more (-27%). Brazil and India are down -29%, while Russia has fallen -31%. Small cap Chinese companies have dropped -39%. For most of the world, we have passed well into bear market territory.  U.S. assets, certainly our bonds and to some degree our stocks as well, have benefited from the global flight to quality that accompanies the street riots in London, Greece, and now the United States.

Our portfolios have been building cash due to our concerns about...

• the crisis in Europe,
• the bear market in stocks, and
• concerns about a new recession in the U.S.

The good news, however, is that we are probably done selling into weakness and have begun to think about redeploying cash, at much more attractive levels, as events unfold.

The crisis in Europe is not an “if.” It is happening now and I don’t see how more frightening headlines can be averted. It is a bit like re-living 2007 and watching the subprime lending car wreck unfold. While trusted public officials deny plausibility, the facts tell a different story (see linked Stratfor analysis). I believe that the market is going to have to deal with the reality of a bank crisis in Europe. Until it does, we are just biding our time.

In 2007, first a few hedge funds owning subprime folded. Then bank managers claimed that their total exposure was limited to a few billion dollars. While Jim Cramer screamed about the system coming down in 2007 around us, the Federal Reserve lowered interest rates a little bit and the stock markets lumbered higher. Then came Bear Stearns. And then Fannie Mae, Wachovia, and Lehman Brothers. By the time it was over, the President was talking about nationalizing the banking system.

Fast forward to Europe where the politicians are still claiming that default can be averted and the central bankers have managed the problem by cutting interest rates this week. In the meantime, Greece can’t borrow money in the private markets, it can’t pay back what it has borrowed already, and it is just about out of cash. Everyone knows they will default. The European Central Bank is now just moving around chess pieces in its attempt to reduce the impact of the event. Whether Greece remains a member of the European Union is anybody’s guess, but – frankly – who cares? What matters is whether the virus spreads to Italy and whether France gets shut out of the bond markets when forced to rescue its own banks.

This week Dexia became the first big bank to fail. A big bank operating mostly in France and Belgium, that had previously passed the European bank “stress tests” with flying colors.  Dexia shareholders were wiped out. The regulators are looking to put all of the bad assets into one bank, owned by shareholders (wiping them out), while moving the other banking operations into good banks that will be backstopped by the governments of each of the countries. The hope is that the impact of the crisis can be limited to private investors without resulting in a run on the banking system. And that, in short, is the hope for the entire European banking system. With luck, and a lot of planning, and very deep pockets at the central bank level, this solution will work.

Dexia is not the only proof that the run on the banks is already underway. French-owned Societe Generale’s Chief Executive Officer told Reuters Insider TV today that the system isn’t “insolvent,” but merely experiencing a liquidity crisis. For the banking system, however, a liquidity crisis is tantamount to a death sentence. Banks are going to be closing down – are already being closed, in fact – and bank shareholders are in the process of being wiped out. In the meantime, the politicians are in denial.

The Presidents of France and Germany are planning to meet this weekend. When the French bank regulators start closing down banks, France’s Nicolas Sarkozy would like to tap into the slush fund that the European central bankers have thrown together to backstop Europe’s financiers. As George Soros has pointed out in the past, however, it is not the borrower that sets the rules in a credit crisis. The primary source of bailout funds will be the Germans, and it has been Germany that has been calling the shots thus far. The Bible says that, “the borrower is servant to the lender,” and the wisdom of that proverb is never more clear than in a crisis. This weekend, it is likely that Germany will dictate that countries tap into their own funds to rescue the banks within their borders. The European Financial Stability Facility (the EFSF is the Old World’s TARP fund) will be reserved for nations who lack the wherewithal to bail out their own institutions.

France, now a AAA credit, is headed for a downgrade. The EFSF won’t be tapped until the headlines are talking about how the banking crisis could bankrupt Portugal, Spain, and Italy. Huge sums of money will be printed in order to prevent the bank crisis from getting out of control. Just as the U.S. printing presses have been running overtime, look for tremendous expansion of the supply of Eurodollars as well. And, yes, the U.S. will have to chip in to prevent contagion.

Unfortunately, Europe is not the only problem in the headlines. The U.S. economy, too, threatens to be an issue.

As it stands now, our concerns about a new recession may not be realized. In any case, I believe, the uncertainties will increase and anxieties about a new recession will grow.

The Conference Board’s traditional Leading Economic Indicator is reaccelerating as this bear market unfolds. That reacceleration is unprecedented. Even more interesting to me, our own May-Investments Leading Economic Indicator is still moving higher. I am hopeful that perhaps our concerns about entering a new economic dip will be for naught. Whether we actually have another recession or not, I think that the sense of uncertainty will increase over the next month.

Just last week, the Economic Cycle Research Institute released a report declaring that the “U.S. Economy (is) Tipping into Recession.” While some jobs statistics released recently have been better than forecast, job growth is still lackluster by any measure – so bad, in fact, that in earlier times the current degree of unemployment would almost certainly be associated with being in a recession already. And while the unemployment numbers were applauded by the press and the market, the layoff numbers were projecting many more layoffs in the coming months. Very few statistics show any real economic strength. The vast majority show an economy barely stumbling along – and the best of them indicate that the recent month isn’t much different than the month before.

The economy is on a precipice. Add uncertainty about Europe to the mix, and additional forecasts for recession seem like a very probable outcome.

Interestingly, research by Leuthold Weeden Capital Markets suggests that it really doesn’t much matter if we head into a recession or not. Bear markets associated with recessions are no worse than bear markets that are not associated with falling into a recession. The typical bear market goes down 30% in each instance.

Our current cash position is testimony to what we believe about the current market cycle. Leuthold’s major trend indicator flashed a warning signal on August 3rd that allowed their Asset Allocation funds to step back from the market early on in the sell-off. Investors Business Daily has twice moved to “Market in Correction” status since the beginning of August, and remains in that status currently.

This bear market was also unprecedented in that it gave almost no notice ahead of time. There were few if any warning signs of internal weakness. One day the market was peaking, and within two weeks it was flirting with “bear market” territory (-20%).  Not since 1938 has the topping process come as such a surprise.

For several reasons, we believe that the sell-off isn’t over. First, volatility remains high. Typically, at a bottom, volatility spikes up when the bottom is set. Though we have had days where volatility increases dramatically, we haven’t seen it return to normal levels. Now, two months into the beginning of the bear market, volatility seems to be riding at a much higher plateau, roughly twice the level of normal volatility. A spike from these levels will be truly gut wrenching.

Nor has the market become so inexpensive that buyers are likely to move in and begin scooping up bargains. If last Monday (October 3rd) is to be “the bottom,” then Leuthold points out that the market will have bottomed at the third most expensive level (based on normalized earnings power) in history. The times when the market bottomed at higher levels were in 1998, on the way up to the tech bubble, and again in 2002, on its way back down.

The Leuthold conference call noted that in their opinion, market bottoms are established by an “end to selling” rather than new buyers coming in to the market. Like most trading generalities (e.g. there were “more buyers than sellers”), this is unprovable. However, I think the point is well made that “selling” drives prices lower. When the European banking crisis hits full stride, it is hard for me to imagine that the pace of selling won’t pick up.

It is true that for every seller there is a buyer, of course. In this case, it is the buyers who establish a “fair price.” Just like the borrower is servant to the lender in a credit crisis, the sellers’ need to get out of a security is subservient to the buyers’ determination of what constitutes a “fair” price. For every seller there is a buyer, but the two do not have equal market power.

The spike up from Monday’s low suggests that market participants are reading the news from Europe and concluding that there are processes and institutions being put in place to resolve the European crisis. From my point of view, the fact that these institutions are being created is proof of the crisis that is to come. My fear, however, is that the anxiety that will be created as bank after bank closes its doors, and as the newspapers speculate on whether Spain and Italy and even France will be forced to default, will create a wave of selling pressure.

In the event that happens, it is the buyers – those of us with cash available for investment – that will determine what constitutes a “fair” price for investment. Market power will be on the side of those investors who have cash available and are willing to act as buyers amidst the chaos.

We have probably sold our last position. We are currently considering what to buy, and what (to us) looks like a fair price to begin buying. Baron Rothschild once said that, “the time to buy is when there’s blood in the streets.” We hope it doesn’t get to that – either in Europe or with the Occupy Wall Street mob.

Unless investors have cash on the sidelines at times like this, however, it doesn’t matter. Because our clients have cash available for reinvestment, we are hoping to be able to take advantage of the volatility which I believe lies just around the corner. It is not my choice that the world has turned ugly. It is, however, my observation that investors are coming in to a very dangerous period. Buy and hold investors will bear the brunt of the downturn and will be anguishing about the question of “is it too late to sell?”

For better or for worse, we will be consumed with the question of “what should we buy?” Not only is it a more positive question to be asking since it turns volatility upside down and makes it the creator of opportunity, researching opportunities also keeps us off the street at night, when the Occupy Wall Street mobs are running rampant. Capitalism is not pretty. Volatility is ugly. But we’re not in the fashion business.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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