Monday, May 5, 2008

Bank profitability at WHI

My last post on banking profitability can be readily applied to W Holding (WHI).

WHI has a leverage ratio assets/equity of about 14.6. In addition it has preferred equity nearly equal to common equity. So equity/common-equity is about 2.

So to build value for common shareholders and pay a small dividend we want to have return-on-common-equity at least 5%. If we cannot reach at least ROCE=5% then we can't really claim even to be worth common book value. The borrowing cost, BC, of preferred shares originally was about 6.7%. We can use the following formula (the the last post) to figure out the ROE that is required.
Using the above numbers, the required ROE is 5.85%. Lets call it 6% for simplicity. Using the above leverage ratio, this requires ROA of 0.4%.

Now 0.4% might seem like a pretty easy target for a bank. Normally a good bank can generate ROA of 1% or so. However WHI has some serious problems that are difficult to overcome. Lets try to see why. We will look at our ROA profitability formula.

ROA = (1-T) * [ (1 - ER + NII) * NIM - L]

T = Tax rate = 40% for WHI
revenue = Net Interest Income + Non-interest income = 260MM (4x the first quarter)
ER = efficiency ratio = Non-interest expense divided by revenue = 67% for WHI (last quarter)
NII = Non-interest income divided by revenue = 10% for WHI (last quarter)
NIM = Net interest margin = net interest income divided by total earning assets = 1.3% for WHI (last quarter)
L = provisions for loan losses divided by total earning assets = 0.72% for WHI (assumes 30MM provisions per quarter)

Current ROA = -0.1%
Given, these number the bank is unprofitable. The only reason it booked a profit in the first quarter was because it had a tax benefit from carrying back losses to previous years earnings. However because it has to pay out preferred dividends, it is even worse. The common equity is going to shrink if it can improve profitability.

What went wrong for WHI over the last few years when it had ROA > 1%? Basically everything that can go wrong. The tax rates went up, efficiency got worse, NIM went down and loan losses went up. WHI never was a high NIM bank but it was very efficient and had excellent underwriting and it made use of lots of leverage. This leverage was great when it was profitable but now acts like an anchor slowing their recovery.

If we go back just a couple of years we have ER=33% and L=0.005 and NIM=2% and T=30%. This gives ROA=0.73%. In 2001, NIM was 2.7% and ROA was almost 1%.

The tax rates went up when they changed the Puerto Rican laws on the taxability of the securities portfolio. This was previously tax free but is now partially taxed. They have also increased the tax rates. This may improve in the future but there is no guarantee. Effective tax rates were also lower because a higher percentage of earnings was coming from the tax-free (or at least tax-efficient) securities portfolio. Now it generates negative earnings as borrowing costs have risen against these fixed rate securities. Only loans are profitable and they are taxed at the full rate.

Their main problems are poor NIM and high loan losses. Loan losses will likely be high for the remainder of the year but should improve in 2009. The poor NIM is probably temporarily low due to loans resetting before deposits. However the deposit scenario is poor for WHI since they rely on brokered deposits and Repos. Even though the Fed has cut rates, brokered CD rates are still high. Much of their Repos are locked in for a year or more at nearly 5% rates.

NIM may get back to 2% by years end but likely will not improve beyond that for quite a while. If they keep their securities portfolio small, it will be higher than previously and they will be a more normal looking bank: less leverage, less reliance on Repos for funding. Expenses will also stay high due to legal expenses and restatement expenses. They should probably improve ER to 50% by years end and improve by a little beyond that.

So by years end, if we adopt these numbers, NIM=2%, L=0.7%, ER=50%, that would bring us to ROA=0.1%. This is still poor and will not lead to a profitable year. However there may be enough in tax benefits from charge offs to make the tax rate temporarily about zero. This would result in a temporary ROA of 0.16% which is slightly better but still might result in shrinkage of equity.

If 2009 is much better, we may see NIM=2.2%, L=0.5%, ER=42% and that would be ROA=0.6% which would be good enough to build value and send the stock back above book value. However it is unlikely to result in rapid growth. Their days of 25%+ growth rates are probably over.

Banking profitability and leverage

There is a fairly simple formula for banking profitability. Return-on-assets, ROA, given by

ROA = (1-T) * [ (1 - ER + NII) * NIM - L]


T = Tax rate
revenue = Net Interest Income + Non-interest income
ER = efficiency ratio = Non-interest expense divided by revenue
NII = Non-interest income divided by revenue
NIM = Net interest margin = net interest income divided by total earning assets
L = provisions for loan losses divided by total earning assets

So the general strategy for banking is always to try to increase non-interest income if it doesn't increase non-interest expense too much. You want to keep your non-interest expenses as low as possible. Then you want to have a high NIM which usually means low deposit costs. Then you want good underwriting i.e. low loan losses. You usually can't do much about taxes. That is really about all there is to banking. The devil of course is in the details of how you actually do this better than your competitors.

Return-on-equity, ROE, is just
ROE = ROA*(assets/equity)
where (assets/equity) is the leverage factor. This leverage factor is limited by banking regulators. It must be less than 25 and is usually required to be less than 20 to be consider "Well capitalized". Most banks try to get it around 12-15. If a bank is profitable, i.e. ROA > 0, then they usually benefit from more leverage. However this can be more dangerous because if things turn bad, the bank may become unprofitable and this leverage will magnify losses to equity. If the bank pays no dividend and retains earnings it can grow at a growth rate equal to ROE, if all of these ratios above stay fixed. It is pays out a fraction PR of earnings as a dividend, then it can grow at (1-PR)*ROE while continuing to pay the dividend at the same payout ratio.

It is also possible to leverage up the shareholders equity by raising other forms of equity such as preferred shares. This requires a fixed dividend payout to preferred shareholders which comes after tax. This involved another leverage factor
EQ/CEQ = (equity/common-equity).
The preferred equity, PE, is the difference between equity and common-equity, PE =EQ-CEQ. If the bank goes bust, the preferred share holders are paid back this preferred equity before common shareholders get anything.

The return-on-common-equity ROCE is given by

where BC = the borrowing cost or the dividend yield of the preferred shares.

If you set this to zero you you can solve for the condition where the bank's total equity stays the same size (before payment of any common dividend). That is
ROE = BC (PE/EQ). For example of PE/EQ is 1/2, then the bank's common equity and total equity stay the same when the ROE is half the borrowing cost. When this is true the bank stays the same every year. If you want it to stay the same size after paying a dividend, you replace ROE with (1-PR)*ROE.

When can the common shareholders grow their common-equity faster by issuing preferred shared? Just set ROCE equal to ROE and solve and you find this is equal when ROE =BC. So your ROE had better be higher than your borrowing cost or issuing preferred shares is not worthwhile.

If you want to know the growth rate of common equity, this is equal to ROCE. If there is a common dividend, just replace the ROE with (1-PR)*ROE. That tells you the growth rate of retained common equity. If you keep issuing preferred shares to keep the ratio EQ/CEQ the same, and the other ratios remain the same, you can grow the whole bank at this faster rate. Like the usual leverage ratio, banking regulators put limits on this leverage factor. Usually they want at least half the equity to be common equity.

Ok, lets do an example. Lets assume:
NIM = 3%
ER= 50%

This results in ROA = (1-T) * [ (1 - ER + NII) * NIM - L] = 0.78%. Now lets assume assets/equity =15. This results in ROE = 11.7%. Now lets suppose the bank pays a dividend at a payout ratio of PR=25% of earnings. Then it can grow at G=(1-0.25)*11.7 = 8.78%. Mid to high single digit growth rates are fairly typical for banks. Now, what about issuing preferred shares? Lets suppose it can sell preferred shares at a yield of 6%. Since ROE > 6%, this sounds promising. Lets say that it raises total equity to twice common equity EQ/CEQ=2

ROCE = ROE * (EQ/CEQ) - BC (EQ/CEQ-1) = 17%
The growth rate after paying preferred and common dividends will be
G = (1-PR)*ROE * (EQ/CEQ) - BC (EQ/CEQ-1) = 11.6%. So as long as they continue to issue preferred shares to keep EQ/CEQ=2, and everything else stays the same, then they can grow at this faster rate. In reality, of course, nothing stays the same but that is a different matter.

Now what if the economy goes into recession and the loss ratio, L, goes to 2%? Now ROA=-0.12%. It is now slightly unprofitable. ROE=-1.8%. Equity of the bank has contracted by -1.8% before payment of preferred and common dividends. ROCE=-9.6%. The leverage due to the preferred shares has magnified this loss. Common equity has dropped by -9.6%. That is a pretty big hit for just 2% loan losses. The bank will likely cancel the common dividend payment and if this goes on for another couple of years, it will have to raise common capital and dilute the interest of current shareholders in order to keep the leverage ratio below the regulatory limit.

Saturday, May 3, 2008

W Holding - Analysis of the 1Q 2008 Call Report

Ok, I finally got some time to go over this. Here is what I see, starting with the income statement. (all numbers in millions, rounded)

Loans rates have reset lower by about 100 bps (from 2007 1Q) but deposits rates have increased by about 26 bps. This is squeezing net interest income. NIM is only 1.28% down from 1.915% 2007 1Q and down from 1.656% last quarter. Net interest income is down 20 from last quarter. This will likely improve next couple two quarters. We would like to see NIM closer to 2%. Expenses are higher by 10 due mostly to legal/FDIC/advisory expenses. I am glad this isn't higher. We lost 7.7 before the tax benefit of 47 but 39.7 after taxes benefit. Additional loss in comprehensive income (i.e. doesn't flow through income statement) of 9.6 probably due to balance sheet restructuring.

Total equity capital is 1097 versus 1072 or a gain of 25. This is $3.43/share of book value.

Securities were completely restructured. It appears that they simply sold most of them and bought some shorter term securities to match their remaining liabilities. Total is 5342 down from 6542 last Q. In addition, they now have 2135 expiring in 3 months or less and another 1025 expiring in one year or less. They also sold or retired all of their structured notes 170.

This reduces assets and combined with the gain in capital, the capital requirement ratios are much improved. The tightest one is still Tot Risk based cap = Tot_risk_based_capital/Tot_Risk_weighted_assets which is now 11.33%. This is above the 10% Well-capitalized level by 146 and 366 above minimum. If after next quarter they do not replace their retiring securities they will be 189 above Well cap. if there is no change in capital. If they make about 30 next quarter,as I expect, they will be 219 above well capitalized. If so they might actually be able to buy back shares. I think they only need a buffer of about 160-180 above Well cap.

Now, Past due and non-accrual. This is actually not looking good. Non-accruals dropped from 481 to 467 but 30 days late increased to 215 from 31. Thus total NPAs increased to 682 from 512. Now some of these will probably be cured but much of it will go into non-accrual. Part of the reduction of Non-farm non-res non-accrual was El Legado. But what about Pueblo, Syroco and others? I was hoping for a larger reduction. Are these loans still in non-accrual or have they been replaced by others? 55 of C&I loans are 30 days late. That is worrisome because they could be ABL loans and could lead to large losses. Construction loans 30 days late increased from 1 to 11. Provisions for the quarter was 30 which is close to what I expected. Overall, it looks like there could be a second wave of losses coming next few quarters as the US recession affects Puerto Rico. Is this what we are seeing in the 30 day lates?

Overall, the report is mixed. The bad news is non-accruals still being higher and 30 day lates increasing sharply. Also the poor NIM due to loans resetting faster is slowing our recovery.

The good news is that we are much better capitalized and this will only get better next quarter. We are still profitable. This is partly due to the tax benefits from our charge-offs offsetting high provisions. Allowance for loan losses is still 217 which will allow for more tax benefits as some of this is charged off. Interest income should improve as deposit costs come down as long as non-accruals do not increase by a lot. We might actually be able to buy back stock. Given that the stock price is 1/3 of book value, this can greatly increase BV/share.

So to conclude, it is a decent report and bolsters my case for holding this stock. We are on track to make 150 for the year which is what Stipes said he expects to do. That would put BV/share at $4.1 and EPS at $0.91 (or 0.7 after subtracting preferred dividends). If so and we get current with the SEC we should sell at around $5/share.


See my posts on profitability. After reviewing this further I no longer think they will make much in 2008. They are being hit on profitability on all fronts: NIM, expenses and loan losses and I don't see these improving much for a few quarters at least. The tax benefit from first quarter is likely much larger than what they will book in the quarters to come. I think it may take them until 2009 to improve substantially. I think they will probably linger around $1 until they get current with the SEC. After that, they will still probably stay around $2 until profitability improves after which they will return to book value. It may take them a few years to get back to $5. Still, this would make them a good long term investment. I think the chance of them buying back any stock is small. Still, they should consider it as long as they can foresee improvements in the future. Even 30MM of buybacks near $1 would increase shareholder value by a lot and probably not endanger capital ratios.