New York | In this issue of The Institutional Risk Analyst, we take a look at an important player in the world of mortgage finance, Texas Capital Bancshares (TCBI), a $27 billion asset institution that punches well above its weight in regional and national markets. If you want to know how we view the entire US banking industry, including our projections for bank funding costs, the latest Q3'18 edition of The IRA Bank Book is now available in our online store.

The first thing to notice about TCBI is that the stock price is up 20% over the past year, outperforming the S&P 500. It currently trades around 2x book value, putting it into the select category of smaller members of Peer Group 1. The equity of the Dallas-based institution has a beta of almost 2, making it twice as volatile as the broad market and a comp for high beta stocks such as Citigroup (C). Bank of the Ozarks (OZRK) has a beta of 1.4, by comparison.

Half of the bank’s $22 billion loan book is allocated to commercial and industrial loans, with about a quarter of total loans held in mortgage finance loans. But that statistic is misleading. Over the past six months, the bank originated and sold short-term mortgage finance loans totaling $45.6 billion or twice the bank’s balance sheet.

The C&I loan portfolio includes business finance and energy sector loans. A lot of the bank’s exposure is tied to the Texas economy and, directly and indirectly, to residential and commercial real estate, but TCBI has a national footprint.

“More than 50% of our loan exposure is outside of Texas and more than 50% of our deposits are sourced outside of Texas,” TCBI notes in its most recent 10-Q. “However, as of June 30, 2018, a majority of our loans held for investment, excluding our mortgage finance loans and other national lines of business, were to businesses with headquarters and operations in Texas. This geographic concentration subjects the loan portfolio to the general economic conditions within this area. We also make loans to these customers that are secured by assets located outside of Texas.”

TCBI is a significant lender to mortgage finance companies, an important but increasingly risky business given the parlous state of the residential lending business. One national warehouse lender told The Institutional Risk Analyst last month that most non-bank mortgage lenders are in violation of their loan covenants due to the poor profitability of the industry. The good news is that most of TCBI’s lending is secured, but once the non-bank mortgage company disappears, the customer is gone and so is the revenue. The watchword in the world of mortgage finance today is “forbearance.”

TCBI is a very strong financial performer, consistently reporting above peer profits and below peer loan loss rates. The bank is very focused on lending as opposed to non-interest income, with almost 88% of total assets in loans and leases vs the mid-60s for its peers. Interest income from earning assets is near the top of the peer group, but loan commitments as a percentage of total loans – what we call “exposure at default” in the lingo of Basel I -- is actually lower than its larger peers.

Significantly, 85% of the bank’s deposits are sourced from “core customers,” the life’s blood of any lender. But with that said, the rate of growth in non-core funding is far higher than its peers, reflecting the above peer rate of asset growth for the bank. This includes $4 billion in advances from the Federal Home Loan Banks or some 15% of total assets. Overall, the funding costs for TCBI have doubled over the past 12 months as with many other banks in the US

There are two big potential threats on the horizon for small, growth oriented lenders such as TCBI. First, the real estate market will eventually cool, making the easy money seen in recent years just a distant memory. That process is already underway in many markets served by this institution. When residential and commercial real estate prices start to weaken in markets such as Texas, that's when you learn that all loans have real estate exposure behind them. Second, the phenomenal economic growth experienced in Texas over the past decade may also start to falter.

“At a time where rest of the country is challenged by aging populations, slowing workforce growth and a loss of working age population, with this population growth, Texas is bucking a lot of those trends,” says Robert Kaplan, President of the Federal Reserve Bank of Dallas. “Texas is extremely well positioned.”

Trees never grow to the sky, even South of the Pecos. But in Texas sometimes the trees can get so tall that you don’t see the clouds forming on the horizon. Remember the oil bust of the 1970s and pass the hot sauce please.