Faux Bear Raids on OZK and AX? But More Trouble Ahead for CRE Equity

June 7, 2024 | Premium Service | In this issue of The Institutional Risk Analyst, we take stock of the banking sector as Q2 2024 grinds to a conclusion in three weeks time. Bank OZK (OZK) fell off the table at the end of May, reflecting market worries about commercial real estate. Several Sell Side equity analysts downgraded OZK and the financial media are working the recession narrative into a frenzy. But we are more concerned about the equity in commercial real estate than the secured lenders.

“When a Citi analyst downgraded Bank OZK from a buy to a sell, sending the stock price tumbling 17 percent, the news shook the industry,” reports The Real Deal. “Normally, an analyst’s downgrade is not the center of real estate water cooler conversations. But OZK is arguably the most important bank in commercial real estate.” Really? The chart below from BankRegData shows the loan categories for OZK.

Bank OZK | Q1 2024

Source: FDIC

Reports from the world of commercial property are a mixed bag to put it optimistically. The financial media decided some time ago that OZK is involved in commercial real estate. A more accurate statement is that the bank is involved in new construction lending on CRE and multifamily. But given the tentative tenor of commercial real estate markets, facts may not matter as much as fear and media hype, especially when that media hype has a hedge fund behind it. Yet we remind readers that unrealized losses on securities are still a bigger problem for banks than CRE.

OZK ranked 25th in the WGA Bank Top 100 Index in Q2 2024. Another name that lost more than 10% at the end of May was Axos Financial (AX), which ranked 16th in the WGA Bank Top 100 Index in Q2 2024. AX is one of the better performing regional banks in the US, but a number of hedge funds have shorted the stock on the premise that the bank’s commercial real estate exposures are problematic and that disclosure regarding the same is lacking. Swarms of trial lawyers follow in their wake like flies. We are a seller of Hindenburg.

The public attack and short-selling strategy against AX launched by Hindenburg Research is well-prepared and compares with the class action lawsuit filed against United Wholesale Mortgage (UWMC) earlier this year. The hostile investment thesis advanced by Hindenburg Research regarding AX essentially accuses the bank of a massive fraud with respect to disclosure on its portfolio of commercial and multifamily loans, many located in New York. The colorful details of some of the loans are pretty typical of the uneven quality of New York City real estate.

The voluminous qualitative analysis in the Hindenburg report is fascinating but unconvincing. Most New York City lenders have similar tales of duplicity and fraud on their books. Every loan has a story. Even the folks at Hindenburg might be surprised how many CRE assets in New York are owned by one flavor of international organized crime gang or another. There is a reason that New York, the Internal Revenue Service and FinCEN have focused on commercial and multifamily real estate in recent years. That's where the money is.

The cute innuendo in the Hindenburg report detracts from the real argument, namely that the equity in these deals is gone. Does that mean that the bank will take a loss? Maybe. Hindenburg does not seem to have the data to make that case. Ultimately, the accusations made by Hindenburg cannot be proven or disproven except by the actual financial results of the bank and its borrowers. AX has called the report misleading, but banks don't generally disclose loan level detail about borrowers. But more significant than the AX accusations is the fact that the bank has a senior secured position in these credits.

Update: AX & OZK

As disclosed in the May 7, 2024 investor presentation, Axos’ largest commercial real estate portfolio, CRE Specialty Lending, had $5.22 billion in outstanding balances as of March 31, 2024. AX states that when collaborating with fund partners, it structures its credits to occupy the most senior secured position in these loans. This explains why the historical realized loss rates for AX are so low compared with the level of CRE delinquency.

"For Axos to incur any principal loss," AX states, "the fund partners would first need to lose the entire principal value of their position.... The fund partners assume a significant risk of loss before it does and this structure ensures robust collateral protection for Axos, even in adverse market conditions."

More than telling us anything new or remarkable about AX, the Hindenburg report confirms our view that there is a lot of trouble coming for the US economy in commercial real estate. New York City is easily the most problematic market in the country, but it is also a magnet for new greater fools with new capital who somehow keep the assets trading. For this reason, attentive lenders have a least 50% equity ahead of them in the credit stack when lending on NYC commercial property.

Both OZK and AX are relatively small banks with above peer revenue and income and below peer loss rates. It is easy for hedge funds and other predators to push these stocks lower because they are relatively small in terms of market cap, especially when the sellers employ derivatives to amplify the weight of short-selling pressure. But the bigger issue raised by Hindenburg is the accusation of false disclosure around troubled CRE loans, an accusation with wider implications for other banks with similar exposures. 

Looking at AX, for example, while non-performing loans are elevated, the very profitable bank’s reported loan loss reserves are more than 100% of NPLs. In effect, AX could charge off their entire NPL portfolio tomorrow, illustrating yet again that income is more relevant to loss mitigation than capital. More important, the rate of charge-offs on the AX portfolio is just a fraction of the charge-off rate for AX peers.

Going back five years, AX has experienced actual loan losses that are in the bottom decile of Peer Group 1. Has the bank been manipulating its results and fooling regulators and audit firm BDO for the past five years? Now we can attribute this excellent performance to the FOMC from 2019 through 2021, but AX has continued to perform above peer in most financial metrics since that time. 

Axos Financial | Q1 2024

Source: FDIC

Note in the chart above that AX has loan loss reserves that exceed total NPLs, perhaps a conservative move by a bank that is 85% loans to assets and has 10% tangible common equity. Even if we were concerned about AX loan losses, the bank is twice as profitable as its peers and is easily able to use that cash flow to remediate a higher loss rate on its portfolio. Like OZK, AX has a gross spread on its loan book that is more than two points above the average for Peer Group 1. 

Likewise at OZK, short-sellers and media are waiving the bloody shirt of commercial real estate exposure, but the reality seems otherwise. In fact, the reported loss numbers for OZK in Q1 2024 were greatly improved. Charge-offs and provisions were down and assets and revenue were up. We last profiled OZK in April of this year (“A Rising Floor on Interest Rates? | Update: Bank OZK”).

Below we look at some of the asset quality metrics from Bank OZK to see if the negative narrative regarding the stock matches the disclosure. While AX has above peer levels of NPLs, OZK continues to show below peer levels of delinquency even while growing top and bottom line results. The chart below from BankRegData tells the story.

Bank OZK | Q1 2024

Source: FDIC

OZK has 4x the level of NPLs put aside in loss reserves and, as the chart shows, the level of delinquency has been falling. Will the level of delinquency on the C&D exposures at OZK rise in 2024? Probably, but the real question is whether the impairment of the equity in these commercial property deals, often more than 50% of the original loan amount, will lead to a loss for the bank. That is a question that only time and future earnings can answer.

The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.