R. Christopher Whalen
Apr 24, 20236 min
April 24, 2023 | Premium Service | A reader of The Institutional Risk Analyst recently complained of seeking investment advice and specific thoughts and insights on preferred equity issued by small banks. First thought: Read our FAQs. Another thought: Ask Manny Friedman at EJF Capital how he feels about small lenders now that the fuss in financials has settled down a bit from last month.
EJF was the subject of derision in the media this past March because of the firm’s focus on small financials. But truth to tell, EJF started to pare back exposures last year. We ourselves decided to migrate up the capital structure in 2020, when the Fed began to “go big” with QE. This meant dumping common equity exposures and buying preferred equities. By the end of 2021, the bloom was off the rose in fintech and the shorts were already feasting on the likes of Upstart (UPST) and Affirm (AFRM).
The dichotomy in financials is profound. Smaller banks have better financial performance and growth, but suffer from the negative risk factor of liquidity. In March 2023, when the FOMC’s intemperate actions in the bond market caused several large depositories to fail, liquidity fled from smaller banks and nonbanks, leaving many investors specializing in smaller names underwater. If you invest in smaller banks, liquidity risk is the prime concern. It’s that simple.
The liquidity concerns of smaller banks are blissful, however, compared to the funding and operating profiles of nonbank financial firms operating in the world of consumer finance. Notice that UPST and AFRM continue to trade at steep discounts to our surveillance group.
Source: Bloomberg
Fact is, with SOFR just under 5% and the 10-year Treasury loitering around 3.5% this week, there is not a lot of juice in the nonbank consumer trade at present, especially with credit concerns weighing on more astute minds. Jumping funding costs for banks are the story of Q1 and Q2 2023, but credit will be the plat du jour by Halloween.
The big concern on everybody’s worry list is commercial real estate. We fussed about some of the existential issues facing New York City and other legacy urban landscapes during COVID, but the glacial pace of change in commercial real estate is finally starting to impact credit. Konrad Putzier just wrote a sobering article in The Wall Street Journal that begins to describe the carnage heading for the world of credit in commercial real estate.
“Landlords are contending simultaneously with a cyclical market downturn and with secular changes in the way people work, live and shop,” Putzier writes. “The sudden surge in interest rates caused property values to fall, while the rise of remote work and e-commerce are reducing demand for office and retail space.”
We noted on Twitter recently that the slippery slope of falling lease rates, phantom occupancy and eventual flight by anchor tenants all spell doom for the equity in commercial buildings in legacy cities. The more progressive the politics in cities like New York and San Francisco, the lower the asset values. Just look at the lease rate in a given building, our friend Nom de Plumber opines, then consider how much leased space is actually occupied.
Unlike the 2008 crisis, when mortgage debtors on 1-4 family homes sent lenders the keys in the mail, today it is tenants that are giving up on whole buildings. The first loss positions on the legacy office buildings typically are held by private equity and REITs. Banks and commercial mortgage backed securities typically hold the mortgage, a 50 LTV affair. But when interest rates have risen 500bp in a year and cap rates are extending accordingly, that 50 LTV of 2021 vintage means zero equity today.
Bank OZK
The world of property development is once again flipping to full-time restructuring. With the increasing focus on credit losses from commercial assets, it is time to check in on Bank OZK (OZK). The $26 billion asset commercial lender is considered a bellwether in the commercial real estate industry. Some 65% of the bank’s loans are secured by commercial real estate, 10x the average for Peer Group 2.
Bank OZK was once a high-flyer among banks, demanding a premium valuation for many years. At the end of 2022, OZK was near the 52-week high, but subsequently slid back after the failure of Silicon Valley Bank. Yet the bank just reported record results in Q1 2023, even as the Little Rock based lender increased credit loss provisions and even grew deposits.
Source: Google
OZK CEO George Gleason talked about the bank’s organic deposit growth:
“On the deposit side, as you saw in the quarter just ended, we had good deposit growth, 3.6% growth in deposits, not annualized. That was organically through our branch networks. Most of our deposit growth comes from our 229 branches in Arkansas, Texas, Georgia, Florida, and North Carolina. We expect those branches will continue to fund that growth going forward in the remainder of the year. We've not had any changes in our deposit gathering strategies or adjustment.”
Not only does OZK gather deposits via its branch network, but the bank manages to price its loans over 6.2% on average vs 4.6% for Peer Group 2. Measured against most operating metrics, OZK ranks near the top of Peer Groups 1 or 2, depending on your preference.
In 2022, for example, OZK’s net income was over 2% of average assets, placing the bank in the 98th percentile of Peer Group 2 (average at 1.2%). OZK had an efficiency ratio of 35.75% in December 2022 vs over 52% for Peer Group 2. The bank has an almost 16% capital leverage ratio and below-peer credit losses. Some 40% of the bank’s loan book is focused on construction and development loans, vs low single digits for commercial & industrial credits.
Like other banks, OZK saw interest expense rise 10x over the past year, but the bank had the growth to use these deposits and actually expanded net interest margin when other banks are in retreat. Significantly, OZK managed to grow net interest income even as it put aside $35 million for future loan losses. The bank has one significant REO asset, a roughly $60 million parcel of land zoned for commercial development. The bank has the luxury of strong capital to hold the REO asset for an eventual sale.
The one thing that seems to worry Gleason is that the flow of new loans may slow as the year progresses. Virtually all of the bank’s assets are originated internally. The bank’s guidance is cautious about being able to maintain past growth rates into the full year 2023.
But the key takeaway for us is that George Gleason and his team at Bank OZK are building credit reserves as we go into the second quarter of 2023. We wish other banks showed the same focus on operating efficiency and loan pricing as is constantly in evidence at OZK. Banks that do not aggressively reprice liabilities and assets as OZK did in Q1 2023 may be left behind.
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