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Interpreting the Banking Numbers

Reid Nagle
President
SNL Securities
Investment analysts evaluate the financial strength of a bank and relate that to its market
pricing. To do so requires assessing liquidation value and going-concern value; making
use of such peer group comparisons as market indicators, profitability, net interest
margin, operating efficiency, capitalization, asset quality, and asset composition; and
identifying market misvaluations.
For financial institutions, unlike companies operat-
ing in other industries, the process of analyzing and
interpreting financial condition is similar both from
the credit and the investment standpoint. In fact,
because the market has come to realize that in highly
leveraged financial institutions the safetyand sound-
ness of an institution is paramount, the interest of
credit analysts and investment analysts are fre-
quently the same. An investment analyst needs to
evaluate the financial strength and well-being of the
company and relate that to its market pricing. The
analyst needs to examine both the economic value of
a company and its market value. Abuy signal occurs
when the market value falls substantially below the
economic value. A sell signal occurs when it is sub-
stantially above the economic value. No other indus-
try that I am aware of has greater investment poten-
tial, both for profit and for loss.
Investing in banks is full of pitfalls for those who
do not understand the fundamentals of profitable
opportunities. The reasons for this are many. One is
that no other industry has as many companies:
about 1,200, including400 publicly traded banks, 400
publicly traded thrifts, and about 400 pink sheet
companies. There is a wide array of companies to
choose from, and each one of them at any point in
time has a different ratio of market value to economic
value. Those ratios are changing constantly, and the
outliers in the market value/economic value rela-
tionship create phenomenal opportunities.
One of the reasons those opportunities exist is
that no one investment firm follows all of the com-
panies; in most other industries, with a limited num-
ber of companies to follow, one security analyst or a
group of industry security analysts within a firm can
cover the industry. In contrast, a firm might cover
only 10 percent of the financial companies at most;
more typically, a firm might cover 20 or 30 compa-
nies. The likelihood that, by covering 20 or 30 com-
panies, someone can find the extremities of market
versus economic value within a 1,200-company uni-
verse is very slim.
Another reason investment opportunities exist
in the banking industry is that the information dis-
seminated on banks and thrifts is often misleading
and sometimes incorrect. People who accept the
published financial statements at face value as an
indication of value will be misled and may suffer
serious financial consequences. Those who know
howto look behind published numbers and discover
the truth will find a wealth of opportunities. The
Securities and Exchange Commission and Financial
Accounting Standards Board are working furiously
to correct the problems in financial disclosure.
Investors who are not restricted to the long side
and can sell short also have opportunities in banking
stocks. At any point in time, such an investor could
identify a basket of undervalued securities relative to
the norm and a basket of securities that are overval-
ued. By going long on the undervalued securities
and shorting the overvalued securities, the investor
can capture the value that lies in between. Of course,
many money managers are prohibited from going
short, but during the past few years, the short side
has presented enormous opportunities. Only on a
few occasions and only to a few people is it crystal
clear that the industry is undervalued or overvalued
to a substantial extent. Last fall, for example, a few
security analysts realized the banking industry had
been oversold. Prices were extremely low, particu-
25
larly for companies that had bright futures, which
provided a tremendous opportunity for those who
invested at that time.
Assessing liquidation Value
Much of the opportunity in bank investing arises
because financial statements often do not accurately
reflect financial reality. One reason for this is the use
of historical cost accounting. Traditionally, the
banking industry has recorded its financial assets
and liabilities at cost, regardless of how the market
may value those instruments. As a result, a sharp
movement in interest rates that dramatically affects
the market value of fixed-income portfolios and
long-term liabilities does not show up in the income
statement or balance sheet.
In the past four or five years, bank managers and
auditors have had tremendous flexibility in deter-
mining the appropriate reserve levels for banking
institutions. Across the spectrum of 1,200 institu-
tions, the difference in reserving practices between
conservative banking managers and those trying to
hold onto the last vestiges of prosperity is a mile
wide. For example, in a highly leveraged institu-
tion-say, at 20:1-equity can be overstated by 20
percent if management is given the ability to value
assets even 1 percent off their true value. The Bank
of New England is an extreme example. Only
months before it failed, it had equity capital of $800
million. Ultimately, the Federal Deposit Insurance
Corporation needed more than $3 billion to resolve
the institution after it failed. That is a tremendous
gulf between reality and perception.
The marketplace is getting smarter. Table 1
shows all banks and thrifts with $10 billion or more
in assets. The companies are ranked by their ratio of
price to book value as of November 13, 1991. At the
end of November 1991, this ratio ranged from a high
of 276 percent for State Street Boston to a low of 4.7
percent for CaiFed. CalFed's management and ac-
countants presented what they perceived to be the
equity level of CalFed in their financial statements,
but the marketplace suggested this value was 96
percent in error. So even using contemporaneous
financials, the disparity between management and
market valuations is tremendous.
In 1987, the range of price-book-value ratios was
much tighter than it is today. The lowest ratio among
banking institutions at that time was 45 percent for
Bank of America and the highest was 167 percent for
Northern Trust. At that time, Bank of America was
teetering, and the institution's long-term viability
was in substantial doubt. Since then, the way the
marketplace understands, evaluates, and assigns
26
value to publicly traded banks and thrifts has been
dramatically transformed. Analysts have learned to
look beyond the accounting numbers and to under-
stand the business and economic fundamentals of
these companies. The market value they assign to a
company is appropriately based on the long-term
expected value that company will generate.
Bank profitability and creation of value come
from two places. One is an economic balance sheet-
not the accounting balance sheet, which typically
records assets and liabilities at cost. The economic
balance sheet reveals the true equity position of a
company when its assets and liabilities are fairly
marked to market. Not all parts of the balance sheet
are created equal. For banks having a market value
significantly below book value, the difference can
usually be found on the asset side of the ledger.
Table 2 compares the five best-performing banks
and the five worst-performing banks in market value
appreciation and depreciation during the past four
years. The types of loans cited in Table 2 are fre-
quently the culprits responsible for market value
depreciation.
Several interesting points can be made about
these companies. Four of the five top-performing
companies are from the Midwest, which has fared
much better than other parts of the United States
through the current recession. Certain kinds of as-
sets, mainly those I euphemistically call "high risk,"
form a much smaller percentage of the balance sheets
for companies that have succeeded than of those for
poor performers during the past four years. In fact,
the only one of the five good companies to have any
highly leveraged transaction (HLT) loans and lesser-
developed country (LDC) loans was Bank of Amer-
ica, and its percentages of those were very small. The
LDC crisis for all intents and purposes is over in U.S.
banking.
The significant differentiation between the five
best and five worst market value performers is in
high-risk real estate loans. Most of the five worst
have a substantial proportion of assets concentrated
in all three categories of this group; this is not the case
for most of the top five performers. In fact, for the
five top market value performers, the average for
high-risk loans amounted to 8.8 percent of assets
compared with 22.8 percent for the worst group.
These numbers show that banks facing a lack of
lending opportunities-those that tried to fill in the
void byacquiring types of credits and loans that were
in vogue at the moment-fared poorly, and the mar-
ketplace rewarded them appropriately for their in-
discretions. With the exception of Banker's Trust
and J.P. Morgan, which are not traditional banks, the
kinds of activities that are appropriate for the bank-
Table 1. Financial Statistics--Banks and Thrifts with $10 Billion or More in
Assets, 1987and 1991
Price Change
Between
Price-Book Value 12/31/87 and
Company State Type
a
12/31/87 11 /13/91 11 /13/91
State Street Boston Corp. MA B 155.0% 275.6% 195.6%
Northern Trust Corp. IL B 166.8 244.6 165.3
Banc One Corp. OH B 156.8 241.4 138.2
J.P. Morgan &Co., Inc. NY B 136.4 233.3 83.4
NorwestCorp. MN B 96.3 200.7 172.6
Bankers Trust New York Corp. NY B 84.9 197.6 113.8
Wachovia Corp. NC B 139.9 185.3 97.0
SunTrust Banks, Inc. GA B 141.3 182.2 94.5
Ameritrust Corp. OH B 89.4 182.1 77.3
Bancorp Hawaii, Inc. HI B 127.7 180.8 142.2
CoreStates Financial Corp. PA B 152.8 172.3 39.8
First Bank System, Inc. MN B 99.5 171.3 17.4
Golden West Financial CA T 102.4 168.0 194.0
KeyCorp NY B 109.8 164.8 107.6
Comerica, Inc. MI B 115.8 164.7 101.8
NBD Bancorp, Inc. MI B 115.3 163.8 105.2
Manufacturers National Corp. MI B 111.2 162.0 125.0
Firstar Corp. WI B 124.0 160.4 114.5
PNC Financial Cort PA B 151.4 155.8 20.5
Republic New Yor Corp. NY B 131.8 152.9 47.0
C&S/Sovran Corp. VA B NA 152.1 NA
Society Corp. OH B 114.1 144.2 47.3
Huntington Bancshares, Inc. OH B 120.4 142.9 63.4
First Union Corp. NC B 120.0 134.9 50.6
US. OR B 97.7 134.6 101.3
Boatmen's ancshares, Inc. MO B 106.6 134.1 49.6
First Fidelity Bancorporation NJ B 116.3 131.3 5.0
Fleet/Norstar Financial Group RI B 143.7 129.4 2.7
National City Corp. OH B 148.3 129.4 24.5
BankAmerica Corp. CA B 45.5 129.1 461.8
Meridian Bancorp, Inc. PA B 108.5 124.9 31.4
Barnett Banks, Inc. FL B 132.9 121.9 15.9
NCNBCorp. NC B 96.5 121.9 126.1
Mellon Bank CorK' PA B 88.4 121.7 37.5
First of America ank Corp. MI B 105.1 114.3 38.9
Security Pacific Corp. CA B 90.7 111.9 23.6
Valley National Corp. AZ B 91.4 109.7 0.9
Wells Fargo &Co. CA B 123.1 106.8 47.1
UJB Financial Corp. NJ B 143.8 99.9 (23.6)
Bank of New York Co. NY B 76.5 97.6 32.5
Great Western Financial CA T 106.7 94.3 3.3
First Interstate Bancorp CA B 92.4 88.1 (24.2)
Crestar Financial Corp. VA B 115.2 82.8 (13.0)
National Corp. MI B 120.2 77.1 (5.2)
First hicago Corp. IL B 78.0 75.4 43.0
H.P. Ahmanson &Co. CA T 92.0 74.7 (4.5)
Chemical Banking Corp. NY B 52.0 71.9 16.4
Shawmut National Corp. MA B 102.3 71.6 (53.3)
Bank of Boston Corp. MA B 95.3 71.4 (44.4)
Manufacturers Hanover Corp. NY B 51.2 71.1 29.7
Signet Banking Corp. VA B 115.2 71.0 (15.3)
Union Bank CA B 114.8 67.6 (35.3)
Chase Manhattan Corp. NY B 57.8 59.4 08.I)
Citicorp NY B 84.2 53.1 (38.3)
Continental Bank Corp. IL B 67.6 49.6 (16.7)
MNC Financial, Inc. MD B 125.6 41.7 (73.7)
Midlantic Corp.
NJ B 106.5 28.9 (82.8)
HomeFed Corp. CA T 51.5 24.6 (97.3)
Dime Savings Bank of New York NY T 56.8 20.4 (75.4)
CalFed, Inc. CA T 42.9 4.7 (90.8)
Source: SNL Securities.
aB = bank; T = thrift.
27
Table 2. High-Risk Lending Statistics, selected Banks with $1 Billion or More in Assets
Five Biggest Price Gainers between Five Biggest Price Decliners between
12/31/87 and 11/13/91 12/31/87 and 11/13/91
Asset BAC MCOR HWKB BRBK RFBC Avg. CFB NBIC HIE MIDL CSTL
a
Avg.
Total assets ($millions) 118,108 1,202 1,336 1,235 1,339 2,538 3,542 6,213 21,234 2,976
Percent of total assets:
Highly leveraged transaction loans 1.57% 0.00% 0.00% 0.00% 0.00% 0.31% 0.00% 0.00% 5.15% 2.91% 0.00% 1.61%
Term lesser-developed countries loans 1.68 0.00 0.00 0.00 0.00 0.34 0.00 0.00 0.00 0.01 0.00 0.00
High-risk real estate loans
Construction & development loans
a
3.40 1.01 0.32 1.38 0.27 1.27 6.46 6.30 1.33 10.37 3.66 5.62
Multifamily loans
a
0.45 1.86 0.24 0.17 4.36 1.42 0.53 1.27 2.05 0.57 0.52 0.99
Nonresidentialloans
a
4.38 10.82 4.81 6.92 6.81 6.75 18.55 10.66 15.87 10.75 17.56 14.68
Subtotal (other high-risk loans) 11.20 12.99 1.47 6.92 11.43 8.80 25.53 18.14 24.25 24.58 21.74 22.85
Nonaccrualloans 2.58 0.37 0.30 0.26 0.50 0.80 5.77 5.36 3.60 6.36 6.20 5.46
Restructured loans 0.05 0.03 0.28 0.04 0.00 0.08 0.34 0.71 0.00 0.12 0.02 0.24
Other real estate owned 0.32 0.16 0.04 0.16 0.27 0.19 3.16 1.18 1.79 2.64 3.19 2.39
Loans 90+ days past due & accruing 0.27 0.11 0.08 0.18 0.63 0.25 0.91 1.51 0.23 0.7 41.16 0.91
Subtotal (other high-risk assets) 3.22 0.68 0.69 0.65 1.40 1.33 10.18 8.76 5.63 9.85 10.57 9.00
Total (high risk assets) 14.42 13.66 2.16 7.57 12.83 10.13 35.71 26.90 29.88 34.43 32.31 31.85
Price change between 12/31/87 and
11/13/91 461.82 307.79 229.17 226.53 225.00 (77.62) (79.88) (81.95) (82.77) (87.88)
Source: SNL Securities.
Note: Financial data as of September 30, 1991, unless otherwise noted.
aAsofJune30, 1991.
Key:
BAC = BankAmerica Corp.
MCOR = Marine Corp.
HWKB = Hawkeye Bancorporation
BRBK = Brenton Banks, Inc.
RFBC = River Forest Bancorp
CFB
NBIC
HIE
MIDL=
CSTL =
Citizens First Bancorp
Northeast Bancorp
Hibernia Corp.
Midlantic Corp.
Constellation Bancorp
ing community are the ones that have traditionally
proven themselves to be both profitable and rela-
tively risk-free. High-risk ventures typically disap-
point shareholders and managements by failing to
generate the returns that traditional banking activi-
ties do.
Measuring Going-COncern Value
The economic value of a balance sheet can be esti-
mated by adjusting each component of the balance
sheet to reflect market value rather than accounting
value. Determining the appropriate reserves is an
important part of this process. With some degree of
judgment applied to each financial institution, one
can generally apply standards of reserves appropri-
ate for different asset types, and these more accu-
rately portray the financial realities of the company
than the picture managements and auditors present.
True economic value is a function of a bank's
mark-to-market net worth (liquidationvalue) plus its
projected earnings as a going concern. Going for-
28
ward, those earnings will be a function of a number
of different factors. These include the starting value
of the balance sheet; the strategic direction of the
company in relation to the evolving role of banking;
and the components of income-net interest income
on a risk-adjusted basis, operating efficiency, and fee
income.
Going-concern value means the extent to which
a bank's franchise can generate a return over and
above a risk-free rate of return, given its starting
marked-to-market net worth. Abank with a starting
net worth of $100, with a risk-free rate of return of 8
percent, should generate $8a year ona risk-free basis.
To the extent a bank has franchised its customer
relationships, its position in the community or region
enables it to generate returns substantially above 8
percent. That reflects the returns attributable to
going-concern value.
Before 1990, banks paid a substantial franchise
premium to acquire branches and deposits of other
banks, believing there was a valuable franchise im-
bedded in the branches and deposits being pur-
\
\
,
chased. The ratio of deal value premium to tangible
book value is probably the best conventional mea-
sure of the economic value of a bank, because it
includes both its liquidation and going-concern val-
ues. The deposit premium paid in branch sales-
which is calculated as the excess of liabilities as-
sumed over assets acquired-is the best measure of
the franchise value of deposit relationships. Buying
branches and deposits does not necessarily capture
the full franchise value of a bank, however, because
it does not capture the inherent customer relation-
ships on the asset side of the ledger.
As shown in Figure 1, the deposit premium was
approximately 6 percent in the first quarter of 1989.
The banker's valuation of the franchise inherent in
banking has diminished, however. In fact, in the
most recent period, the premium declined to 1 per-
cent. The premium to tangible book value has not
changed too much during the past three years, al-
though it has shown some volatility. The decline in
branch sale premia indicates bankers have a dimmer
view of the franchise value of banking than they did
a couple of years ago. In particular, deposit relation-
ships are seen to have little value, independent of
other less price sensitive banking relationships.
Rgure 1. Merger and Branch sale Pricing, Quarter1y
Median Premium, 1989-S1
7,---------------------------,
6
2
O'----'-_...L----'_---'-_.L..-----'-_...L----'_---'-_.L..----l
1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q
'89 '89 '89 '89 '90 '90 '90 '90 '91 '91 '91 '91
-- Branch Deposit Premium
- - - Dealers Tangible Book Premium
Source: SNL Securities.
Industry Trends
Several developments in the financial sector may
explain what is happening to banks. Figure 2 com-
pares the shares of the nation's financial assets held
by depository institutions and by other sectors. The
share for depository institutions has been on a secu-
Figure 2. Rnancial Assets Held by Depository Institutions as a Percentage of Total Rnancial sector Assets,
1900-2000
(projected)
1950
General Moturs
Pension Fund
'1 f
, ~
~ i ~ _ f "
1940
!nv<!stm<!nt
Cvn"pany Act
2000 '90 '80 '70 '60 '50 '40 '30
100
90
80
70
60
C
<lI
U
50 ....
<lI
P-.
40
30
20
10
0
1900 '10 '20
-- Depository Institutions
- - - Nondepository Institutions
Sources: Federal Reserve Board Annual Statistical Digest; Goldsmith, Financial Intennediaries in the American Economy, 1958.
29
Sources: Richard D. Crawford and William W. Silher, The Troubled
Money Business (New York: Harper Business, 1991): 9.
lar decline throughout the century, with a few short-
term exceptions. In the 1970s and 1980s, traditional
lending opportunities for the banking industry di-
minished, and banks rushed to replace those with
loans to LDCs, energy companies, HLTs, and real
estate credits. The result was a brief bubble. The
banks are now in a period of liquification of many of
the excess credits that were created during that pe-
riod, a process that accelerates the reduction in their
share of total assets.
The depository sector accounted for 85 percent
of financial assets in 1900; today its share is 40 per-
cent, and it is likely to be close to 30 percent by the
end of this decade. Several different types of finan-
cial institutions have picked up the slack. Figure 3
shows the total assets of different types of financial
institutions from 1940 through 1990, with projections
to 2000. Since 1980, the fastest growing financial
asset category has been pension funds. This growth
is largely a function of public policy and individual
preferences. Public policy has now established pen-
sion funds as the major tax-advantaged vehicle for
individual savings. Pension funds do not require
any capital for their existence, so pension fund assets
offer infinite leverage possibilities. This should lead
to continued growth in pension funds. Mutual
funds, because of technology and the absence of any
meaningful capital constraint, have also experienced
a rapid growth rate.
The growth of commercial bank assets has
slowed in recent years, and thrifts' assets have
dropped off precipitously. These trends are likely to
continue in the future. Unfortunately, government
policy was not designed to accommodate the declin-
ing role of banks and thrifts in the financial sector. In
fact, during much of the 1970s and 1980s, govern-
ment policy encouraged expansion of depository in-
stitution balance sheets. The process of contraction
and failure evident today is a natural consequence of
a sector that will ultimately represent less and less of
the total financial assets of our economy.
These trends have several implications for the
banking industry. It might be tempting to say that
banking is not a growth industry, that it does not
provide many investment opportunities. That is not
the case, however. Banking will be around for a long
time, although in a diminished role compared to
other forms of savings and intermediation. Many of
the traditional banking activities have been stripped
away from banks. For example, blue-chip compa-
nies in the 1970s began bypassing the banking system
by issuing commercial paper and medium-term
notes. That meant the largest banks, which had tra-
ditionally supplied credit to these firms, lost a big
part of their asset base. Many of them rushed into
high-risk, aggressive credits to fill the void.
In the past 10or 15 years, we have seen more than
just large corporations sucked away from the bank-
ing system. We have seen the mortgage sector and
the consumer-lending sector diminish as well. The
prominence of Fannie Mae and Freddie Mac, which
are involved in a majority of the mortgages being
written in the United States, has rendered depository
institutions inefficient holders of mortgage assets. In
fact, financial institutions, which traditionally were
both the originators and holders of financial assets,
now find those functions are being split. Banks and
thrifts may still be the most efficient originators of
certain financial assets, but they may not be the most
efficient holders of financial assets. This is certainly
true with mortgage products.
Similar, though less dramatic, changes have oc-
curred in consumer lending. Over time, federal pol-
icy has had a large influence on what form consumer
lending takes. As a result of the period of debt dis-
gorgement resulting from the excesses of the 1980s
and also the fact that nonmortgage interest expense
for consumer credit is no longer tax-deductible, con-
sumer loans will undergo a very slow rate of growth
in the years to come. Moreover, many forms of con-
sumer credit are increasingly being integrated into
the capital markets. Equity (second-mortgage) loans
are being integrated into the capital markets to the
point that the opportunity for banks to hold equity
'90 2000 '80 '70 '60 '50
Commercial Banks
Pension Funds
Mutual Funds
- - - Money Market Funds
Thrifts
Figure 3. Total Assets of Different Types of
Financial Institutions, 1 ~ 2 0 0 0
(projected)
5,500 r-----
5,000 L .....
4,500
4,000
<Jl
3,500
S
i:E 3,000
~ 2,500
<Jl
Q)
~ 2,000
~ 1,500
1,000
500
o L = : ~ ~
'40
30
loans as a profitable component of the balance sheet
will diminish.
Automobile lending has become an intensely
competitive business. Auto buyers do not need to go
to a bank to get a loan. They simply go to a car
dealership, pick out a car, and a half-hour later leave
with the financing. Unlike the role of banks in orig-
inating equity loans, the role of banks in automobile
lending is diminishing. Prevailing auto loans are no
longer profitable for most bank portfolios.
The credit card business is moving away from
the banking industry as well. Recently, two non-
depository institutions have become major players in
this business-AT&T and Sears. A number of other
entrants are expected soon. The secondary market
for credit card loans, which is very active, has under-
gone significant changes in recent years. The premi-
ums paid in the secondary market have declined
from 20 or 25 percent a couple of years ago to 10
percent today. As a result, the profit margins and the
premiums banks will be able to extract on the con-
sumer credit card loan balances they generate will
continue to decline.
Although these trends sound negative, a number
of opportunities exist. One area of opportunity is
lending to small- and medium-size businesses.
These loans are not easily securitized and integrated
into the capital markets. Furthermore, small busi-
ness accounts for more than 50 percent of gross na-
tional product. To serve this market, banks will need
to change their underwriting processes. They will
need to retrain themselves in evaluating businesses,
because the nature of businesses that exist today is
very different and much less physical-capital inten-
sive than the businesses of 20 years ago. They are
much more human-capital intensive and require a
different degree of sophistication and underwriting
skill to evaluate.
The other opportunity is cost savings. The best-
managed companies have an opportunity to acquire
companies that are not so well managed and then
achieve cost efficiencies. Even though that does not
sound as alluringas makingloans, consolidation that
produces net efficiencies is a very profitable activity.
The major realignment of bank market values during
the past several years has given those banks that have
demonstrated the technological and management
skills to undertake profitable consolidation the op-
portunity to buy less successful banks.
Peer Group Comparisons
Peer group comparisons are very important to the
valuation of banks. By comparing financial and op-
erating performance, investors can assess the perfor-
mance and trend line for a given institution.
To illustrate the elements of a peer group com-
parison, I will use the Worthen BankingCorporation,
a bankthat epitomizes the kind of institution that has
been able to make many of the changes necessary to
generate value for shareholders. Investors who buy
based on standard ratios, such as price-book, would
probably not buy this company. In the mid-1980s,
Worthen had some severe problems. It had some
significant loan-quality problems, including about
$60 million in loans to a securities firm that went
bankrupt. Management was replaced, and now it is
difficult to recognize the company because of the
changes that have been made. This is a compelling
company that has demonstrated the ability to gener-
ate value for shareholders.
The most useful peer group comparisons are
market indicators, profitability measures, net inter-
est margin, operating efficiency, noninterest reve-
nue, capitalization, asset quality, and asset composi-
tion.
III Market indicators. Table 3shows compara-
tive market information for Worthen, four regional
peers, and the median for all banks nationally, all
southwest banks, and all banks of Worthen's size. In
some categories, Worthen looks different from its
peers. For example, Worthen does not pay a divi-
dend. It realized in the mid-1980s that it was capital
deficient and needed to build its equity base.
Worthen has been able to generate better returns on
equity every year for each of the past five years, and
its return on equity is close to 16 percent now. That
rate of return exceeds the implied cost of capital for
a company with its risk profile. Any time a company
generates a return on its equity base in excess of its
cost of capital, it should retain that capital and con-
tinue to build. This company has done exactly that.
Second, Worthen's price-tangible-book ratio of
147.5 percent is well above the median for all banks-
110 percent-and above the median for regional and
asset-size peer groups. Based on this ratio, an analyst
might conclude that Worthen is fully priced now, but
that may not be the correct conclusion. In this case,
the price-earnings ratio is a more meaningful mea-
sure because these are true earnings. Worthen's
price-earnings ratio is considerably lower than that
of its peers-8.6 compared with 12.4 for all banks.
This suggests that Worthen's underlying earnings
power comes from a variety of factors.
III Profitability. Figure 4 shows Worthen's fi-
nancial performance compared to its peers. Over this
period, Worthen showed continual improvement in
its return on average equity. Another measure of
profitability is the ratio of adjusted earnings to aver-
age assets. As Figure 5 shows, Worthen's adjusted
31
32
Table 3. Worthen Banking Corporation: Comparative Market Infonnation, November 11, 1991
Peer Group Median
All South- Size
Characteristic WOR AFBK BNKS BOMA COLC Banks west Group
Liquidity'
Past month 0.29% 2.23% 2.38% 0.23% 2.45% 0.35% 0.70% 0.37%
Past quarter 0.43 2.41 1.89 0.32 2.53 0.40 0.98 0.45
Past year 0.33 1.72 1.11 0.30 2.26 0.41 0.73 0.45
Price change
Past month -2.2 8.0 -6.0 1.9 6.6 1.1 5.1 2.1
Past quarter 9.1 18.7 -11.3 31.0 9.9 0.0 6.3 1.2
Past year 36.1 174.3 38.2 71.9 154.3 32.1 71.9 44.4
Dividends
Dividend yield 0.00 1.58 2.13 0.00 0.72 3.08 0.00 3.04
LTM payout ratio 0.00 7.50 18.40 0.00 34.00 34.70 7.50 36.00
Market Ratios
Price-earnings (fourth quarter) 8.6 23.7 8.6 29.3 47.3 12.4 14.4 12.2
Price--core earnings (fourth quarter) 8.8 22.3 8.3 16.8 53.0 12.7 16.8 12.6
Price-book 137.0 136.8 86.3 76.7 123.1 103.1 86.3 116.5
Price-tangible book 147.5 156.5 116.3 79.8 140.5 110.7 103.0 125.0
Ownership profile
Inside ownership 4.89 12.05 41.55 43.47 8.36 13.83 13.95 11.83
Institutional ownership 12.61 43.39 9.34 43.89 36.24 11.52 13.89 13.90
Shares outstanding 10,931,399
Market value of common ($millions) $180.37
Price as of 11 /11 /91 $16.500
52-week high $18.000
52-week low $10.375
Source: SNL Securities.
aAverage weekly volume as percent of shares outstanding.
Key:
WOR = Worthen
AFBK = Affiliated Bankshares of Colorado
BNKS = United New Mexico
BOMA = Banks of Mid-America, Inc.
COLC = Colorado National Bankshares
Source: SNL Securities.
6/'91
-
---
'90 6/'91
3/'91
'89 '88
1.0f-
0.2 '-- -'-__-_--_-_--:-'L-_-- -l..- ---l
6/'90 9/'90 12/'90
-0.5<-- --'- -'- -'-_---'
'87
Worthen Banking Corporation
All Banks
Banks in the Southwest
- - - Banks with Assets of $1 Billion to $5 Billion
0.4 f-
penses required to support low-cost deposits. To-
gether they provide a good measure of operating
efficiency. Figure 7 shows that Worthen's ratio was
higher than all of the peer groups in 1987 but has
declined since 1988 and has been lower than that of
its peers since 1989. Typically, the bigger banks have
a smaller net interest margin than smaller banks.
Regional banks tend to have larger net interest mar-
gins, but they also have larger operating expenses.
Attracting demand deposits, which have a very low
cost of funds associated with them, frequently re-
quires a much higher level of accompanying operat-
ing expense. In this category, Worthen has tradition-
ally outpaced its peers.
III Capitalization. Figure 8 shows capitaliza-
tion ratios for Worthen and its peers. In 1987,
Worthen's equity-asset ratio was significantlybelow
those of the other banks. By June 1991, it had in-
creased its capitalization ratio so that it is close to
those of its size peers.
III Asset quality. Sound asset quality is one of
Worthen's strongest characteristics. Figure 9 shows
the ratio of nonperforming assets to total assets.
Worthen has made phenomenal progress in bringing
its nonperforming asset ratios down since 1987.
Latest 4 Years and Past 12 Months

Most Recent 5 Quarters
1.2,-----------------------,
.:-=-:.-:::-:::.----- --------
0.81- '-::-:- ----
l::
P': 0.6 f-
Figure 5. Worthen Banking Corporatioll-Adjusted
Earnings as a Percent of Average Assets
Source: SNL Securities.
6/'91
'90 6/'91
3/'91
:.-=:-----
'89
-------
-------
'88
9/'90 12/'90
------------_...
5L- ...l- ---'-- ---'L--__----'
6/'90
o
-5 L- L- ---' --'-_----'
'87
15
Worthen Banking Corporation
All Banks
Banks in the Southwest
- - - Banks with Assets of $1 Billion to $5 Billion
Most Recent 5 Quarters
201========:::::----------1
Latest 4 Years and Past 12 Months
20,-------------------:;::=====l
Figure 4. Worthen Banking Corporatioll-
Profitability: Return on Average Equity
15
c
B
10

- 10
earnings-assets ratio has increased dramatically,
particularly relative to its peers, since 1987. The
adjustment removes extraneous nonrecurring earn-
ings and expenses.
III Net interest margin. Figure 6 shows
Worthen's net interest margin relative to its peers.
Worthen's net interest margin was severely deficient
relative to its peers in 1987, improved materially in
1988 and 1989, and since then has largely paral-
leled-though remaining below-that of its peer
group. Worthen is taking steps that will ultimately
lead to a resumption of growth in its net interest
margin.
III Operating efficiency. A good measure of
relative efficiency is the ratio of net noninterest ex-
pense to net interest income, where the net noninter-
est expense is defined as operating expense less non-
interest income divided by net interest income on a
fully taxable equivalent basis. The numerator of this
ratio captures operating efficiency, which is how
much was spent on operating expenses less how
much was earned in fee income. The denominator
captures the ability to produce net interest income.
It is important to relate operating efficiency to net
interest income because of the higher operating ex-
33
Rgure 6. Worthen Banking Corporation-Net
Interest Margin
Latest 4 Years and Past 12 Months
4.75.--------------------,
Figure 7. Worthen Banking Corporation-Net
Noninterest Expenseas aPercent of Net
Interest Income
Latest 4 Years and Past 12 Months
80
l::
'@> 4.25
~
4.0
75
~ 70
~ 65 -----------------
---
4.0
6/'91 '90 '89 '88
60
55 :--=--= ~ - - ---- - ~ - - =-=--=-=- ~ -=--=.::--
'------'--------'-------"------'
'87
60
Most Recent 5 Quarters
70 r---------------------,
'90 6/'91 '89 '88
3.75"-------'--------'---__--'-_---'
'87
Most Recent 5 Quarters
4.6r-------------------",
--- -- -- -- -- -- .... -,#---
- - ---
4.4 : : . ~ _ : . ~ _ - _ - - - - ~ = : . - : : : - : - ~ - - 2 = - - - - - - - - -
l::
'@> 4.2
t"<l
:::E
--------
Source: SNL Securities.
6/'91 3/'91 12/'90
-------------
55 --------
6/'90 9/'90
Worthen Banking Corporation
All Banks
Banks in the Southwest
- - - Banks with Assets of $1 Billion to $5 Billion
6/'91 3/'91 12/'90 9/'90
3.8 L- l.- l.-_-====t:::::=---_---..J
6/'90
Worthen Banking Corporation
All Banks
Banks in the Southwest
- - - Banks with Assets of $1 Billion to $5 Billion
Source: SNL Securities.
Source: SNL Securities.
Latest 4 Years and Latest Quarter
Rgure 8. Worthen Banking Corporation-
capitalization: Equity as a Percent of
Assets
it is now below those of its peers. This is character-
istic of a number of successful bank investment sto-
ries during the past few years.
Figure 10 shows reserves as a percent of nonper-
forming assets. This is another indication of
Worthen's progress in improving its asset quality.
One of the things that always identifies a sure win-
ner, froman investment standpoint, is bank manage-
ment that wants to hide income rather than manufac-
ture it. Historically, when reported profits were thin
at year end, banks did the reverse of what most
individuals would do at year end. Most individuals
with a mix of gains and losses would sell the stocks
with losses to minimize their aftertax cash outflows
and maximize their economic positions. This ap-
proach leads to accounting losses, and many bank
managers are loathe to show losses because they are
afraid of how the marketplace will interpret the loss.
Whether it is realizing losses from a portfolio or
making conservative additions to reserves, those are
all signs of a management willing to build long-term
value. Taking voluntary steps that reduce reported
income today in favor of building long term eco-
'90 6/'91 '89 '88
-_:--=-~ -=-=-=-= ---=- -:-=--: ~ -=--= -- - ---
Worthen Banking Corporation
All Banks
Banks in the Southwest
- - - Banks with Assets of $1 Billion to $5 Billion
Management indicated in 1986 and 1987 that it was
going to dedicate itself to this task, and indeed it did
exactly what it promised. Whereas Worthen's ratio
in 1987was substantially in excess of that of its peers,
7
1::
6
-
Cli
u
...
Cli
p...
5
4
'87
34
4
'90 6/'91
3/'91 6/'91
'89
12/'90
'88
9/'90
----------------------------- 40L-- .L- ...l- ....L. .....J
6/'90
40
---------- ---------
35 =_'-_-_._-._-_-._...l- ---L ---L_----l
'87
Figure 11. Worthen Banking Corporation--l.oans as
a Percent of Deposits
has been deleveraging its balance sheet and shed-
ding risk, it has concentrated its energies and built
up its expertise in commercial banking, which is
destined to be the most profitable balance sheet ac-
tivity for the years to come. This company has honed
Worthen Banking Corporation
All Banks
Banks in the Southwest
- . - Banks with Assets of $1 Billion to $5 Billion
Source: SNL Securities.
Most Recent 5 Quarters
100
1
-----------=:::=========1
I-----
c 80"-
'"

60 - - - - -=:-":-=-::'-::--....---
-:--------
Latest 4 Years and Latest Quarter
100 r--------------------,
Figure 10. Worthen Banking Corporation--Reserves
as a Percent of Nonperforming Assets
c
'"
60
6/'91 '90 '89 '88
-=--- - -- ==--==--
I C- --l.- ---L
'87
2
Latest 4 Years and Latest Quarter
5r------------------,
nomic value will always reward the patient, long-
term investor. Periodically, managers will do the
"right" thing, providing a real opportunity for in-
vestors to get in on the ground floor. Ultimately,
economics always prevails over accounting.
Figure 11 shows loans as a percent of deposits.
The company has significantly reduced its risk expo-
sure and deleveraged its balance sheet. For credit
analysts and investors, this is an indication that the
company is close to being rock solid; it has done
everything it can to clean up its balance sheet. Dur-
ing the mid-1980s, the state of Arkansas went
through substantial problems with the failure of a
number of large savings institutions, attributable
both to mismanagement and to fraud. Worthen has
been a very active acquirer of these franchises. These
acquisitions will provide Worthen with a dominant
market position, which will allow it to influence the
pricing of deposits (which are not securitized like
mortgages and consumer loans) and to influence the
pricing of loans to businesses in the markets it serves.
Asset Composition. Figure 12 shows the
ratio of domestic commercial and industrial loans to
assets for Worthen and its peers. While the company
Figure 9. Worthen Banking
Nonperfonning Assets as a Percent of
Total Assets
Most Recent 5 Quarters
3.5r-----------------
Latest 4 Years and Latest Quarter
------- .......
3.0
6/'91 '90 '89
- ------------
---
'88
------
65 L- .L- ----'L- --L_--'"
'87
J
...... 70
-----
3/'91 6/'91 9/'90 12/'90
.-_::--=-----
1.0L- --'- -'-- --'- ----'
6/'90
2.5
i::
2.0
1.5
Worthen Banking Corporation
All Banks
Banks in the Southwest
- - - Banks with Assets of $1 Billion to $5 Billion
Worthen Banking Corporation
All Banks
Banks in the Southwest
- - - Banks with Assets of $1 Billion to $5 Billion
Source: SNL Securities. Source: SNL Securities.
35
'90 3/'91 '89 '88
------........
Latest 4 Years and Latest Quarter
13
10
'-------'--------'--- --1.----1
'87
Worthen Banking Corporation
All Banks
Banks in the Southwest
- - - Banks with Assets of $1 Billion to $5 Billion
12 -
~
~ 11
Source: SNL Securities.
Figure 14. Worthen Banking Corporation-
Consumer Loans as a Percent of Assets
An investor who knows what signals to look for can
target obvious misvaluations in the marketplace.
These misvaluations are egregious, despite the sig-
nificant progress the marketplace has made in the
past few years in understanding the value, or lack of
value, that underlies banking companies relative to
what their accounting statements show. The way
our company analyzes these companies is an exam-
ple of one methodology for identifying
misvaluations. Our method of analysis will proba-
bly not work in a few years, because the marketplace
will be that much more savvy then; but it does work
now.
'90 3/'91 '89 '88
Worthen Banking Corporation
All Banks
Banks in the Southwest
- - - Banks with Assets of $1 Billion to $5 Billion
0'-------'----__--'--- --1.----1
'87
5
Latest 4 Years and Latest Quarter
20,------------------0
15 fC:::-=-=-==-:';-=:;-;;;":"-.::.,-, ; , - ~ - ~ - ~ - ~ ~
------
Rgure 12. Worthen Banking Corporation--Domestic Identifying Marketplace Misvaluations
Commercial and Industrial Loans as a
Percent of Assets
Source: SNL Securities.
its business lending skills even while reducing loans
overall as a percent of the balance sheet.
Twocategories ofloans Worthen has reduced are
high-risk real estate loans and consumer loans, as
shown in Figure 13 and Figure 14, respectively. In-
creasingly, banks are becoming originators of loans
but not holders of assets that are easily securitized
and integrated into the capital markets. That is ex-
actly what Worthen has done. It has diminished its
reliance on what is becoming an increasingly less
profitable part of the balance sheet.
16
Source: SNL Securities.
Latest 4 Years and Latest Quarter
By looking at the composition of the balance
sheet and the makeup of the income, it is possible to
mark the balance sheet to market. Our process is
quite simple.
1
For each company, we approximate
the liquidation value by applying the appropriate
level of reserves for different categories of assets. For
example, high-risk activities-eonstruction lending,
commercial real estate lending, HLTs-would get
significant levels of reserves. From the liquidation
value, we approximate the going-concern value, re-
membering that economic value is the sum of liqui-
dation value and going-concern value. We tried to
approximate the going-concern value by making
gross generalizations and setting franchise value
equal to the greater of 5 percent of core deposits to
capture the franchise premium or to five times net
income to reflect the value that companies like State
1Por a description of our process, see Rhonda Brammer,
"Good Banks, Bad Banks," Barron's (September 9, 1991):14.
'90 3/'91
..........
'89 '88
8L- l.- --'--- -L-----'
'87
10
14
Worthen Banking Corporation
All Banks
Banks in the Southwest
- - - Banks with Assets of $1 Billion to $5 Billion
Figure 13. Worthen Banking Corporation-
High-Risk Real Estate Loans as a Percent
of Assets
36
Most Recent 5 Quarters
65,---------------------,
6/'91
'90 6/'91
3/'91
'89
12/'90
---
'88
----------------
9/'90

Wells Fargo & Company
All Banks
Banks in the Southwest
- - - Banks with Assets of $10 Billion or More
Latest 4 Years and Last 12 Months
'87

6/'90
60
60
45
1::
(l) 50

Figure 15. Wells Fargo & Noninterest


Expenseas aPercent of Net Interest
Income
short positions we recommended, the decline was 28
percent and even more since the ending date shown
in the table.
Source: SNL Securities.
Tremendous misvaluations exist among800 publicly
traded banks and thrifts, but you must be willing to
examine the full range of companies to identify value
opportunities. I guarantee that at least for the next
five years, until the marketplace reaches full throttle
and until enough participants understand the valu-
ation process, these misvaluations will continue.
+' 55

.... 50
Conclusion
Street and Northern Trust generate largely off bal-
ance sheet. Admittedly, this method may capture
only 80 percent of the truth, but in investing in a field
that is so grossly misvalued, 80 percent of the truth
tends to work out very well.
This type of analysis provides a ranking of com-
panies. Table 4 lists the best and the worst banks as
of November 15, 1991. We suggested buying nine
companies and selling eight short. Despite a fall in
bank stock prices since then, six of the nine long
positions are up in price and six of the eight short
positions are down in price, and the average appre-
ciation is 10 percent. Of the companies listed on the
short side, Michigan National is a poorly managed
company; had it been operating on the East Coast or
the West Coast, it probably would have met the same
fate as Bank of New England or City Trust. Because
it was in the Midwest, however, it survived.
Wells Fargo has been the subject of considerable
conjecture. I believe the preponderance of risk in
Wells Fargo's balance sheet and its rapid growth are
causes for concern. In high-growth institutions, 99
times out of 100, even the best management cannot
defy the odds. When a bank grows that rapidly in a
nontraditional activity, it is going to get singed.
On the other hand, Wells Fargo is immensely
well managed, if the risk concentration issue is over-
looked. Figure 15 shows an operating efficiency
chart comparing Wells Fargo to its various peer
groups. Normally, banks are well managed or
poorly managed in all aspects. Most often, the com-
panies that have rushed into high-risk kinds of lend-
ing activities are also the most inefficient. Those are
the companies that do not maximize fee income. In
this case, management is bifurcated. They seem de-
ficient at risk analysis (although they are probably
very good underwriters) yet operate very efficiently. _
So that has to weigh on one's mind.
Table 5 is a counterpart of Table 4, but for thrift
stocks. Investing long in the thrift industry requires
great patience and a lot of hope. You must be willing
to hedge so that you really do not care what hap-
pens-you simply want to capture the misevalua-
tion. The calculations shown in Table 5 were done at
the end of October, and by mid-November, the 14
long positions had not changed much. For the four
37
Table 4. Portfolio Results of Long and Short Bank candidates
Company
Long candidates
State
As of 09/04/91
Price/
Economic
Value Price
Price as
of
11/15/91
Percent
Change
in Price
Return
on
Investment
Annualized
Retumon
Investment
Commerce Bancshares, Inc.
First American Corp.
United Missouri Bancshares Inc.
Worthen Banking Corp.
United Counties Bancorporation
Hawkeye Bancorporation
Chemical Financial Corp.
USBANCORP, Inc.
First Merchants Corp.
Total for longs
Short candidates
Citicorp
Chase Manhattan Corp.
Wells Fargo & Co.
Fleet/Norstar Financial Group
Barnett Banks, Inc.
Michigan National Corp.
City National Corp.
Mark Twain Bancshares, Inc.
Total for shorts
Total for long & short
portfolio
Source: SNL Securities.
MO $95.7 $32.750 $32.625 (0.38)% (1.43)% (7.23)%
TN 70.9 14.625 17.250 17.95 34.32 173.98
MO 89.1 34.500 36.250 5.07 9.48 48.07
AR 89.9 15.125 16.750 10.74 19.91 100.93
NJ 74.5 62.500 59.000 (5.60) 01.39) (57.74)
IA 60.1 10.000 9.750 (2.50) (5.39) (27.35)
MI 71.6 32.000 32.500 1.56 2.83 14.34
PA 54.8 16.500 18.125 9.85 19.55 99.13
IN 86.4 29.500 30.750 4.24 8.55 43.37
4.55 8.49 43.06
NY 901.1 14.625 10.750 (26.50)
NY 335.2 19.875 16.875 05.09)
CA 239.2 74.000 59.625 09.43)
RI 230.4 24.125 22.250 (7.77)
FL 180.2 33.000 32.000 (3.03)
MI 152.8 36.000 37.250 3.47
CA 174.7 12.500 10.875 03.00)
MO 165.3 22.625 22.750 0.55
00.10)
28.86 143.31
Notes: Economic value of common equity = tangible equity + reserves - preferred equity - 80% of LDC loans - 40% of non-LDC
nonperforming loans +90+ day delinquent loans-3.3% of nonrisk performing loans - (highly leveraged transactions + high-risk real estate)
+ 5% of core deposits (or 5 x adjusted income).
Nonrisk performing loans = total loans - LDC loans - high-risk real estate - non-LDC nonperforming assets + 90+ day delinquent loans.
Core deposits = total deposits - deposits> $100,000.
Assumes an equal dollar amount is invested in basket of longs and basket of shorts; within each basket, an equal dollar amount is spent
on each stock.
38
Table 5. Portfolio Results of Long and Short Thrift candidate
Company
Long candidates
State
As of 10/25/91
Price/
Economic
Value Price
Price as
of
11/15/91
Percent
Change
in Price
Return
on
Investment
Annualized
Return on
Investment
Germantown Savings Bank
Parkvale Financial Corp.
ESB Bancorp, Inc.
Charter FSB Bancorp, Inc.
Lincoln Savings Bank
First Savings Bancorp
FedFirst Bancshares
First Federal of Lenawee
Portsmouth Bank Shares
Omni Capital Group
Glacier Bancorp, Inc.
First Northern Savings Bank
ONBANCorp
TriState Bancorp
Total for longs
Short candidates
PA $252.57 $13.250 $13.500 1.89% 3.31% 57.59%
PA 210.38 13.375 13.750 2.80 5.53 96.04
PA 209.57 12.875 12.875 0.00 0.25 4.43
NJ 206.44 16.000 15.000 (6.25) 02.41) (215.76)
PA 189.77 17.250 16.750 (2.90) (5.86) 001.80)
OH 182.38 19.250 19.250 0.00 0.09 1.56
NC 180.86 16.500 17.250 4.55 8.91 154.86
MI 177.90 16.750 16.250 (2.99) (5.83) 001.26)
NH 176.09 10.750 10.750 0.00 0.05 0.93
NC 172.04 18.000 18.000 0.00 (0.18) (3.11)
MT 166.84 10.500 10.750 2.38 4.74 82.39
WI 160.74 19.000 18.500 (2.63) (5.29) (91.90)
NY 153.35 17.500 17.250 (1.43) (3.13) (54.46)
OH 151.12 16.250 16.500 1.54 3.10 53.85
(0.22) (0.48) (8.33)
Old Stone Corp.
Citadel Holding Corp.
GLENFED, Inc.
Coast Savings Financial
Total for shorts
Total for long & short
portfolio
Source: SNL Securities.
RI
CA
CA
CA
058.47)
007.31)
(9.16)
43.62
4.000
24.500
6.375
7.750
3.500
15.000
4.375
5.375
02.50)
(38.78)
(31.37)
(30.65)
(28.32)
56.93 989.46
Note: Economic value = common equity - intangibles + loan loss reserves -40% of nonperforrning assets - 20% of 90+ day delinquent loans
- 13.2% of high-risk real estate loans - 2% of (commercial nonreal estate + consumer loans) - 1% of (total loans - nonperforrning assets -
90+- high-risk real estate- commercial nonreal estate- consumer loans) +30% of I-year gap + 1.5%of loans serviced for others - capitalized
cost of servicing + greater of [3% of (deposits - brokered deposits) or 5 x (66% of last 12 months core income)].
Nonperforming assets =nonaccrualloans + restructured loans +other real estate owned.
High-risk real estate =total construction loans +total permanent mortgages - 1-4 family mortgages.
Assumes an equal dollar amount is invested in basket of longs and basket of shorts; within each basket, an equal dollar amount is spent
on each stock.
39
Question and Answer Session
Reid Nagle
Question: Banks often get
pushed into failure because they
lack liquidity. What are the red
flags for illiquidity?
Nagle: Illiquidity was the main
cause of bank failure in the 1930s,
when 9,000 banks failed because
they were illiquid. This occurred
even though the equity-asset
ratio of banks before the Great De-
pression was 13 percent. I do not
think liquidity is a big concern
now, however.
If the liability side is either
uninsured or noncollateralized,
then liquidity is a real issue. Liq-
uidity is not a big issue now be-
cause banks can always raise
money if they have collateral and
most deposits are insured. There
will not be any capital flight un-
less the creditworthiness of the
U.s. government comes into ques-
tion.
As an indicator of potential
failure due to illiquidity, look at
the liability side and see how
much is subject to flight if a panic
should occur. Insured deposits,
for example, are not subject to
flight. If they are, we are all in
trouble. If a substantial amount
of money is subject to flight, mea-
sure that against the liquid re-
sources the institution has to
cover it.
Question: When marking assets
and liabilities to market, how im-
portant is monitoring the dura-
tion of the assets and liabilities
and avoiding duration mismatch?
Nagle: Duration mismatch is be-
coming increasingly important,
but right now it is impossible to
measure the duration of assets
and liabilities. With the disinte-
gration of the thrift industry,
40
much of its balance sheet, particu-
larly the mortgages and mort-
gage-backed securities, has
flowed to bank balance sheets.
The proportion of bank balance
sheets devoted to long-term fixed-
rate mortgages and mortgage se-
curities has increased signifi-
cantly. Traditional analysis using
Generally Accepted Accounting
Principles, typically available
only once a year, provides crude
insight into the relationship of a
company's market value to
changes in interest rates. Dura-
tion information, currently un-
available, would represent an im-
provement. Ultimately, market
value accounting would provide
the most meaningful information
to investors.
Question: You made the state-
ment that "commercial and indus-
trial loans are destined to be the
most profitable area." Please ex-
pand on that.
Nagle: Commercial and indus-
trial loans do not lend themselves
to securitization, because no com-
mon underwriting standards
exist that are universally accepted
and trusted, which is what allows
loans to be packaged and securiti-
zed. Ultimately, securitization
reduces bank profitability; In
smaller, less competitive cities,
businesses have only a couple of
players they can deal with, and
the banks can basically charge
whatever rate they want, within
reason. They have a local monop-
oly. That kind of business will be
the most attractive for bank bal-
ance sheets going forward.
Question: Losses on real estate
portfolios can be severe-say 50,
60, or 70 percent of balance sheet
value. On a commercial loan,
you can lose the whole loan if
you make a bad judgment. Is
that contrast a meaningful one?
Nagle: Traditionally, loss experi-
ence on noncollateralized com-
merciallending has been far
below the levels currently experi-
enced on real estate lending,
which is collateralized. If man-
agement has a good track record,
the level of prior loss experience
can provide a reasonable degree
of comfort. Investors can evalu-
ate and speak to management to
assess the likely underwriting
standard for business lending.
Question: Is out-of-market lend-
ing wise?
Nagle: Out-of-market lending is
a cause of great concern. That is
the first question that should be
asked of management. I met with
the management of a West Vir-
ginia bank a few weeks ago, and
it seemed very well run. I liked
everything I heard. Then, the
managers started telling me
about making loans in Texas and
about correspondent relation-
ships in a lot of different places
other than West Virginia, and
that made me very nervous. I
would stay away from that.
Question: Do you see more
value in equity investments in
top-tier banks that are stabilized
nonperformers or in more contro-
versially discounted debt or sub-
debt investments in lower tier
banks that have a reasonable in-
terest margin?
Nagle: Prior experience, particu-
larly with subdebt of financial in-
stitutions, is that it is an all or
Table 6. Real Estate Nonaccruals by Region, December 1990and June 1991
(percent of type of loan)
United States North South Midwest West
Type of Loan 12/90 6/91 12/90 6/91 12/90 6/91 12/90 6/91 12/90 6/91
1-4 family residential 1.08% 1.26% 1.79% 2.21% 0.96% 1.04% 0.62% 0.60% 0.39% 0.46%
5 or more family residential 5.06 6.77 7.31 9.34 5.58 8.72 2.11 2.91 1.70 1.72
Construction & development 11.67 13.65 20.18 21.84 8.66 10.90 5.63 6.04 6.35 10.09
Commercial 5.50 6.31 9.10 10.04 4.97 6.14 2.19 2.60 3.73 4.35
Total real estate loans 4.24 4.71 6.95 7.37 3.82 4.43 1.75 1.91 2.37 3.18
Sources: SNL Securities, W.e. Ferguson & Co.
Table 7. Real Estate Charge-Qffs by Type, 1990-91
(percent of nonacx::ruals)
nothing experience. Tremendous
opportunities existed in the thrift
industry just a couple of years
ago, because investors in subordi-
nated debt did not realize that
with financial institutions, you do
not get 70 cents back on the dol-
lar. You either get it all or you
get nothing.
Question: Peer groups for
banks always seem to be based
on asset size. Is this the best way
to select a peer group in today's
society, or should we choose
some other basis such as business
concentration?
Question: What have been his-
toricalloss percentages on non-
performing loans, especially in
real estate? Do any measures in-
clude principal and interest losses,
foreclosure costs, and so on?
Nagle: No very good measures
are available. You would need to
get that information from individ-
ual banks, because the data typi-
cally available from public
sources do not combine all of the
accrued interest and do not add
the net charge-offs back in. Table
6 shows the nonaccruals by re-
gion, and Table 7 looks at net
charge-offs as a percent of nonac-
cruals, but they do not show what
the cumulative charge-off is. I be-
lieve that loss experience on dis-
tressed high-risk real estate lend-
ing is actually somewhere near 50
percent. On the highest risk real
estate, the rate is probably some-
where between 50 percent and 75
percent in severely depressed re-
gions and probably between 40
percent and 60 percent on other
types of high-risk real estate.
Nagle: Given the way the econ-
omy has behaved in recent
years-namely, characterized by
rolling recessions-regionality
and business line are probably
the two most important consider-
ations in peer group compari-
sons. Asset size can often be a
misleading indicator in selected
peer group composition.
Type of Loan
1-4 family residential
5 or more family residential
Construction & development
Commercial
Total real estate loans
Sources: SNL Securities, W.e. Ferguson & Co.
1990
12.75%
30.73
25.16
19.63
21.59
Year to Date
June 1991
Annualized
15.99%
23.20
25.73
21.12
21.12
41