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.