Why We Own CRBC: Warnings And a Pet Peeve

The prior post in this series is here. And before we go much further – two warnings about investing in banks in general.

First – much more than most publicly traded business, a bank’s fate is tied to the local economy (or economies) in which it operates. Because of the amounts a bank borrows, its results are uniquely leveraged to the conditions in its immediate surroundings. To invest in a bank solely because it’s statistically cheap is unwise.

When it comes to investing in small banks in particular, it’s a good idea to have a solid grasp of the main drivers of economic growth and all potential headwinds in that particular area. Since local economies on balance will mirror the national economy, having some knowledge of broader macroeconomic trends won’t hurt, either. As I blabbed on about here, I believe the strength of our current economic recovery, though not great, is not as bad as many pundits seem to think, either. I’ll talk more about Michigan’s economy as relates to Citizens Republic later in this series.

Second, there is no investing in regional banks these days without assuming what could be significant risk in terms of commercial real estate (CRE). Commercial real estate loans simply represent a ton of regional banks’ business. So at the risk of greatly understating this: it’s important to do all your worrying about the loan book upfront, before you buy shares.

One of the reasons I’m looking at banks is that I believe we’re already through the worst in the commercial real estate market. Regardless of my opinion, however, by buying shares in a bank that is already priced for the CRE apocalypse but which has enough capital to absorb it, I can be wrong about CRE and still do well as a long-term investor. I’ll write more about construction and development loans a bit later, too.

I am cautiously optimistic about CRE in that vacancy rates appear to have peaked, hotel occupancy is up, and credit, though not great, is starting to flow again. It also seems highly probable that the CMBS market (which packages and sells CRE loans to big investors) will be up and running in time to absorb the loans coming due over the next two to three years. And while there is no way to prove this, I would suspect that most of the really bad CRE loans were already packaged and sold off to CMBS investors. So, to me, and assuming you’re not sitting on a great big pile of crappy securitized loans, the plumbing in the commercial real estate world looks okay – it’s general confidence that is the issue. Plenty of others disagree with me on this point, however, and they could be right. I simply contend that as long as there is a big enough margin of safety in the shares you buy, in the end it should not matter who is more right.

Lastly – jargon alert! – I’d advise investors tread carefully around banks that don’t consider modified or restructured loans to be non-performing. This practice is also referred to as “extend and pretend.” Just this week the Wall Street Journal finally brought this issue the attention it deserves in the popular press.

Banks can reduce the number of defaulted loans they have to recognize by modifying those loans – extending terms or offering low interest rates. However, history has shown that 50% of all modified loans eventually default. It also can be nearly impossible for investors to identify which banks are extending or restructuring loans which management believes are one day going to fail anyway.

So, loan modifications can make a banks’ books look good in the short-term, but there is a fair chance those problems are really being kicked down the road.

Now I can certainly understand the business case for a bank to hold off on foreclosing on a property. It makes all the sense in the world to extend a loan if it increases the chances that it will be repaid – plus, then the bank can avoid having to sell the property in a deeply depressed market. And I don’t believe all banks are systematically restructuring or modifying loans in an attempt to hide the bad ones. But to not consider restructured or modified loans as non-performing in spite of that historically high level of eventual default seems, mmmm, a bit too conveniently optimistic.

So, I am on you like white on rice, SunTrust Bank.

And good on you, CRBC, for doing the right thing – even if only a few of us are watching.

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Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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4 Responses to Why We Own CRBC: Warnings And a Pet Peeve

  1. Jeff says:

    I just looked into CRBC based on your position in them. I’m pleased about your comment that you intend to discuss CRBC in relation to its “Michigan economy”, as that is the primary factor that prevents me from also jumping on board with you on this one. Michigan ranked 41st in CNBC’s 2010 States Business Rankings. Also, I don’t believe the fundamental mindset of many workers and their devotion to big labor unions (Flint and Detroit are CRBC’s two biggest markets) has changed much; and those lost jobs are simply not going to return. So although it is hard to imagine things getting any worse there than they already are, the state and local obstacles are great that would prevent significant, above-average economic improvements. As you also alluded to, my secondary concern is the unknown status of their commercial real estate holdings and prospects there. I really like their approach of selling out rapidly from their lower quality residential properties. I’m hoping they will provide further clarification on their status and plans there on their earnings conference call later this week.

    Their top management is impressive (especially CEO Cathy Nash) with their proactive, but conservative, style.
    I don’t think CRBC is in any real jeopardy of being delisted from Nasdaq (and that fear has probably exacerbated the recent stock decline), since they would be likely to authorize a reverse stock split if there was a serious threat of that occurrence.
    And with their good-sized asset base and the likelihood that they can improve their earnings closer to breakeven in 2011 along with an even very slightly improving Michigan economy, it is extremely unlikely that FDIC would liquidate them anytime within the next couple of years.

    • Cale Cale says:

      Yes, more soon on Michigan. Thanks, Jeff. Also would recommend the company’s slideshow from the Q1 call on their website. They maintain they don’t need Michigan to boom to do well, just to stop declining. Appears to be doing that. The other irony here is that Michigan was in a recession long before the rest of the country…and as a result, housing prices didn’t go nuts. So, silver lining in there when it comes to CRBC’s book. But yes, more soon. Thx again. – Cale

  2. Zehua says:

    I long CRBC too. Thanks for your excellent post!nRegarding restructured loans, the usual practice is to keep that for 6 months, and if it is paying as the new defined term, then take it off the book. Therefore even if a bank treats restructured loans as NPA, it will still be taken off soon. I see some banks that kept making more and more restructured loans each quarter. Should I be extremely aware of that, and simply stay away?n

    • Cale Smith says:

      Yep, would definitely keep an eye on it, but doesn’t necessarily mean to run for the hills automatically. Case by case basis, really. That said, there are plenty of possible investments among banks right now where that isn’t a risk…so opportunity costs could be significant.nnTon of good banks out there right now trading really cheaply still – but right now the best seem to be nano-caps…really small and very illiquid. Even I can’t get my little old fund into them. But those opportunities are out there.