Colarion Partners' Sam Haskell on the financial sector and banks (podcast #178)
Sam Haskell, CIO of Colarion Partners and Editor of the 5 Points newsletter on Substack, is today's guest on the Yet Another Value Podcast. In the last few months, we've been covering all aspects of the financial sector, banks in particular, so we had Sam on today to get his thoughts on wide array of topics in this space, and what he's focused on in these current market conditions.
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Transcript begins below
Andrew: Hello and welcome to Yet Another Value podcast. I'm the host Andrew Walker. If you like this podcast would mean a lot if you could follow, rate, subscribe, and review it wherever you're watching or listening to it. With me today, I'm happy to have Sam Haskell. Sam is the CIO. Let's see if I get it right this time. Colarion partners. Sam, how's it going?
Sam: Doing well, thank you, Andrew.
Andrew: Thanks for coming on. Let me start this podcast the way I do every podcast. Just a quick disclaimer to remind everybody. Nothing on this podcast is investing advice. That's always true, but I think we're going to be talking broadly about the financials and banking sectors today. People should just keep in mind that means a couple of extra names will probably get mentioned. Please do your own work and consult a financial advisor. Nothing on this podcast is ever financial advice. I always say when you talk about extra names, that means extra risk. And with the financial sector today, that certainly is true.
Sam, I wanted to have you on because, over the past few months, I've been super interested in the financials and banking space in general. I found the five-point sub stack, which I'll include a link to in the show notes if everybody wants to go check that out. I've really been interested and your sub has just done such a great job of talking about all the different things going on in the financial space. So I wanted to have you on. I'll just pause there. You focus on financials. How are you thinking about the financial space, in general, these days?
Sam: Lots of different aspects of that. From insurance, which is seeing a lot of strength in pricing, we see that and a lot of it is interconnected. You have multifamily loans and then they're upset about insurance. And then you have alts, which feel like they have a great opportunity to grow loans. Whereas you have banks that are retrenched. When I say Alts, I'm referring to alternative credit and private debt and private equity folks raising funds. I tend to spend most of my time focused on the bank sector within the group but a lot of attention is paid to all the ancillary elements of the sector. That includes credit and loan demand and it includes a lot of different parts between real estate and the CNI which is commercial and industrial credit.
Putting it all together we are in a very slow moving stressed situation where we have a massive amount of what you would call legacy liquidity, which is something like 4 trillion of liquidity that was pumped in just a couple of months in 2020 and that's in this really slow runoff phase. That's why you don't have 2008-style disruption and defaults and contagion but you have very slowly rising delinquencies, whether you're looking at different elements of commercial real estate or you're looking at consumer credit it's in an almost mesmerizing, slow pattern or development. It's a little bit tricky in that you have to be patient and let it all play out because there are going to be a lot of movements. Today people are concerned about the jobs number. last week folks were a little bit more excited about the soft landing idea. This back and forth is going to go on for a while but we're probably headed towards an ultimate destination that's going to challenge a number of different business models in the financial sector.
Andrew: When you're looking at a generic bank these days, what is the thing you're focused on because I'm looking at tangible book value, I'm looking at capital ratios, but then you'll hear people come, oh, I'm really worried about margin compression. I want banks with fees. I understand the answer is probably all of the above, but what are the things you're really focused on in the current environment?
Sam: Every environment changes. I remember in 2008 we used to create a burn-down tangible book value model but right now and this is really the only time I've ever done this, I use SAP lot, it's the SNL but you go in and you go to the data source and there's a component of it that tells you yield on earning assets and then the cost of funds. How is that moving? A lot of people are looking at this but over time there are fewer and fewer people actually looking at the fundamentals of the sector more and more just playing it through an ETF. There are specific banks CBB Financial, for example, in California or Glacier, GBCI is another one.
They've just been favorites of long-term investors for years. I think Glacier, if you bought in 77 or something, you'd be up like 50000%. They just happen to have to earn asset yields that are depressed. Somewhere in the range of 3.7, 3.8%. You don't need to know linear algebra to understand that if the going rate on deposits is somewhere between 4 and 5% and your earning assets are stuck below 4 as of the first quarter, you've got some work to do as a management team. We can get into the details of all this, but that's why guys like me are like Hawaii is another place where this is really prevalent. Well, how sensitive are depositors to rates in Hawaii? How sensitive are depositors to rates in upstate New York? That becomes the game, that's what's very important right now. We'll learn a lot in the second quarter. It's going to be somewhat difficult. I would suggest that 2024 will be a little bit better period for banks just because rate stability is very helpful for the sector but to give you the short answer to your question, earning asset yields is what's very important right now.
Andrew: I'm glad you mentioned Hawaii, the two there are Bank of Hawaii, the ticker there is BOH, and then there's I think first Hawaii and Bank, the ticker there is FHB. A lot of people have mentioned these. I think especially Bank of Hawaii, BOH they've got a lot of, I don't want to say Silicon Valley, but Silicon Valley has really low rate loans, lots of low fixed rate health to maturity and I think a lot of people have looked at them and said why is this not the next one to go? Tangible book value is about $30, but if you mark to market everything, I think they would've negative tangible book value if you market everything. I'm trying to quickly look at my notes, but a lot of the Bank of Hawaii bulls would push back and say this is Hawaii there are 5 banks with branches there. They actually do have 50-year-long relationships. Like JP Morgan's not there. If you're an operating business, you're not just going to say, oh my gosh, negative book value I need to pull out because there's nowhere else to go there. What would you think about kind of the Hawaii banks right now?
Sam: It is a little bit tricky. We'll just stick with the Bank of Hawaii. There's the first Hawaiian bank, there's territorial, there's American savings, there's a bunch of credit unions and there are a couple of others beyond that. Bank of Hawaii said our margin, and I'm just going off the top of my head, it was down in the low twos. They thought it might fall another 10 or 20, but 0.1, 0.2% and get to the low 2s and then start to rebound. That's how a lot of management teams are thinking about the world at the end of the April timeframe mid-April when they were reporting, I think right now, if you were to take another look at it, you'd be slightly more pessimistic and part of the reason for that is just a number of different banks have said that the need to shore up liquidity and the need to pay up for deposits has sustained and perhaps intensified in many areas and in many geographies.
Now what about Hawaii? You can't just go to JP Morgan if you're in Hawaii and that's part of the reason I do all this, is to go out to Twitter to ask people. For example, in one situation there was a CFO who said I bank in Hawaii and I moved my money to Brenton. My bank didn't even really care. You look at American Savings, which is a private Hawaiian bank, they will advertise CD rates in the 4% range and their rate sheet for the money market is like five basis points. Maybe they're trying to conceal the panic, but if you desperately needed liquidity, you would just go out there like Pack West and pay 5 and a half percent. I think that they're in a situation where it is slower than the overall mainland.
By the way, guys like me, we will poke holes at Hawaii because the Hawaiian banks bought a lot of agency securities, which are kind of these whammy securities where not only is the rate 2% but it's based on everybody's mortgage. Everybody is locked in a 3% mortgage and you as this holder there's a scrape to the servicer. So you end up getting like2 and a half percent and you think, well, that's fine. People will move and this will only be out for4 or5 years. Well, people will stop moving. Maybe it's going to be out for nine or 10 years. You're stuck with this trash bond for almost a decade.
Hawaii has this substantial amount of these agency securities that are on bank balance sheets and it's just going to be a ball and chain. That's the term that I used in my note. You look over, there's another island, it's Puerto Rico. Well, these banks, they make auto loans that are variable rate and they make consumer loans and mortgages and things of that nature. And their earning asset yield is not 3 and a half the way it is in Hawaii. It's 5 or 6. And so guys like me love Puerto Rico and we just assume that deposit rates are going to stay low and we'll see. I think that in both islands they will inch off. It's just going to take longer than it does on the mainland.
Andrew: Bank popular islands that years and years ago, I haven't looked at it. Is Bank Popular Island the play there or are there other Puerto Rican banks you're looking at?
Sam: We have been involved from time to time in Oriental. I think Oriental the CEO's name is Jose Raphael Fernandez. I think he's relatively dynamic. That's not to take anything away from First Bank and popular but beyond just management flexibility in Puerto Rico you have when I first started looking at Puerto Rico, there were about 6 o r8 banks. They're now3 and that doesn't count. There might be a crypto bank or a few small players, but it's really three banks on the whole island. Not only that there's a possibility you get government stimulus, although that's very much in flux you have a lot of wealthy people. I say a lot. It's hundreds, maybe a couple thousand a year, wealthy people avoiding taxes. The economy's actually done quite well in Puerto Rico.
Andrew: I laugh when you say a lot of wealthy people avoiding taxes because a few of my friends have pitched me. Every now and then I'll pitch my wife and they're like, Hey man, you moved to Puerto Rico, all those taxes out the window. I know there are a few hedge fund managers who have made that trade. You go to Puerto Rico you get all those taxes out the window and they've got the little app and they're like I'm in Puerto Rico 183 days in the year and I can be anywhere else and I save all my stuff.
Sam: It is not a joke. You pay 4%, you go to Dorado, you get behind high gates and you hang out at the beach with your friends if that's what suits you but I think it's a particular type of a person that wants to do that. The point is that those banks that have high margins are doing really well. which really if you want to ask about banks, you almost can use Puerto Rico and Hawaii as a microcosm of the broader sector. You have the banks that are earning three to 4% and bought a bunch of bonds and are stuck. You have the banks that are variable rate lenders and are earning5,6 like employment was high, the Fed is really hawkish, want to do another 25. Maybe they want to do another 50, bring it on.
It's going to put some stress on our borrowers, but our margin is going to hold up. We have capital maybe we're going to buy back. The capital point, by the way, is pretty important because it's an additional element if you bought these bonds, now they mark the bonds against your capital because those bonds are not as viable. Now you don't have as much capital to go make loans to go expand your balance sheet to grow out of your legacy issue. It's really a case of the haves and the have-nots across the sector.
Andrew: There's so much I want to talk about that every time you talk, there's another area I want to go on there, but let me just ask. The thing that brought the First Republic down was not the held-to-maturity bonds, they had a lot of held-to-maturity loans, basically. They have lent rich people mortgages at 2%, which doesn't matter when interest rates are at 3, but then interest rates go up to 6. They've got the mortgages on their book at face value, but obviously, they're worth way less than face value. I think one thing, like just me as a generalist or a lot of people have looked at, a lot of these banks, when you look at them, they don't have the held-to-maturity issues, but half their book value will be made up of loans that are fair value of4 that are held to maturity at 4 billion.
If you look at the fair value, they're 3 billion and they're these loans that were made low-interest rates, they're permanent, they've got a hollow them. I guess you're hitting that when you're talking about the asset yields but how do you think about banks that have those big loans, asset issues? Do you look at them in tangible books? Do you think they probably need to lose money for the next year? What do you kind of think about those types of banks?
Sam: Every bank is different. I have a few banks, or maybe I should say I had a few banks in the portfolio where I would, one was the circumstance where they're going to up merge with another bank that has very low-cost rural deposits and that's going to help give them time to work out of the issue. But really your question is, are these banks going to be able to work out of the issue? Every bank is different, but let's just take the banks that everybody knows, bank of America decided to go out and buy 500 billion of agency and mortgage-backed securities. Ball and chain[?] Wells Fargo, JP Morgan going to be in relatively, that was a question everybody kept asking JP Morgan like when are you going to put this money to work? Because there was a flood of deposits.
And they said we don't see any problem with just being patient. Well, now they're able to really do what they want to do. Maybe they want to take market share from Bank of America while Bank of America is sitting on 420 or 430 asset yields. It's going to take Bank America longer it is on to take JP Morgan not very much time at all and there are a couple of banks that are kind of in the vanguard, one of which has been very unpopular for a long time. Customers bank.
I write about this because it's a rare circumstance where the son has a bunch of great ideas and is able to bring the bank ahead of where the father put it but through different technology initiatives recruitment efforts, deposit verticals, he's running around and talking about bringing in 2 billion or transaction deposits over the next year or two and the market is saying I buy because he's going to have margin expansion, he's got a really good treasurer, his asset yields are north of 6%, they had their funding costs blow out but then these pushing them back down and paying off wholesale borrowings and brokered CDs. There are banks that will probably end the year up 20 or 30% because of the flexibility that they've put together on their balance sheet.
Andrew: I laugh when you say customers bank, the ticker is CUBI because in the depths of March and April, I was just trying to ramp up on banks and that was one that caught my eye. I asked three financial specialists who I know, and all of them said the exact same thing that you had in your note. Maybe we were talking to the same people, but they were like statistically it looks cheap, but there's like other things outside the spreadsheet and you just can't trust this management team. They did something where I think it was the CEO's daughter who ran a SPAC and took assets out of the bank for the SPAC and like they were on the boards and stuff. I could totally get how they could say there are some extracurriculars. Maybe you just don't want to step in there. As you said, you look at the Excel, you look at the book value, you look at the asset yields and you're like that looks really darn cheap.
Sam: It's an interesting process trying to speak to the son because the management board understands this at this point and that's why the son is the face of the company in front of the investment community. But nonetheless, at some point, it's hard to prove the negative. It's hard to prove that your governance has improved after you spent so many years taking large salaries or giving these mega bonuses for ROAS of 1%. Over time the record is starting to speak for itself. But we'll see. It's at five times earnings and 75% of tangible. They haven't exactly completely worn off the discount.
Andrew: Commercial real estate has been very much in the crosshairs. Every time you mentioned banks to someone, people will say, oh, you had three banks fail and you didn't even have the recession. Wait till those commercial loans really come to and they start to have to roll. Park hotels handed over to hotels in San Francisco and Brookfield handed over the mall and everybody knows that office space in San Francisco and New York's bad. There's2 areas we could attack that from. We could talk about what you think about commercial real estate for banks going forward. I'm just looking at yours, I think this is your post from late June figuring out 2024 and you lead it off by talking about the commercial real estate REITs, which I think are really interesting as well. I'll just kind of toss all of that over to you and let you go with it where you want to.
Sam: We're going to go back to this extremely slow motion. I don't what to call it a slow-motion train wreck. I spoke to a banker in LA who would say it's a disaster. I'm here in Birmingham. We wouldn't necessarily call it a disaster because it's different markets. The sunbelt market is not CMBS-reliant but commercial real estate is a massive topic. If you bring up the last note I put out, it was just a very simple trend of delinquencies by subcategory of commercial real estate. The way I think the office was maybe 2% delinquent a year ago and now it's 7%. Hospitality, I think partially because of certain towns, San Francisco, Chicago, towns where you don't have as much convention business that's starting to pick up on the delinquency side, although hospitality across the country is actually quite strong.
It's really just the certain self-sabotage towns that went overboard. I went to a conference in New Orleans in 2022 they wanted me to show my VAX card to get into the hotel. That's something that you're going to have to get around. Unfortunately, I think no one is coming back, but like your cell phone traffic, I noticed the other day is still 45% of what it was in 2019. Just think about Seattle where they were trying to create an autonomous zone downtown. You could be in a much more difficult circumstance anyhow, sub-sectors, office leads hospitality are kind of following in certain cities. And then multifamily to my mind, it's only a matter of time for multifamily.
Very much city by city, state by state because of rent growth. The supply of multifamily just the amount of capital that is available that is no longer available is going to create problems and that goes into the second part of the discussion, which is what happens when you have hundreds of billions of dollars available to finance a sector and then you don't. If you were to aggregate the amount that's available to just lend against commercial real estate, across commercial mortgage rates, CMBS, or capital markets, banks. If you were to do that in 2022 and you were to do it today, how big would the bucket be then versus now? I think that the amount that's available is probably gone down. If you just do it by transaction volume, I think you're almost 75%, but just the pool available, you really got to dig in, find family offices, find private equity or private deck providers who have become very valuable dry powder and then you're going to have to operate under their terms or you can be an existing customer of a bank that that bank really wants to take care of, just in the sense of that bank doesn't want a non-performing asset.
What we're all getting at is this, I hate to use the cliché of the coyote just sort of hovering in the ear, but the point is it's folks just waiting and not transacting and because of that there's no choice but for the valuations to continue to settle. The owners of the assets know that they have a call option that maybe they can wait it out and rates will fall at some point and they'll make it through, the call to survive to 25 that's the term across a lot of the commercial real estate sub-sectors. It is just going to hurt. We can get into how it hurts the CMBS versus the banks if you want to, but go ahead.
Andrew: Let me just jump in and ask a question. This is more on the bank side than on the commercial REITs but for every bank that I follow in q1, I think the disclosures got a lot better in q1. Obviously, everybody’s banks started coming out with their insured deposit disclosures and breakdowns of deposit ratios. But I think on the commercial real estate side, everybody got better. Any bank under 100 or 50 billion in assets, I'm just using rough numbers but they'd come out with a slide that said most of our loans are in CNI, not commercial real estate or they'd say our loans are in commercial real estate, but let me break down my commercial real estate for you.
They'd say here's my commercial real estate. Most of it is related to hospitals or all this and they knew that the buzzword was office. All of them would come out and somehow magically all of them said only 5 to 10% of our loan book is in the office. Then they would do another little pie chart and they said none of it is downtown New York, none of it is downtown San Francisco. 66% of it is owners who are kind of occupying their own office. Only 33% is investible office. All of those are very small, so it's very diversified and these are much different. Every single bank came out and said, by the way, we've stressed it, it's 50% LTV, it's 60% LTV you've got great equity cushion beneath it and this is our updated numbers.
There's this old thing, it's not the issue that you see coming that kills banks. It's really an issue that hits you suddenly. These banks have had 18 months to 2 years to prepare for the commercial real estate downturn. Everybody knew things weren't going to be great. Do you believe them when they say that their portfolios are this clean or do you think they're kind of playing games and we should be taking a much more distrustful eye to these portfolios?
Sam: Well I don't believe any of the loan values. That's number 1. Number two, the smartest management teams are going to be the ones that actually lean into this and that's going to sound crazy, but what I'm talking about is just taking the Flatiron building, for example, I don't know where the Flatiron building was valued. Maybe it was 3 or 400 million and then it got cleaned up at auction at 160 and on the reset valuation, somebody's going to find a guy who's got 50 to $100 million in liquidity and is going to provide recourse and they're going to make a 40 to 50% loan to value loan at like 8% plus. It might be a bank might be, it's probably not going to be a bank but that's where the opportunity is.
As far as where the losses are going to come from, we already saw a sneak peek of this in the first quarter. P&C got asked and gave a lot of disclosure about their commercial real estate. So did M&T I think they said that they were 6 or 8% reserved for the office. Surely that reserve is going to end up going higher to 10, 15, 20% of their total book. The smaller the bank, generally speaking, it's going to be a little bit less of an issue because you end up with, why would you use a bank for commercial real estate? Usually, you would want to position putting it into a conduit market. You're flipping it to the idiots, Fannie[?] Freddie maybe you're going to find a CMBS conduit that's going to be funded by an insurance company effectively, but you use the bank because while you want to get the tenancy up or some sort of a go-between a bridge to get to permanent financing market or you just like that the bank is more flexible and so you're willing to pay a percent or two more and you're willing to accept 55 to 60% loan to value instead of a 70% loan to value.
With that said, the most stressed sectors, The majority of the non-recourse stuff is going to be at the regionals. It's the trust and the PNCs and the mentees and Wells Fargo. I guarantee you they'll have their fair share of charge-offs through the cycle. When you get to the smaller banks the ones that do deal with developers, the ones that have construction, there's the one that comes to mind or two that come to mind in the New Jersey area. Anything with more than 15% construction has to be looked at carefully because the recourse is not as valuable. But for the most part, I'm on the board of a bank that does a ton of commercial real estate and they're all rich guide loans. The question is, well some of them, the guarantor has too much exposure to the same real estate class and so there can be a domino effect and that will get you. If you blow through his recourse and you have a 2008-type situation, you're going to take a charge off but we've never had anything, we're not even looking at being close to having anything. It's going to take a while in the smaller banks and that's going to be very much helped by the recourse and the granularity.
Andrew: You mentioned PNC and I think that's an interesting transition because PNCs is the one I thought was really interesting their CEO was at a conference in early June and he was asked about any lending verticals that you think they are really interested in. And he said exactly what you said. He said the spreads we see in the office right now I'd love to be lending into the office because you could do a 50% LTV on a super marked-down valuation and you could do it at really big spreads. But he said I'm scared to do it because my shareholders would freak out just because office exposure's going out. But the transitions are something I did want to ask about. You had a note on the key to the rest of the year is going to be capital wins.
I do know of a lot of banks that have excess capital like set one you've probably got to run it at 8 to 10%, but I know a lot of banks that have it well above 12, 14%, and some of the ECIP recipients are way above that. I guess there is a question, what would you like to see banks do with excess capital right now? Because I see the gamut, I see some banks that sit and say now is not the time to be aggressive. We would generally like to run this bank at 10%, we're at 12 or 13% right now and we're just going to keep building up that capital because we want to make sure we're safe. We don't know the regulations that are coming down the horizon.
You'll see other banks that everybody's pulling back on lending, I want to go lend right now, there's great spreads or you'll see other banks that say our stocks trading below tangible book we've built up a lot of excess capital let's go buy our stock back. There might not be a right answer there, but kind of what do you think banks should be doing right now if they do have excess capital? If they don't have excess capital, they're probably in trouble. What if they do have excess capital?
Sam: Every bank's situation is different. Some of us on Twitter pick on Triumph because they're repurchasing their stock at the north of twice tangible because they think that...
Andrew: They're going to revolutionize the payments industry, right?
Sam: Yeah. They have a really valuable payment subsidiary and they're not repurchasing their preferred at wherever it is, 18 on a 25 par. I believe their preferred is treated such that they would get a guaranteed or an immediate capital benefit by doing that. That's what companies like a firm are doing. They'll have these busted converts way out of the money trading at 60 cents on the dollar. So they're just buying it in and creating capital for themselves. Why you wouldn't do that unless you have some liquidity requirements, you know, that, that would make a lot of sense for me to consider doing something like that. it just depends if you're in a slow-growth market, you don't necessarily need to be making loans there. There is another bank I write about Service Bank[?].
Service bank[?] got themselves in a little bit of a jam because they're 63% fixed rate loans and their correspondent deposits were pitching and rolling them all over the place. They felt like they had to run off some loans or run off some customers. When you do that, it creates a lot of disruption and you should be able to take advantage of it. The answer to your question is all of the above, yes, you should be making loans, you should be refreshing your shares depending upon their secreted tangible, and obviously, repurchasing your debt. you need to be making loans to some degree anyway so that you can reprice your balance sheet. So that you can grow out of these situations and customers go back to them like it actually makes sense.
These guys are sitting on 6% TCE and I think their ET1 is nine or 10%. They wanted to build that back up again, I totally understand that regulators also have a say in what you're able to do. There are so many good opportunities for banks to create value at this excess capital that for the bank that's sitting on 9, 10, 11 and just wanting to sit and wait it out, they're really missing because we all see this, like you take the example of the office, the opportunities on the lending side, you don't have to go much further than to listen to Marc Rowan or whoever at Apollo or these guys on the private equity side or the private debt side, and they all say the same thing. It's like Blackstone, Blackstone's going to take out Blackstone on Blackstone's bad assets.
They just raised another 50 billion maybe it was 40 billion. The guys who are in the 50 billion you know why they're in there. It is because they want to make, they want to buy the distress, they want to buy the stuff that PacWest is being forced to sell. Unless you believe that we're going to be in a severe protracted recession, there is a very good opportunity to be made, whether it's distressed commercial real estate or commercial restructuring, a lot of good lending verticals out there. You just have to be in a position to be with the right customers and to be able to make those loans. I'm sorry I can't give you a more specific answer.
Andrew: That was fantastic.
Sam: It helps maybe give a little bit of color as to why capital is so valuable.
Andrew: Do you follow Capital 1 at all?
Sam: yeah, to some degree.
Andrew: I look at them and I'm doing this all for memory, but they always run a little bit higher in terms of capital, and in part, it is because they probably have to. They're a much more consumer-focused book with credit cards and auto, which are riskier than a lot of the other things. I do note that they've got great returns on equity. They're trading around tangible books right now. They've got a deposit franchise that I think is very much where the Puck [?] is going in terms of its very online heavy, but you look at them and they say we're pulling back. They're pulling back from a lot of autos right now, they're not repurchasing shares. Historically I think Capital One has been very sophisticated and I look at that combo and say, have they lost it? Is there something else going on here? I don't know if you've got any thoughts on that.
Sam: Well, actually there are 2 types of banks. The banks where you speak to them and you're teaching them or you're trying to convince them of what you consider to be a truth and the other is the banks that are teaching you. Most successful consumer lenders, particularly unsecured consumer lenders or credit card providers are going to have teams of data analysts. You're talking about AI but the number of people at Capital1 managing data and running machines to try to parse the data better is in the hundreds. It is worth paying attention to what they're seeing because they're going to see the leading indicators maybe a little bit faster than you are. I'm going to defer to their judgment relative in particular to maybe some fintech that is trying to grow into what's happening now.
One of the key variables in all this is obviously student repayment and Richard Fairbank was asked about that about3, or 4 weeks ago and he gave a good garbled answer, but the Fed has an MO right now, and that is to not directly, but somewhat indirectly raise unemployment that's number one. Number two, the fiscal stimulus, the student debt situation, just one example we're on the tail end of that. It's gone from tail end to headwinds. If you're combining all of this, like do you really want to be aggressive on unsecured consumers or auto in the here and now? I trust to some degree Capital1's judgment in that regard.
Andrew: I totally agree with you. I look at what we were saying about aggressive and I look at Capital One and I say I get it but they're running with a lot of excess capital and they're not buying back shares either. I look at the 2 and I wonder, let me change you to a different area. you wrote in the late GMPs about the US commercial real estate trust, this is Blackstone mortgage, Starwood property, KKR real estate, all these sorts of stuff and they had a really interesting way. These guys are generally pretty levered. They had a really interesting way of trying to deal with the stress and the funding issues and the current thing. They basically all stopped making loans in Q1 23. That was just let's secrete the capital. How do you look at those guys? Because I do have a lot of people who look at them and say statistically they look pretty cheap. But then I would kind of lean into the yeah, but these are quite levered and as you said I'm looking at your Q1 piece, they've got a 1.3% reserve ratio for their loans and I think 1.3% reserve is a sign of a much different environment, but they are cheapish. So how do you kind of look at all of them?
Sam: Well, if you're not doing business, you are kind of running yourself out of business over time and why would you be doing that? It's just because your opportunity set is not what you want it to be. You talked earlier about banks marking everything to the market. Banks at least don't give the implied value of their deposits, but if you were to mark their deposits to market, banks actually could have a fair amount more equity on their balance sheet than they're given credit for.
Andrew: This is what Silicon Valley said or Zion loves to come out and say they make us take marks on all the loans, but they don't let us mark our zero-cost deposit at improve improvements as yield goes up.
Sam: Silicon Valley was screaming into the wind. If they had time to actually make that point maybe they could have bought themselves a little bit more time, but they didn't. That doesn't exist with the lease. There is no franchise value. If you have a book filled with legacy credits 21 vintages, 22 vintages when everybody else is making these loans and your funding is wholesale funding, you really need to be careful. And I wrote with regards to Arbor[?] that you cannot take your funding for granted whether it's repo funding, whether it's CLOs like THO that's open until it isn't. If you start showing a bunch of delinquencies your best bet is to have ample capital to support that. Now the other problem with the REIT is that you have to pay out 90% of your income so these REITs could be bolstering themselves, but they're just not really not allowed to. The only lever they have is just to stop doing business. If you want to jump in and get 11% yield or whatever as a result of that you can be my guest but I'll comfortably stay away from that.
Andrew: One of the things on the heel of the crisis, especially I'd hear this a lot at the end of March or early April, like right when the crisis was really ongoing, you'd hear people and you still do hear it today, these are difficult to invest in because you don't know what the regulations are going to look like coming down the line, but don't we have a better model like private credit. A lot of people talk about private credit, that's the future. You go, you raise capital that's dedicated lifespan, and you can match up your liabilities with your loans. You don't have this issue. I do think banks now have to be much more concerned about liquidity runs, all that sort of stuff. You do private credit, you don't have to worry about any of that because you've got it dedicated. You can pull on it and really match it up. What do you think about future banking versus private credit lending?
Sam: When you look at business development companies and you look at private lenders and it's grown dramatically. If you look over the last decade, it's something like 100 billion to over a trillion. And they'll say we're making loans at five times EBITDA, 6 times EBITDA. You dummies on the bank side are tracked by regulators and you're doing it two to three times EBITDA on these private equity and, and buyout loans. We found a better way. Well if you have found a better way, then shoot, the bank should be grabbing that 10% because a lot of these loans are at 4 plus 500, and the banks are sitting around at lower leverage at 4 plus 250 to 300. It's a function of how much stability you want in a real downturn.
This is what I wrote, but like if it's a relatively shallow downturn, private credit's going to look great and I think that's the bet that a lot of people are making. When you look at Aries stock, I think Aries is up from 70 to 90 in 2023 in part because of the perception that the growth of the sector will be unimpeded. To some degree, it's a bet on the tenor of the recession. What I would say is that also private credit can have certain pretty substantial advantages. For example, let's say a company runs into a ditch, what are you going to do about it? No bank is going to say well you ran this company into the ditch, so we're going to foreclose, restructure the credit and put our guy in charge and create a lot of value.
Number one that's the benefit that you get from that sector and number2 you go raise money. Blackstone is the master of this. You're trapped. Every month there are 10 billion redemptions of only which like 1 billion is funded. You would think that that would destroy the model. No, it doesn't. Whatever it was 35, $40 billion fund that they just raised to take advantage of the legacy bag holders. That plus the benefits that you just mentioned, like for those reasons alternative credit really needs to be taken seriously. Is it a better model than banking over time? You get non-recourse leverage but you don't get the same leverage that banks have.
That remains to be seen. I think that it is a pretty strong model. It is a model that needs some testing. I think it will be tested a little bit second half of this year, the beginning of 2024. There's this situation where you do these middle market deals and you just roll them and you do fund 1, fund 2, fund 3, fund 4, well, fund 4 is going to be negative, fund 5 is going to be flat. We're going to see how that all works out. The model has grown really quickly and now it needs some seasoning.
Andrew: Community banks. you wrote about Needham in your most recent post, I followed community banks for a long time. I do think it is interesting. Most people who've done events in special situations know all about demutualization and everything, but community banks go further than that. I look at these very small banks and a lot of them are trading, forgetting the demutualization is included. A lot of them are trading below book value and I want to get bullish on them. But I do wonder like these sub 5 or 10 billion banks are just too small in the new regulatory environment where they don't have the same tech offerings as the giant people. Now we've seen there are issues with the FDIC I wonder when you're going.
Sam: You're talking about whether should people buy conversions?
Andrew: Should people buy conversions or just these really small community banks? Is there really a case there or are they kind of going to get the worst of all trends?
Sam: I think there are two parts to that question. Number one is, should you buy conversions? And number two is, should you buy...
Andrew: This is not about whether should you buy conversion at all. This is not investing advice. We're just talking like historically they've been a great place to look.
Sam: I'll speak about some generic conversions that can be replicated in real life. I have about 5 or 6 different conversions in the portfolio. I've written a little bit about William Penn, there's one in Louisiana. There's a handful. TC is down in South Georgia, CCBC. We talked about how capital is king or capital is very valuable going to the second half of 23 and 24. A lot of these conversions can repurchase something like, it just depends on the specific one, but 50 to 75% of the shares outstanding. If you're in that situation you really just need to figure out if there's anything crazy going on in the mind of the CEO. Are they going to do some dilutive acquisition? Does he have some monoline vertical where he wants to make a bunch of construction loans? William Penn did a lot of the same stuff that the Bank of Hawaii did, doesn't matter. Their capital got beaten down from 23% of assets to something like 19% of assets and they probably bought 15% of the float outstanding through June.
Andrew: The catalyst, the one in Lafayette you were talking about. They're so overcapitalized because they just did it. And my only question is they're buying back shares at a really aggressive rate. I don't even know how they're buying back shares at such an aggressive rate because the stock never trades. I'm like how are they doing this? Where are all these shares coming from?
Sam: You got to look at the volume. There are blocks from time to time, they just sort of show up. In the bank sector, there are people who are forced sellers from time to time because their funds mine down, but they don't always own these conversions. You talk about how you benefit from capital, you hire producers, and you repurchase stock. These guys hire producers, and they add a couple of guys, but it doesn't make too big of a difference. All that matters is if they're trading at 70 or 80% of tangible books and they want to repurchase until they get to book value. And if you can find a CEO who's got hell on his shoulders and agrees with you, you just sort of set your watch. You might have to wait nine months, you might have to wait 18 months, but that's a relatively lower-risk way to get a 20 or 30% while everything else is going haywire in the sector.
Andrew: I think there are statistics that show this is they do the demutualization, hopefully, they return a lot of capital aggressively to shareholders at really advanced prices by buying back shares. And then 3 to 5 years from the demutualization, I think like 75% of them sell, if I remember correctly. You've got a really nice exit on the back end. Catalyst is one I've been following for a while. I just haven't been able to get a position. It's extremely liquid. I guess you've kind of got to get in on the demutualization itself.
Sam: To some degree but a bunch of guys flips. If you want to talk about Needham, it's going to come in a couple of months and a bunch of guys have a deposit there and maybe it'll come at 10 and if it's 11 and a half or 12, these people aren't necessarily wanting to hold Needham for 3 years. They just want easy money.
Andrew: It makes sense. You've got a deposit if your deposit gives you access to quote-unquote an IPO that you can flip for 15% in a day pretty quickly. It makes sense to take that and let somebody else kind of play the 3-year game.
Sam: They don't care if it's a 65 or 75, they just know that they just made a ton of money with no risk or very little risk in one day.
Andrew: What else should we talk about?
Sam: You asked about community banks. Do you want to talk about community banks and M&A?
Andrew: Sure, go ahead.
Sam: The point I would make on the second half of your question is community banks and M&A. M&A require both sides of the balance sheet to be marked. People are asking like, when is the M&A cycle going to start back up again? It's when you're able to mark the balance sheet anywhere close to where it's being held on gap numbers, that's going to take time. It's very much company dependent. I've written about the first Sunflower, FSUN, which has a balance sheet that requires relatively little marking and has very high-quality deposits. It's in Colorado and Texas. It's heavily owned by private equity. If I were to expect some merger activity to happen that company would probably move faster than your average bank that's holding fixed-rate mortgages at 4% bonds at 3% but even that is taking some time because again, like who's going to buy them prosperity down 30%, Zion's down 40%. There are 2 sides to the equation. They've got to level back out. The marks on the target have got to improve the stocks for the acquirers. We've got to improve. It's going to take several quarters at least to really get going again. For the vanilla community bank that's really going nowhere fast. I wouldn't necessarily want to sit around just waiting for M&A.
Andrew: This is on the smaller side, but you said M&A and the smaller side. Have you looked at the ECIP banks?
Sam: Yes.
Andrew: What do you think of them because I've heard 2 different things. ECIP for those who don't know, was a treasury program that was kind of free money. They gave a bunch of banks who do mainly minority-focused lending prefer that come with like 0% coupons for the first year to 3 and then after that very low coupons if they lend the money to minorities. I know a lot of people look at it like this is free money, this is manna from heaven. And then I know a lot of people who will say anytime you've got a government program that's encouraging you to lend on metrics other than just how good the loan is, that tends to work out really poorly for people. Where do you kind of come out on the ECIP banks?
Sam: Before it got to be sort of a popular thing and there's somebody who I wrote about it, this other guy wrote about it.
Andrew: Tim Erickson, I bet was the other guy. I didn't realize you were the other one who wrote about it, but Tim Erickson's the one who's really been pumping him, if I remember correctly, not pumping. He has really been talking about them.
Sam: But this was in late last year and I sort of called security federal and they called a bunch of management teams. I was kind of interested to see who is actually going to make mortgages in distressed communities and who is going to sit and see what they could do, it's a 0% preferred for the first 2 years and if you don't use a large amount of it, it becomes 2%, which is in a rising rate environment, still quite attractive. Then you can also potentially convert it to a big discount. There's a bank in Atmore, UBAB that I ended up thinking could be well positioned. That bank kind of makes a living off of government-related programs and subsidies makes a very good living off that. If what you want to do is buy a bank that grows tangible book value faster than the other banks, you can do a lot worse than UVAB. BFCC hit a few pet peeves. The guys in Mississippi I kind of respect some of the things that they're doing and at some point, they'll be a very good candidate to enter the Russell, but I wasn't necessarily certain or comfortable with their acquisition strategy.
Andrew: Do you hear this? The guy from Alabama coming out pitching United Bank Corp of Alabama hating on the Mississippi banks. I should have known.
Sam: Moka[?] is a good friend. So is Luke in any event. There are a couple of others that screen well. One of the things you have as far as owning these stocks and making money on them, you have a lot of value nerds like me who just sort of jump in because the numbers are so good and then they become all dressed up with nowhere to go because these banks are going to make a little bit more money than they were before, but they're not like now who do you sell your stock to? Now that everybody got into it. There's not necessarily an aggressive buyback like PCB and Los Angeles will repurchase a little bit. I ended up deciding that I need to be particularly selective around it. I do think UVAB will be pretty active on the buyback if the stock gets inexpensive but it's very much for me, it's a case-by-case basis and Broadway looked like it could be interested as well in BYFC.
Andrew: You mentioned PCB. So I'll just jump on that. I've done some work on the Korean focus banks because they are Korean-focused. PCB some of them are Chinese-focused, open [inaudible]. I look at them and I'm kind of mystified by their valuation because historically like they've got pretty good loan trends, they do seem to have some deposit franchises where like these are banks where if I live in New York City, so you go to K-Town and you see all these banks, but basically what these banks are is they target Koreans or Chinese and all of their tellers speak 2 languages, they speak English and Korean. So I could see how that's a deposit franchise where you're not exactly going to pull your deposit from this bank that literally speaks your language to go to JP Morgan or Bank of America. I think there's a franchise there. They've got better than you would expect. Loan trends all seem pretty interesting to me. But all of these tend to trade for pretty low valuations. And I've talked to a few people and they're like I don't really get what's going on. Am I missing anything? I don't even know if you looked at them, I was just throwing them out because they've been an area of focus for me.
Sam: They will gain or lose a multiple based on the direction of commercial real estate because they tend to be very commercial real estate heavy and corporate governance. Corporate governance has always been erratic on a bank-by-bank basis within that sector.
Andrew: There's one that literally you look at their 8Ks and they're we had a lot of issues last year. We still have directors resigning. I might have to do a post on that about some of the best director resignations letters I've ever seen, but they've like, this time we think we've got it 5 of our 7 directors resigned, but we think we've got all the cockroaches out the kitchen this time. That was RBB that was funny. When I mentioned commercial real estate earlier, that was one I was kind of focused on where they come out and they say we've got a lot of commercial real estate, but it's not giant towers. It tends to be smaller business owners who are leasing their restaurant building or their office space. But their NPAs look great, they seem cheaper. I could make a real argument for the kind of franchise value there.
Sam: With regards to credit, really the only time that that sector has come into material credit shock is shortly after 08. And a lot of it was SBA oriented. It was the risk piece of a 7 a loan that 25% that's not guaranteed. That's where they ran into trouble where it was maybe small business or some different type of commercial real estate. Are they going to repurchase the shares at the right time? Are they going to pay a substantial dividend? Is it going to be a prestige thing? Are they never going to sell? You have to dig in a little bit on the corporate governance side because it's very different bank by bank.
Andrew: Last one and this is why I do these podcasts because a lot of times I can just be a generalist and acts sector experts or company experts. A lot of the smaller banks that I've seen have really started leaning into the SBA lending e especially now, what do you think about the companies that are really leaning into the SBA lending? Because when I've talked to them I get why you want to do SBA, I absolutely get why I want to do SBA lending, but I think that's a very competitive area. How are you thinking about the companies that have started really trying to lean into that?
Sam: Live Oak is the biggest one actually. I won't get into their expense structure. I write a little bit about this recently, but for SBA lending, I wouldn't say it is free money because there's the risk piece. You got to staff up for it.
Andrew: The staff up is the big piece and the risk piece as you said, but staff plus the risk.
Sam: Nobody's going to pay you for it. If you go to sell your bank and it's the big chunk of SBA the acquirer doesn't necessarily like SBA. But with that said, probably one of the most valuable banks in the country, at least one of the highest performing banks in the country, just very sad for me no longer exists as an independent entity because it was sold in 2020 and is now a part of Enterprise Bank. It's called Seacoast Commerce. Those guys Rick Sanborn was the CEO, he basically decided what his ROE was going to be every quarter. They usually decided it would be somewhere between 15 and 16% because he developed a handful of deposit verticals homeowner’s association, property management, and 1031 exchanges escrow for real estate purchasers and sellers.
He lent into variable rate SBA which comes with a substantial government guarantee and depending upon who you want to lend it to, you can press and, and get a borrower with 5 million or more net worth, maybe 10 million net worth, pretty good guarantee. A pretty strong piece of real estate against it. He almost had through the years, for about 7 or eight years, including COVID before he sold, he just really had very little charge-off experience. He had excellent credit, he had excellent margins, and he had variable-rate loans. Those loans would be 8 or 9% right now. A lot of them are Prime plus 2. There are different degrees in the SBA universe, but the guy would be just absolutely printing money right now. He'd be having a 6 to 7% margin.
He'd be making probably low twenties ROE and now it's part of the enterprise. Now there are other entities like that. Richler loves to talk about G Bank Live Oak although Live Oak has some other considerations if you want to invest in them. I wrote a little bit about an SBA lender. 8 to 10% premiums is a good business. If nobody wants to buy those loans 4 or 5% premiums are not quite as attractive. But right now, it is an excellent way for banks to create income and to get variable right loans on the books.
Andrew: I guess you get a little fee income because you can sell off the government-guaranteed part and it all works really well. We have covered so much. It's 5points.substuck.com if you want to follow it. I really enjoyed it. I think it's one premium post a month and then one free post a month. I discovered it because I started getting really into the banks, but I've really been enjoying it. I like how you see the world. I see the financial sector the same way you do except much shallower because I'm just hopping into the financial sector. Anything else you think we should have kind of hit or people should be thinking about as they think about financials in general?
Sam: People don't have 3 hours to go through every little detail of the sector, I'll leave it there. But I do appreciate it.
Andrew: I told you before we started recording if you wanted to do a 5-hour podcast...
Sam: I do appreciate it when people give feedback and give local color. Always drop me a line, send me a DM, or whatever you want to do because when you tell me about what's going on in your part of the world, that really helps me out and we share the wealth in that regard.
Andrew: I'll include a link to the 5point sub stack in the show notes and you can find Sam's Twitter and everything else from there and kind of go from there. Sam really appreciates you coming on and looking forward to the next one.
Sam: My pleasure. Thank you, Andrew.
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