Interpreting the Banking NumbersReid NaglePresidentSNL Securities

Investment analysts evaluate the financial strength of a bank and relate that to its marketpricing. To do so requires assessing liquidation value and going-concern value; makinguse of such peer group comparisons as market indicators, profitability, net interestmargin, operating efficiency, capitalization, asset quality, and asset composition; andidentifying market misvaluations.

For financial institutions, unlike companies operat­ing in other industries, the process of analyzing andinterpreting financial condition is similar both fromthe credit and the investment standpoint. In fact,because the market has come to realize that in highlyleveraged financial institutions the safetyand sound­ness of an institution is paramount, the interest ofcredit analysts and investment analysts are fre­quently the same. An investment analyst needs toevaluate the financial strength and well-being of thecompany and relate that to its market pricing. Theanalyst needs to examine both the economic value ofa company and its market value. A buy signal occurswhen the market value falls substantially below theeconomic value. A sell signal occurs when it is sub­stantially above the economic value. No other indus­try that I am aware of has greater investment poten­tial, both for profit and for loss.

Investing in banks is full of pitfalls for those whodo not understand the fundamentals of profitableopportunities. The reasons for this are many. One isthat no other industry has as many companies:about 1,200, including 400 publicly traded banks, 400publicly traded thrifts, and about 400 pink sheetcompanies. There is a wide array of companies tochoose from, and each one of them at any point intime has a different ratio of market value to economicvalue. Those ratios are changing constantly, and theoutliers in the market value/economic value rela­tionship create phenomenal opportunities.

One of the reasons those opportunities exist isthat no one investment firm follows all of the com­panies; in most other industries, with a limited num­ber of companies to follow, one security analyst or agroup of industry security analysts within a firm can

cover the industry. In contrast, a firm might coveronly 10 percent of the financial companies at most;more typically, a firm might cover 20 or 30 compa­nies. The likelihood that, by covering 20 or 30 com­panies, someone can find the extremities of marketversus economic value within a 1,200-company uni­verse is very slim.

Another reason investment opportunities existin the banking industry is that the information dis­seminated on banks and thrifts is often misleadingand sometimes incorrect. People who accept thepublished financial statements at face value as anindication of value will be misled and may sufferserious financial consequences. Those who knowhow to look behind published numbers and discoverthe truth will find a wealth of opportunities. TheSecurities and Exchange Commission and FinancialAccounting Standards Board are working furiouslyto correct the problems in financial disclosure.

Investors who are not restricted to the long sideand can sell short also have opportunities in bankingstocks. At any point in time, such an investor couldidentify a basket of undervalued securities relative tothe norm and a basket of securities that are overval­ued. By going long on the undervalued securitiesand shorting the overvalued securities, the investorcan capture the value that lies in between. Of course,many money managers are prohibited from goingshort, but during the past few years, the short sidehas presented enormous opportunities. Only on afew occasions and only to a few people is it crystalclear that the industry is undervalued or overvaluedto a substantial extent. Last fall, for example, a fewsecurity analysts realized the banking industry hadbeen oversold. Prices were extremely low, particu-

25

larly for companies that had bright futures, whichprovided a tremendous opportunity for those whoinvested at that time.

Assessing liquidation Value

Much of the opportunity in bank investing arisesbecause financial statements often do not accuratelyreflect financial reality. One reason for this is the useof historical cost accounting. Traditionally, thebanking industry has recorded its financial assetsand liabilities at cost, regardless of how the marketmay value those instruments. As a result, a sharpmovement in interest rates that dramatically affectsthe market value of fixed-income portfolios andlong-term liabilities does not show up in the incomestatement or balance sheet.

In the past four or five years, bank managers andauditors have had tremendous flexibility in deter­mining the appropriate reserve levels for bankinginstitutions. Across the spectrum of 1,200 institu­tions, the difference in reserving practices betweenconservative banking managers and those trying tohold onto the last vestiges of prosperity is a milewide. For example, in a highly leveraged institu­tion-say, at 20:1-equity can be overstated by 20percent if management is given the ability to valueassets even 1 percent off their true value. The Bankof New England is an extreme example. Onlymonths before it failed, it had equity capital of $800million. Ultimately, the Federal Deposit InsuranceCorporation needed more than $3 billion to resolvethe institution after it failed. That is a tremendousgulf between reality and perception.

The marketplace is getting smarter. Table 1shows all banks and thrifts with $10 billion or morein assets. The companies are ranked by their ratio ofprice to book value as of November 13, 1991. At theend of November 1991, this ratio ranged from a highof 276 percent for State Street Boston to a low of 4.7percent for CaiFed. CalFed's management and ac­countants presented what they perceived to be theequity level of CalFed in their financial statements,but the marketplace suggested this value was 96percent in error. So even using contemporaneousfinancials, the disparity between management andmarket valuations is tremendous.

In 1987, the range of price-book-value ratios wasmuch tighter than it is today. The lowest ratio amongbanking institutions at that time was 45 percent forBank of America and the highest was 167 percent forNorthern Trust. At that time, Bank of America wasteetering, and the institution's long-term viabilitywas in substantial doubt. Since then, the way themarketplace understands, evaluates, and assigns

26

value to publicly traded banks and thrifts has beendramatically transformed. Analysts have learned tolook beyond the accounting numbers and to under­stand the business and economic fundamentals ofthese companies. The market value they assign to acompany is appropriately based on the long-termexpected value that company will generate.

Bank profitability and creation of value comefrom two places. One is an economic balance sheet­not the accounting balance sheet, which typicallyrecords assets and liabilities at cost. The economicbalance sheet reveals the true equity position of acompany when its assets and liabilities are fairlymarked to market. Not all parts of the balance sheetare created equal. For banks having a market valuesignificantly below book value, the difference canusually be found on the asset side of the ledger.Table 2 compares the five best-performing banksand the five worst-performing banks in market valueappreciation and depreciation during the past fouryears. The types of loans cited in Table 2 are fre­quently the culprits responsible for market valuedepreciation.

Several interesting points can be made aboutthese companies. Four of the five top-performingcompanies are from the Midwest, which has faredmuch better than other parts of the United Statesthrough the current recession. Certain kinds of as­sets, mainly those I euphemistically call "high risk,"form a much smaller percentage of the balance sheetsfor companies that have succeeded than of those forpoor performers during the past four years. In fact,the only one of the five good companies to have anyhighly leveraged transaction (HLT) loans and lesser­developed country (LDC) loans was Bank of Amer­ica, and its percentages of those were very small. TheLDC crisis for all intents and purposes is over in U.S.banking.

The significant differentiation between the fivebest and five worst market value performers is inhigh-risk real estate loans. Most of the five worsthave a substantial proportion of assets concentratedin all three categories of this group; this is not the casefor most of the top five performers. In fact, for thefive top market value performers, the average forhigh-risk loans amounted to 8.8 percent of assetscompared with 22.8 percent for the worst group.

These numbers show that banks facing a lack oflending opportunities-those that tried to fill in thevoid byacquiring types ofcredits and loans that werein vogue at the moment-fared poorly, and the mar­ketplace rewarded them appropriately for their in­discretions. With the exception of Banker's Trustand J.P. Morgan, which are not traditional banks, thekinds of activities that are appropriate for the bank-

Table 1. Financial Statistics--Banks and Thrifts with $10 Billion or More inAssets, 1987 and 1991

Price ChangeBetween

Price-Book Value 12/31/87 andCompany State Typea 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 166.8 244.6 165.3Banc One Corp. OH B 156.8 241.4 138.2J.P. Morgan & Co., Inc. NY B 136.4 233.3 83.4NorwestCorp. MN B 96.3 200.7 172.6Bankers Trust New York Corp. NY B 84.9 197.6 113.8Wachovia Corp. NC B 139.9 185.3 97.0SunTrust Banks, Inc. GA B 141.3 182.2 94.5Ameritrust Corp. OH B 89.4 182.1 77.3Bancorp Hawaii, Inc. HI B 127.7 180.8 142.2

CoreStates Financial Corp. PA B 152.8 172.3 39.8First Bank System, Inc. MN B 99.5 171.3 17.4Golden West Financial CA T 102.4 168.0 194.0KeyCorp NY B 109.8 164.8 107.6Comerica, Inc. MI B 115.8 164.7 101.8NBD Bancorp, Inc. MI B 115.3 163.8 105.2Manufacturers National Corp. MI B 111.2 162.0 125.0Firstar Corp. WI B 124.0 160.4 114.5PNC Financial Cort PA B 151.4 155.8 20.5Republic New Yor Corp. NY B 131.8 152.9 47.0

C&S/Sovran Corp. VA B NA 152.1 NASociety Corp. OH B 114.1 144.2 47.3Huntington Bancshares, Inc. OH B 120.4 142.9 63.4First Union Corp. NC B 120.0 134.9 50.6US. Banco~ OR B 97.7 134.6 101.3Boatmen's ancshares, Inc. MO B 106.6 134.1 49.6First Fidelity Bancorporation NJ B 116.3 131.3 5.0Fleet/Norstar Financial Group RI B 143.7 129.4 2.7National City Corp. OH B 148.3 129.4 24.5BankAmerica Corp. CA B 45.5 129.1 461.8

Meridian Bancorp, Inc. PA B 108.5 124.9 31.4Barnett Banks, Inc. FL B 132.9 121.9 15.9NCNBCorp. NC B 96.5 121.9 126.1Mellon Bank CorK' PA B 88.4 121.7 37.5First of America ank Corp. MI B 105.1 114.3 38.9Security Pacific Corp. CA B 90.7 111.9 23.6Valley National Corp. AZ B 91.4 109.7 0.9Wells Fargo & Co. CA B 123.1 106.8 47.1UJB 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 3.3First Interstate Bancorp CA B 92.4 88.1 (24.2)Crestar Financial Corp. VA B 115.2 82.8 (13.0)Mich~an National Corp. MI B 120.2 77.1 (5.2)First hicago Corp. IL B 78.0 75.4 43.0H.P. Ahmanson & Co. CA T 92.0 74.7 (4.5)Chemical Banking Corp. NY B 52.0 71.9 16.4Shawmut 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 between12/31/87 and 11/13/91 12/31/87 and 11/13/91

Asset BAC MCOR HWKB BRBK RFBC Avg. CFB NBIC HIE MIDL CSTLa 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 0.00High-risk real estate loans

Construction & development loansa 3.40 1.01 0.32 1.38 0.27 1.27 6.46 6.30 1.33 10.37 3.66 5.62Multifamily loansa 0.45 1.86 0.24 0.17 4.36 1.42 0.53 1.27 2.05 0.57 0.52 0.99Nonresidentialloansa 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 0.91Subtotal (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 and11/13/91 461.82 307.79 229.17 226.53 225.00 (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 BancorporationBRBK = Brenton Banks, Inc.RFBC = River Forest Bancorp

CFBNBICHIEMIDL=CSTL =

Citizens First BancorpNortheast BancorpHibernia Corp.Midlantic Corp.Constellation Bancorp

ing community are the ones that have traditionallyproven themselves to be both profitable and rela­tively risk-free. High-risk ventures typically disap­point shareholders and managements by failing togenerate the returns that traditional banking activi­ties do.

Measuring Going-COncern ValueThe economic value of a balance sheet can be esti­mated by adjusting each component of the balancesheet to reflect market value rather than accountingvalue. Determining the appropriate reserves is animportant part of this process. With some degree ofjudgment applied to each financial institution, onecan generally apply standards of reserves appropri­ate for different asset types, and these more accu­rately portray the financial realities of the companythan the picture managements and auditors present.

True economic value is a function of a bank'smark-to-market net worth (liquidation value) plus itsprojected earnings as a going concern. Going for-

28

ward, those earnings will be a function of a numberof different factors. These include the starting valueof the balance sheet; the strategic direction of thecompany in relation to the evolving role of banking;and the components of income-net interest incomeon a risk-adjusted basis, operating efficiency, and feeincome.

Going-concern value means the extent to whicha bank's franchise can generate a return over andabove a risk-free rate of return, given its startingmarked-to-market net worth. A bank with a startingnet worth of $100, with a risk-free rate of return of 8percent, should generate $8 a year ona risk-free basis.To the extent a bank has franchised its customerrelationships, its position in the community or regionenables it to generate returns substantially above 8percent. That reflects the returns attributable togoing-concern value.

Before 1990, banks paid a substantial franchisepremium to acquire branches and deposits of otherbanks, believing there was a valuable franchise im­bedded in the branches and deposits being pur-

\

\ ,

chased. The ratio of deal value premium to tangiblebook value is probably the best conventional mea­sure of the economic value of a bank, because itincludes both its liquidation and going-concern val­ues. The deposit premium paid in branch sales­which is calculated as the excess of liabilities as­sumed over assets acquired-is the best measure ofthe franchise value of deposit relationships. Buyingbranches and deposits does not necessarily capturethe full franchise value of a bank, however, becauseit does not capture the inherent customer relation­ships on the asset side of the ledger.

As shown in Figure 1, the deposit premium wasapproximately 6 percent in the first quarter of 1989.The banker's valuation of the franchise inherent inbanking has diminished, however. In fact, in themost recent period, the premium declined to 1 per­cent. The premium to tangible book value has notchanged too much during the past three years, al­though it has shown some volatility. The decline inbranch sale premia indicates bankers have a dimmerview of the franchise value of banking than they dida couple of years ago. In particular, deposit relation­ships are seen to have little value, independent ofother less price sensitive banking relationships.

Rgure 1. Merger and Branch sale Pricing, Quarter1yMedian Premium, 1989-S1

7,---------------------------,

6

2

O'----'-_...L----'_---'-_.L..-----'-_...L----'_---'-_.L..----l1Q 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 mayexplain what is happening to banks. Figure 2 com­pares the shares of the nation's financial assets heldby depository institutions and by other sectors. Theshare 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)

1950General MotursPension Fund

'1 f,~

~·i~·_f"·

1940!nv<!stm<!ntCvn"pany Act

2000'90'80'70'60'50'40'30

100

90

80

70

60

C<lIU 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 TroubledMoney Business (New York: Harper Business, 1991): 9.

lar decline throughout the century, with a few short­term exceptions. In the 1970s and 1980s, traditionallending opportunities for the banking industry di­minished, and banks rushed to replace those withloans to LDCs, energy companies, HLTs, and realestate credits. The result was a brief bubble. Thebanks are now in a period of liquification of many ofthe excess credits that were created during that pe­riod, a process that accelerates the reduction in theirshare of total assets.

The depository sector accounted for 85 percentof financial assets in 1900; today its share is 40 per­cent, and it is likely to be close to 30 percent by theend of this decade. Several different types of finan­cial institutions have picked up the slack. Figure 3shows the total assets of different types of financialinstitutions from 1940 through 1990, with projectionsto 2000. Since 1980, the fastest growing financialasset category has been pension funds. This growthis largely a function of public policy and individualpreferences. Public policy has now established pen­sion funds as the major tax-advantaged vehicle forindividual savings. Pension funds do not requireany capital for their existence, so pension fund assetsoffer infinite leverage possibilities. This should leadto continued growth in pension funds. Mutualfunds, because of technology and the absence of anymeaningful capital constraint, have also experienceda rapid growth rate.

The growth of commercial bank assets hasslowed in recent years, and thrifts' assets havedropped off precipitously. These trends are likely tocontinue in the future. Unfortunately, governmentpolicy was not designed to accommodate the declin­ing role of banks and thrifts in the financial sector. Infact, during much of the 1970s and 1980s, govern­ment policy encouraged expansion of depository in­stitution balance sheets. The process of contractionand failure evident today is a natural consequence ofa sector that will ultimately represent less and less ofthe total financial assets of our economy.

These trends have several implications for thebanking industry. It might be tempting to say thatbanking is not a growth industry, that it does notprovide many investment opportunities. That is notthe case, however. Banking will be around for a longtime, although in a diminished role compared toother forms of savings and intermediation. Many ofthe traditional banking activities have been strippedaway from banks. For example, blue-chip compa­nies in the 1970s began bypassing the banking systemby issuing commercial paper and medium-termnotes. That meant the largest banks, which had tra­ditionally supplied credit to these firms, lost a bigpart of their asset base. Many of them rushed intohigh-risk, aggressive credits to fill the void.

In the past 10 or 15 years, we have seen more thanjust large corporations sucked away from the bank­ing system. We have seen the mortgage sector andthe consumer-lending sector diminish as well. Theprominence of Fannie Mae and Freddie Mac, whichare involved in a majority of the mortgages beingwritten in the United States, has rendered depositoryinstitutions inefficient holders of mortgage assets. Infact, financial institutions, which traditionally wereboth the originators and holders of financial assets,now find those functions are being split. Banks andthrifts may still be the most efficient originators ofcertain financial assets, but they may not be the mostefficient holders of financial assets. This is certainlytrue with mortgage products.

Similar, though less dramatic, changes have oc­curred in consumer lending. Over time, federal pol­icy has had a large influence on what form consumerlending takes. As a result of the period of debt dis­gorgement resulting from the excesses of the 1980sand also the fact that nonmortgage interest expensefor consumer credit is no longer tax-deductible, con­sumer loans will undergo a very slow rate of growthin the years to come. Moreover, many forms of con­sumer credit are increasingly being integrated intothe capital markets. Equity (second-mortgage) loansare being integrated into the capital markets to thepoint 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 ofFinancial Institutions, 1~2000(projected)

5,500 r----­

5,000 L .....

4,500

4,000<Jl

§ 3,500Si:E 3,000

~ 2,500<JlQ)~ 2,000

~ 1,500

1,000

500

oL=:~~'40

30

loans as a profitable component of the balance sheetwill diminish.

Automobile lending has become an intenselycompetitive business. Auto buyers do not need to goto a bank to get a loan. They simply go to a cardealership, pick out a car, and a half-hour later leavewith the financing. Unlike the role of banks in orig­inating equity loans, the role of banks in automobilelending is diminishing. Prevailing auto loans are nolonger profitable for most bank portfolios.

The credit card business is moving away fromthe banking industry as well. Recently, two non­depository institutions have become major players inthis business-AT&T and Sears. A number of otherentrants are expected soon. The secondary marketfor credit card loans, which is very active, has under­gone significant changes in recent years. The premi­ums paid in the secondary market have declinedfrom 20 or 25 percent a couple of years ago to 10percent today. As a result, the profit margins and thepremiums banks will be able to extract on the con­sumer credit card loan balances they generate willcontinue to decline.

Although these trends sound negative, a numberof opportunities exist. One area of opportunity islending to small- and medium-size businesses.These loans are not easily securitized and integratedinto the capital markets. Furthermore, small busi­ness accounts for more than 50 percent of gross na­tional product. To serve this market, banks will needto change their underwriting processes. They willneed to retrain themselves in evaluating businesses,because the nature of businesses that exist today isvery different and much less physical-capital inten­sive than the businesses of 20 years ago. They aremuch more human-capital intensive and require adifferent degree of sophistication and underwritingskill to evaluate.

The other opportunity is cost savings. The best­managed companies have an opportunity to acquirecompanies that are not so well managed and thenachieve cost efficiencies. Even though that does notsound as alluring as making loans, consolidation thatproduces net efficiencies is a very profitable activity.The major realignment ofbank market values duringthe past several years has given those banks that havedemonstrated the technological and managementskills to undertake profitable consolidation the op­portunity to buy less successful banks.

Peer Group Comparisons

Peer group comparisons are very important to thevaluation of banks. By comparing financial and op­erating 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 Banking Corporation,a bank that epitomizes the kind of institution that hasbeen able to make many of the changes necessary togenerate value for shareholders. Investors who buybased on standard ratios, such as price-book, wouldprobably not buy this company. In the mid-1980s,Worthen had some severe problems. It had somesignificant loan-quality problems, including about$60 million in loans to a securities firm that wentbankrupt. Management was replaced, and now it isdifficult to recognize the company because of thechanges that have been made. This is a compellingcompany that has demonstrated the ability to gener­ate value for shareholders.

The most useful peer group comparisons aremarket indicators, profitability measures, net inter­est margin, operating efficiency, noninterest reve­nue, capitalization, asset quality, and asset composi­tion.

III Market indicators. Table 3 shows compara­tive market information for Worthen, four regionalpeers, and the median for all banks nationally, allsouthwest banks, and all banks of Worthen's size. Insome categories, Worthen looks different from itspeers. For example, Worthen does not pay a divi­dend. It realized in the mid-1980s that it was capitaldeficient and needed to build its equity base.Worthen has been able to generate better returns onequity every year for each of the past five years, andits return on equity is close to 16 percent now. Thatrate of return exceeds the implied cost of capital fora company with its risk profile. Any time a companygenerates a return on its equity base in excess of itscost of capital, it should retain that capital and con­tinue to build. This company has done exactly that.

Second, Worthen's price-tangible-book ratio of147.5 percent is well above the median for all banks­110 percent-and above the median for regional andasset-size peer groups. Based on this ratio, an analystmight conclude that Worthen is fully priced now, butthat may not be the correct conclusion. In this case,the price-earnings ratio is a more meaningful mea­sure because these are true earnings. Worthen'sprice-earnings ratio is considerably lower than thatof its peers-8.6 compared with 12.4 for all banks.This suggests that Worthen's underlying earningspower comes from a variety of factors.

III Profitability. Figure 4 shows Worthen's fi­nancial performance compared to its peers. Over thisperiod, Worthen showed continual improvement inits return on average equity. Another measure ofprofitability is the ratio of adjusted earnings to aver­age assets. As Figure 5 shows, Worthen's adjusted

31

32

Table 3. Worthen Banking Corporation: Comparative Market Infonnation, November 11, 1991

Peer Group MedianAll 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 0.45Past year 0.33 1.72 1.11 0.30 2.26 0.41 0.73 0.45

Price changePast month -2.2 8.0 -6.0 1.9 6.6 1.1 5.1 2.1Past quarter 9.1 18.7 -11.3 31.0 9.9 0.0 6.3 1.2Past year 36.1 174.3 38.2 71.9 154.3 32.1 71.9 44.4

DividendsDividend yield 0.00 1.58 2.13 0.00 0.72 3.08 0.00 3.04LTM payout ratio 0.00 7.50 18.40 0.00 34.00 34.70 7.50 36.00

Market RatiosPrice-earnings (fourth quarter) 8.6 23.7 8.6 29.3 47.3 12.4 14.4 12.2Price--core earnings (fourth quarter) 8.8 22.3 8.3 16.8 53.0 12.7 16.8 12.6Price-book 137.0 136.8 86.3 76.7 123.1 103.1 86.3 116.5Price-tangible book 147.5 156.5 116.3 79.8 140.5 110.7 103.0 125.0

Ownership profileInside ownership 4.89 12.05 41.55 43.47 8.36 13.83 13.95 11.83Institutional ownership 12.61 43.39 9.34 43.89 36.24 11.52 13.89 13.90

Shares outstanding 10,931,399Market value of common ($millions) $180.37Price as of 11 /11 /91 $16.50052-week high $18.00052-week low $10.375

Source: SNL Securities.

aAverage weekly volume as percent of shares outstanding.

Key:WOR = WorthenAFBK = Affiliated Bankshares of ColoradoBNKS = United New MexicoBOMA = 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. To­gether they provide a good measure of operatingefficiency. Figure 7 shows that Worthen's ratio washigher than all of the peer groups in 1987 but hasdeclined since 1988 and has been lower than that ofits peers since 1989. Typically, the bigger banks havea smaller net interest margin than smaller banks.Regional banks tend to have larger net interest mar­gins, but they also have larger operating expenses.Attracting demand deposits, which have a very lowcost of funds associated with them, frequently re­quires a much higher level of accompanying operat­ing expense. In this category, Worthen has tradition­ally outpaced its peers.

III Capitalization. Figure 8 shows capitaliza­tion ratios for Worthen and its peers. In 1987,Worthen's equity-asset ratio was significantly belowthose of the other banks. By June 1991, it had in­creased its capitalization ratio so that it is close tothose of its size peers.

III Asset quality. Sound asset quality is one ofWorthen's strongest characteristics. Figure 9 showsthe ratio of nonperforming assets to total assets.Worthen has made phenomenal progress in bringingits nonperforming asset ratios down since 1987.

Latest 4 Years and Past 12 Months1.0,-------~--------____:::_-==:_l

Most Recent 5 Quarters1.2,-----------------------,

.:-=-:.-:::-:::.----- --------~ 0.81- '-::-:- ----

l::P': 0.6 f-

Figure 5. Worthen Banking Corporatioll-AdjustedEarnings 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 Quarters201========:::::----------1

Latest 4 Years and Past 12 Months20,-------------------:;::=====l

Figure 4. Worthen Banking Corporatioll­Profitability: Return on Average Equity

~ 15cB~ 10

~- 10

earnings-assets ratio has increased dramatically,particularly relative to its peers, since 1987. Theadjustment removes extraneous nonrecurring earn­ings and expenses.

III Net interest margin. Figure 6 showsWorthen's net interest margin relative to its peers.Worthen's net interest margin was severely deficientrelative to its peers in 1987, improved materially in1988 and 1989, and since then has largely paral­leled-though remaining below-that of its peergroup. Worthen is taking steps that will ultimatelylead to a resumption of growth in its net interestmargin.

III Operating efficiency. A good measure ofrelative efficiency is the ratio of net noninterest ex­pense to net interest income, where the net noninter­est expense is defined as operating expense less non­interest income divided by net interest income on afully taxable equivalent basis. The numerator of thisratio captures operating efficiency, which is howmuch was spent on operating expenses less howmuch was earned in fee income. The denominatorcaptures the ability to produce net interest income.It is important to relate operating efficiency to netinterest income because of the higher operating ex-

33

Rgure 6. Worthen Banking Corporation-NetInterest Margin

Latest 4 Years and Past 12 Months4.75.--------------------,

Figure 7. Worthen Banking Corporation-NetNoninterest Expenseasa Percent of NetInterest 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 Quarters70r---------------------,

'90 6/'91'89'883.75"-------'--------'---__--'-_---'

'87

Most Recent 5 Quarters4.6r-------------------",

--- -- -- -- -- -- .... -,#---- - ---§ 4.4 ::.~_:. ~_-_----~=:.-:::-:-~--2=---------

l::'@> 4.2

t"<l

:::E

--------

Source: SNL Securities.

6/'913/'9112/'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/'913/'9112/'909/'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 Corporation­capitalization: Equity as a Percent ofAssets

it is now below those of its peers. This is character­istic of a number of successful bank investment sto­ries during the past few years.

Figure 10 shows reserves as a percent of nonper­forming assets. This is another indication ofWorthen's progress in improving its asset quality.One of the things that always identifies a sure win­ner, from an investment standpoint, is bank manage­ment that wants to hide income rather than manufac­ture it. Historically, when reported profits were thinat year end, banks did the reverse of what mostindividuals would do at year end. Most individualswith a mix of gains and losses would sell the stockswith losses to minimize their aftertax cash outflowsand maximize their economic positions. This ap­proach leads to accounting losses, and many bankmanagers are loathe to show losses because they areafraid of how the marketplace will interpret the loss.Whether it is realizing losses from a portfolio ormaking conservative additions to reserves, those areall signs of a management willing to build long-termvalue. Taking voluntary steps that reduce reportedincome 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 wasgoing to dedicate itself to this task, and indeed it didexactly what it promised. Whereas Worthen's ratioin 1987was substantially in excess of that of its peers,

7

1:: 6 -Cliu...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 asa Percent of Deposits

has been deleveraging its balance sheet and shed­ding risk, it has concentrated its energies and builtup its expertise in commercial banking, which isdestined to be the most profitable balance sheet ac­tivity 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 Quarters1001 -----------=:::=========1

I-----c 80"- -----~

'"~ ~---

60 - - - - -=:-":-=-::'-::--....----:--------

Latest 4 Years and Latest Quarter100 r--------------------,

Figure 10. Worthen Banking Corporation--Reservesas a Percent of Nonperforming Assets

c'"~ 60

6/'91'90'89'88

-~~~- -=--- - -- ~_.----==--==--I C- --l.- ---L ---L_~

'87

2

Latest 4 Years and Latest Quarter5r------------------,

nomic value will always reward the patient, long­term investor. Periodically, managers will do the"right" thing, providing a real opportunity for in­vestors 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 expo­sure and deleveraged its balance sheet. For creditanalysts and investors, this is an indication that thecompany is close to being rock solid; it has doneeverything it can to clean up its balance sheet. Dur­ing the mid-1980s, the state of Arkansas wentthrough substantial problems with the failure of anumber of large savings institutions, attributableboth to mismanagement and to fraud. Worthen hasbeen a very active acquirer of these franchises. Theseacquisitions will provide Worthen with a dominantmarket position, which will allow it to influence thepricing of deposits (which are not securitized likemortgages and consumer loans) and to influence thepricing of loans to businesses in the markets it serves.

Asset Composition. Figure 12 shows theratio of domestic commercial and industrial loans toassets for Worthen and its peers. While the company

Figure 9. Worthen Banking Corporatio~

Nonperfonning Assets as a Percent ofTotal Assets

Most Recent 5 Quarters3.5r-----------------

Latest 4 Years and Latest Quarter

------- .......

3.0

6/'91'90'89

- ---------------

'88

------

65 L- .L- ----'L- --L_--'"

'87

J...... 70

-----

3/'91 6/'919/'90 12/'90

.-_::--=-----1.0L- --'- -'-- --'- ----'

6/'90

~ 2.5i::~ 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 Corporation­Consumer Loans as a Percent of Assets

An investor who knows what signals to look for cantarget obvious misvaluations in the marketplace.These misvaluations are egregious, despite the sig­nificant progress the marketplace has made in thepast few years in understanding the value, or lack ofvalue, that underlies banking companies relative towhat their accounting statements show. The wayour company analyzes these companies is an exam­ple of one methodology for identifyingmisvaluations. Our method of analysis will proba­bly not work in a few years, because the marketplacewill be that much more savvy then; but it does worknow.

'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 Quarter20,------------------0

15 fC:::-=-=-==-:';-=:;-;;;":"-.::.,-,;,-~-~-~-~~------

Rgure 12. Worthen Banking Corporation--Domestic Identifying Marketplace MisvaluationsCommercial and Industrial Loans as aPercent of Assets

Source: SNL Securities.

its business lending skills even while reducing loansoverall as a percent of the balance sheet.

Two categories ofloans Worthen has reduced arehigh-risk real estate loans and consumer loans, asshown in Figure 13 and Figure 14, respectively. In­creasingly, banks are becoming originators of loansbut not holders of assets that are easily securitizedand integrated into the capital markets. That is ex­actly what Worthen has done. It has diminished itsreliance on what is becoming an increasingly lessprofitable part of the balance sheet.

16

Source: SNL Securities.

Latest 4 Years and Latest Quarter

By looking at the composition of the balancesheet and the makeup of the income, it is possible tomark the balance sheet to market. Our process isquite simple.1 For each company, we approximatethe liquidation value by applying the appropriatelevel of reserves for different categories of assets. Forexample, high-risk activities-eonstruction lending,commercial real estate lending, HLTs-would getsignificant levels of reserves. From the liquidationvalue, we approximate the going-concern value, re­membering that economic value is the sum of liqui­dation value and going-concern value. We tried toapproximate the going-concern value by makinggross generalizations and setting franchise valueequal to the greater of 5 percent of core deposits tocapture the franchise premium or to five times netincome 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 Corporation­High-Risk Real Estate Loans as a Percentof Assets

36

Most Recent 5 Quarters65,---------------------,

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

401=:=======r::==~-..L.-------I...--~

6/'90

60

60

45

1::(l) 50

~

Figure 15. Wells Fargo &Compan~NoninterestExpense as a Percent of Net InterestIncome

short positions we recommended, the decline was 28percent and even more since the ending date shownin the table.

Source: SNL Securities.

Tremendous misvaluations exist among 800 publiclytraded banks and thrifts, but you must be willing toexamine the full range ofcompanies to identify valueopportunities. I guarantee that at least for the nextfive years, until the marketplace reaches full throttleand until enough participants understand the valu­ation process, these misvaluations will continue.

+' 55

~~.... 50

Conclusion

Street and Northern Trust generate largely off bal­ance sheet. Admittedly, this method may captureonly 80 percent of the truth, but in investing in a fieldthat is so grossly misvalued, 80 percent of the truthtends to work out very well.

This type of analysis provides a ranking of com-panies. Table 4 lists the best and the worst banks asof November 15, 1991. We suggested buying ninecompanies and selling eight short. Despite a fall inbank stock prices since then, six of the nine longpositions are up in price and six of the eight shortpositions are down in price, and the average appre­ciation is 10 percent. Of the companies listed on theshort side, Michigan National is a poorly managedcompany; had it been operating on the East Coast orthe West Coast, it probably would have met the samefate as Bank of New England or City Trust. Becauseit was in the Midwest, however, it survived.

Wells Fargo has been the subject of considerableconjecture. I believe the preponderance of risk inWells Fargo's balance sheet and its rapid growth arecauses for concern. In high-growth institutions, 99times out of 100, even the best management cannotdefy the odds. When a bank grows that rapidly in anontraditional activity, it is going to get singed.

On the other hand, Wells Fargo is immenselywell managed, if the risk concentration issue is over­looked. Figure 15 shows an operating efficiencychart comparing Wells Fargo to its various peergroups. Normally, banks are well managed orpoorly managed in all aspects. Most often, the com­panies that have rushed into high-risk kinds of lend­ing activities are also the most inefficient. Those arethe companies that do not maximize fee income. Inthis case, management is bifurcated. They seem de­ficient at risk analysis (although they are probablyvery 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 thriftstocks. Investing long in the thrift industry requiresgreat patience and a lot of hope. You must be willingto hedge so that you really do not care what hap­pens-you simply want to capture the misevalua­tion. The calculations shown in Table 5 were done atthe end of October, and by mid-November, the 14long 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 09/04/91Price/

EconomicValue Price

Price asof

11/15/91

PercentChangein Price

Returnon

Investment

AnnualizedRetumon

Investment

Commerce Bancshares, Inc.First American Corp.United Missouri Bancshares Inc.Worthen Banking Corp.United Counties BancorporationHawkeye BancorporationChemical Financial Corp.USBANCORP, Inc.First Merchants Corp.

Total for longs

Short candidates

CiticorpChase Manhattan Corp.Wells Fargo & Co.Fleet/Norstar Financial GroupBarnett Banks, Inc.Michigan National Corp.City National Corp.Mark Twain Bancshares, Inc.

Total for shorts

Total for long & shortportfolio·

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 34.32 173.98MO 89.1 34.500 36.250 5.07 9.48 48.07AR 89.9 15.125 16.750 10.74 19.91 100.93NJ 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 14.34PA 54.8 16.500 18.125 9.85 19.55 99.13IN 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 3.47CA 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-LDCnonperforming 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 spenton each stock.

38

Table 5. Portfolio Results of Long and Short Thrift candidate

Company

Long candidates

State

As of 10/25/91Price/

EconomicValue Price

Price asof

11/15/91

PercentChangein Price

Returnon

Investment

AnnualizedReturn on

Investment

Germantown Savings BankParkvale Financial Corp.ESB Bancorp, Inc.Charter FSB Bancorp, Inc.Lincoln Savings BankFirst Savings BancorpFedFirst BancsharesFirst Federal of LenaweePortsmouth Bank SharesOmni Capital GroupGlacier Bancorp, Inc.First Northern Savings BankONBANCorpTriState 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 96.04PA 209.57 12.875 12.875 0.00 0.25 4.43NJ 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 1.56NC 180.86 16.500 17.250 4.55 8.91 154.86MI 177.90 16.750 16.250 (2.99) (5.83) 001.26)NH 176.09 10.750 10.750 0.00 0.05 0.93NC 172.04 18.000 18.000 0.00 (0.18) (3.11)MT 166.84 10.500 10.750 2.38 4.74 82.39WI 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 & shortportfolio·

Source: SNL Securities.

RICACACA

058.47)007.31)

(9.16)43.62

4.00024.5006.3757.750

3.50015.0004.3755.375

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 - capitalizedcost 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 spenton each stock.

39

Question and Answer SessionReid Nagle

Question: Banks often getpushed into failure because theylack liquidity. What are the redflags for illiquidity?

Nagle: Illiquidity was the maincause of bank failure in the 1930s,when 9,000 banks failed becausethey were illiquid. This occurredeven though the equity-assetratio of banks before the Great De­pression was 13 percent. I do notthink liquidity is a big concernnow, however.

If the liability side is eitheruninsured or noncollateralized,then liquidity is a real issue. Liq­uidity is not a big issue now be­cause banks can always raisemoney if they have collateral andmost deposits are insured. Therewill not be any capital flight un­less the creditworthiness of theU.s. government comes into ques­tion.

As an indicator of potentialfailure due to illiquidity, look atthe liability side and see howmuch is subject to flight if a panicshould occur. Insured deposits,for example, are not subject toflight. If they are, we are all introuble. If a substantial amountof money is subject to flight, mea­sure that against the liquid re­sources the institution has tocover it.

Question: When marking assetsand liabilities to market, how im­portant is monitoring the dura­tion of the assets and liabilitiesand avoiding duration mismatch?

Nagle: Duration mismatch is be­coming increasingly important,but right now it is impossible tomeasure the duration of assetsand liabilities. With the disinte­gration of the thrift industry,

40

much of its balance sheet, particu­larly the mortgages and mort­gage-backed securities, hasflowed to bank balance sheets.The proportion of bank balancesheets devoted to long-term fixed­rate mortgages and mortgage se­curities has increased signifi­cantly. Traditional analysis usingGenerally Accepted AccountingPrinciples, typically availableonly once a year, provides crudeinsight into the relationship of acompany's market value tochanges in interest rates. Dura­tion information, currently un­available, would represent an im­provement. Ultimately, marketvalue accounting would providethe most meaningful informationto investors.

Question: You made the state­ment that "commercial and indus­trial loans are destined to be themost profitable area." Please ex­pand on that.

Nagle: Commercial and indus­trial loans do not lend themselvesto securitization, because no com­mon underwriting standardsexist that are universally acceptedand trusted, which is what allowsloans to be packaged and securiti­zed. Ultimately, securitizationreduces bank profitability; Insmaller, less competitive cities,businesses have only a couple ofplayers they can deal with, andthe banks can basically chargewhatever rate they want, withinreason. They have a local monop­oly. That kind of business will bethe most attractive for bank bal­ance sheets going forward.

Question: Losses on real estateportfolios can be severe-say 50,60, or 70 percent of balance sheet

value. On a commercial loan,you can lose the whole loan ifyou make a bad judgment. Isthat contrast a meaningful one?

Nagle: Traditionally, loss experi­ence on noncollateralized com­merciallending has been farbelow the levels currently experi­enced on real estate lending,which is collateralized. If man­agement has a good track record,the level of prior loss experiencecan provide a reasonable degreeof comfort. Investors can evalu­ate and speak to management toassess the likely underwritingstandard for business lending.

Question: Is out-of-market lend­ing wise?

Nagle: Out-of-market lending isa cause of great concern. That isthe first question that should beasked of management. I met withthe management of a West Vir­ginia bank a few weeks ago, andit seemed very well run. I likedeverything I heard. Then, themanagers started telling meabout making loans in Texas andabout correspondent relation­ships in a lot of different placesother than West Virginia, andthat made me very nervous. Iwould stay away from that.

Question: Do you see morevalue in equity investments intop-tier banks that are stabilizednonperformers or in more contro­versially discounted debt or sub­debt investments in lower tierbanks that have a reasonable in­terest margin?

Nagle: Prior experience, particu­larly with subdebt of financial in­stitutions, is that it is an all or

Table 6. Real Estate Nonaccruals by Region, December 1990 and 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 1.72Construction & development 11.67 13.65 20.18 21.84 8.66 10.90 5.63 6.04 6.35 10.09Commercial 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. Tremendousopportunities existed in the thriftindustry just a couple of yearsago, because investors in subordi­nated debt did not realize thatwith financial institutions, you donot get 70 cents back on the dol­lar. You either get it all or youget nothing.

Question: Peer groups forbanks always seem to be basedon asset size. Is this the best wayto select a peer group in today'ssociety, or should we choosesome other basis such as businessconcentration?

Question: What have been his­toricalloss percentages on non­performing loans, especially inreal estate? Do any measures in­clude principal and interest losses,foreclosure costs, and so on?

Nagle: No very good measuresare available. You would need toget that information from individ­ual banks, because the data typi­cally available from publicsources do not combine all of theaccrued interest and do not addthe net charge-offs back in. Table

6 shows the nonaccruals by re­gion, and Table 7 looks at netcharge-offs as a percent of nonac­cruals, but they do not show whatthe cumulative charge-off is. I be­lieve that loss experience on dis­tressed high-risk real estate lend­ing is actually somewhere near 50percent. On the highest risk realestate, the rate is probably some­where between 50 percent and 75percent in severely depressed re­gions and probably between 40percent and 60 percent on othertypes of high-risk real estate.

Nagle: Given the way the econ­omy has behaved in recentyears-namely, characterized byrolling recessions-regionalityand business line are probablythe two most important consider­ations in peer group compari­sons. Asset size can often be amisleading indicator in selectedpeer group composition.

Type of Loan

1-4 family residential5 or more family residentialConstruction & developmentCommercial

Total real estate loans

Sources: SNL Securities, W.e. Ferguson & Co.

1990

12.75%30.7325.1619.63

21.59

Year to DateJune 1991

Annualized

15.99%23.2025.7321.12

21.12

41