R. Christopher Whalen
Apr 77 min
Updated: Apr 8
“We are worried about a loss of adequate liquidity in the market.”
Treasury Secretary Janet Yellen
October 2023
April 8, 2024 | Premium Service | Last week, we made several changes to the WGA Bank Indices in the wake of the 70% drop in the share price of New York Community Bank (NYCB). Below we have a little pre-earnings look at Bank OZK (OZK). We interviewed founder and CEO George Gleason back in 2017 (“The Interview: George Gleason, Bank of the Ozarks”).
Last week, we updated our methodology for the WGA Bank Indices to allow us to drop a stock when it becomes not timely with the SEC and/or federal bank regulators. Since we use published financials for our tests, when an issuer says that their financials are no longer to be relied upon, then you may be dropped from the index immediately. If the restatement is material, then you lose your LA privileges.
Second, we have added a new test to the WGA Bank Indices to give some weight to size. Size matters. As we noted in an earlier comment, “Big Banks Good, Small Banks Bad,” in times of stress, investors flee to size. Thus in Q1 2024, for example, the best performing bank stock in our 108 bank surveillance group was Citigroup (C) owing to cost cutting announced in 2023 and market concerns about regional banks. Subscribers to The IRA Annual Service may inspect the latest WGA Top Bank 100 list below.
By adding a fifth test for size to our WGA Bank Indices, we keep the focus on operating strength, but acknowledge the human desire to avoid financial loss. When the fundamentals for the US markets are under a growing cloud, people line up in the parking lot at Costco (COST) in the wee hours to buy 1 oz gold bars. Only in the strange confines of Washington do you still find people who think that the federal budget deficit is not a problem. But then again, the left in Albany and Buenos Aires still have yet to repudiate socialism.
We naturally say “told you so” on interest rates as the Wall Street consensus walks back the idea of multiple rate cuts this year. Back in January, most bankers were telling investors to look for three cuts in 2024. But for banks, frankly, higher rates and thereby higher gross yields on earning assets is what the industry needs to support market valuations and deal with loss mitigation.
Troubled banks survive because they have enough net operating income to clean up the mess without spending capital. Recall the performance of BB&T after 2008, when the bank just kept on going without suspending dividends or showing any real operational stress. But the volatility injected into credit markets by the FOMC and the Treasury’s debt issuance makes running a bank or any financial enterprise today increasingly problematic.
Retired Tudor Investment Corp partner Robert Dugger opined in The International Economy that the shrinking pool of savings globally will make financing the US public debt far more difficult.
“Asian asset managers argue that the cost of investable capital worldwide is determined where the curves of world net savings supply and demand intersect,” writes Dugger. “They refer to this cost as the “savings-market clearing rate” (SMCR). There is a yield curve of SMCRs ranging from hours to decades. In their view, the SMCR curve is the key determinant of national interest rates at all maturities and currency values worldwide.”
As the pool of investable savings tightens, the US, China and Europe will be drawing down savings to pay for their respective retirement waves. The cost demanded by those asset managers to finance tomorrow's fiscal deficits will rise, meaning that nations that balance spending and revenue will be advantaged. Dugger continues:
"Currently, Powell prefers to “stay in his lane” and not discuss fiscal policy. However, because the SMCR and ideas like R* are directly affected by Congressional budget policy, he will have no option but to comment on the need for fiscal sustainability. When he does, it will mark the end of the beginning of Congressional resistance to fiscal reform."
Financial institutions that understand this dynamic of a rising floor on interest rates and prepare themselves accordingly will prosper in the years ahead. The age of saving surpluses and lower interest rates forever is ending as the Baby Boom dissipates, another great example of entropy right in our faces.
Source: FDIC
In the world of banking, as shown above, the two key relationships investors must follow are operating income on the one hand and credit expenses in the form of provision for future loss on the other. The ebb and flow of these two key parts of the expense ledger determine what is left for equity holders in the form of earnings. This brings us to Bank OZK, a bellwether in the industry when it comes to commercial real estate and banks generally.
Bank OZK
Probably the biggest accolade that we can give OZK is that when much of the industry saw earnings decline in 2023, the $34 billion asset lender had a record year even as income weakened along with the rest of the industry. OZK has outperformed USB and the rest of the industry over the past year.
In the latest version of the WGA Bank Top 100 for Q1 2024, OZK came in 22nd overall. The only reason that the bank did not score higher is that OZK is still only trading around book value because of fears regarding commercial real estate.
WGA Bank Top 100
Source: WGA LLC
When we talk about commercial real estate, naturally people think of OZK because this relatively small bank is a key national player in the world of construction and development of commercial properties. The table below is from the OZK earnings presentation.
The key thing to understand about OZK is that they focus on construction and development finance in CRE. They look to exit the exposure upon completion of the development process, usually with another lender providing a commercial mortgage. By focusing on the early part of the life cycle of a property and other carefully chosen verticals, OZK has delivered best in class credit performance. Below we compare OZK to U.S. Bancorp and Peer Group 1. Technically OZK is part of Peer Group 2, but we'll compare them to the big boys.
Source: FFIEC, FDIC
Basically, OZK with its southern branch network and national lending focus manages to deliver a loss rate that is one-fifth that of USB and below the average for Peer Group 1, which includes all banks above $100 billion. The data from OZK comes from the FDIC since the depository has no parent holding company. Below we show the gross spread on loans and leases. Again, OZK handily outperforms both USB and Peer Group 1.
Source: FFIEC, FDIC
Yeah, OZK CEO Gleason almost got his bank up to a 9% gross spread in Q4 2023. Bank OZK has been quite adept at managing its balance sheet to increase spread in times of rising interest rates. In fact, even as the market rallied more than a point in terms of residential loan yields since October 2023, OZK has continued to increase its gross loan spread in C&D lending, dealer finance for new RVs and boats, and specialty asset-based lending. Common thread here is lending on new assets early in the life cycle.
A numbers of banks that compete with OZK in the C&D channel pulled back in 2023, allowing the bank generate record revenue and earnings," noted President Brannon Hamblen:
"When there aren't nearly as many competitors on the field, you tend to get calls that you might not have received before. And our guys have done a phenomenal job of converting on new relationships, and obviously, loans with existing relationships. The pie has been smaller, without question. We're just able to take a proportionately larger slice of that pie with our team. And this year will be very interesting in terms of how things play out."
The chart below shows funding costs for OZK, USB and Peer Group 1. Notice that OZK's funding costs are higher than Peer Group 1, but since the bank's gross spread is almost 3 points higher than USB, the net is very positive. This fact helped OZK report a return on assets over 2% when the rest of the industry was struggling to get over 1% ROA. More, look at the volatility in the movement of US interest rates since 2019 under the Powell FOMC.
Source: FFIEC, FDIC
The results for Bank OZK at year-end 2023 was a stellar performance. Whlle the bank did see returns drop due to the FDIC insurance assessment and other factors, OZB still delivered results that were 2x Peer Group 1. Note that OZK actually grew earnings in 2022 when the industry was suffering from NIM compression thanks to the FOMC and QT.
Source: FFIEC, FDIC
One reason that OZK does so well compared to its larger peers is operational efficiency. Bank OZK has an efficiency ratio half of the average for Peer Group 1. In terms of overhead costs, the bank is in the bottom quartile of Peer Group 2, which are banks from $10 billion to $100 billion in assets. Average personnel expenses at OZK are in the bottom 20% of Peer Group 2 at less than $100,000 average annually.
Source: FFIEC, FDIC
Bottom line is that despite worries about commercial real estate, Bank OZK manages to outperform and take market share when other lenders are very literally running away from the market. When the industry sees efficiency ratios going up, OZK's CEO George Gleason and his team are pushing their operating costs down and thereby increasing the dividend to shareholders for the 54th consecutive quarter. Worries about commercial real estate will weigh on OZK in the near term, but when the sun starts to shine again this perennial over-performer will run ahead of the pack.
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