The narrative fallacy of thrift conversions and their deposits

I was going to focus on other aspects like loan quality, but I think looking at the deposit mix of some of the recent thrift conversions is enough to prove my point.  I might be making this up, but I sense that people make the assumption that thrifts by virtue of being local have these great local relationships and strong deposit bases.  This is plainly false to hold as a rule and its easy to prove/disprove by looking at the types of deposits the bank attracts.  Just because Peter Lynch and Seth Klarman have singled out thrift conversions as a fertile hunting ground for investments doesn't mean that all conversions are brimming with investment potential.  It's kind of easy to determine that they are cheap with huge discounts to TBV, but you still need to consider whether or not the business is any good.  Deposits are very important to banks, so it stands that examining them in greater detail is worthwhile in judging the bank's overall attractiveness.

I'd also caution people that because it's difficult (not impossible) for an amateur investor that isn't less than incredibly enterprising to get in on the initial offering, purchase prices are higher so you need to pick out the overcapitalized conversions that have the most potential.  If you do participate in the offering, you really are getting a dollar for 50 cents and the markets generally boost the price a cool 10-15% once they list on the exchange.  If the deposits give the bank some additional franchise value, it can still be had for 50 cents on the dollar without trading at 50% of TBV.

I've seen a narrative floating around that these thrift conversions have been happening due to regulator shopping.  This is dumb.  This reeks of sloppiness.  I'd call it intellectually irresponsible, but I don't want to taint the idea of intellect with this notion.  An awful credit bubble occurred over the past decade, banks have lost money, mutual thrifts weren't in a position to earn their way out of their reduced capital and now they need to go to markets to raise funds.  This isn't rocket science and even if I put forth this reasoning solely out of stubbornness and knee jerk contrarianism, it reduces my risk of making a mistake (although possibly at the expense of return).  

It reflects a political bias because the inverse is that different regulators need to justify their existence and therefore would not act in an egregious manner to justify their constituents abandoning their regulatory structure for another.  This is equally plausible under the same set of assumptions.  The entire discussion of regulators neglects the fact that plenty of mutual banks still exist and don't look like changing.

The investment opportunity lies not in the idea that management is being so kind offering us these amazing banks to avoid regulatory uncertainty, but in the fact that these banks end up raising more capital than they need (it was the only way they could) and now are incentivized to generate greater profits on that capital.  To even entertain this regulator shopping idea is just to distract people from the fact that many of these banks are not worth considering post-offering.  I wouldn't pay something like 70 cents on the dollar for a bank that has enormous interest rate risk from a poor deposit mix and loads of 30 year mortgages unless the bank is very efficient, demonstrates conservative underwriting standards, and has generated a nice ROE preconversion (see Versailles Financial).

A recent thrift conversion demonstrates my point well in that it is totally unexciting and a pass.  Naugatuck Valley Financial Corporation (NVSL) recently completed its second step conversion and trades at the offering price.  Second steps aren't quite as profitable historically from an investment standpoint since the bank raises equity for 75-80 cents on the dollar instead of 50 cents on the dollar.  It still does result in a discount to TBV which is generally unwarranted.  It can be plenty rewarding if the bank is capable of double digit ROE's and now has even more capital to do that with, but this hasn't been the case over the past 2 years.  NVSL trades at about 70% of book value post offering, although their NPLs are a good measure above their allowances so the denominator in that equation might fall in coming quarters (they could also have no problems, but I'm a pessimist).

NVSL does mention regulatory uncertainty in is prospectus as one of the top reasons for converting.  While this may be fairly plausible since they were half public, half mutual, the reality is that they have a depleting capital cushion.  If you adjust their allowances to be 100% of NPLs, instead of the current 35%, this becomes clear.  Instead of lacking a profit motive though like most straight mutual conversions, the bank really just lacks profit.  I attribute this a good part due to deposits, which is what I want to focus on.

It has a poor funding mix.  The bank is dependent on CDs and FHLB advances for 80% of its funding.  What is really absurd about this is how much they pay for them.  The part that really sticks out about this is that they pay very similar interest rates for both: ~2.60%.  CDs account for $238m out of $409m of deposits with FHLB advances totaling $88m out of a total of $497m in total interest bearing liabilities.  They are starved for funding in an environment where there it is cheap and plentiful.

One reason I will put forth is that they only give their customers 0.07% on their checking accounts, which is insultingly low.  They clearly face competition for local deposits, but have adopted a strategy that is not going to lead to a high return business.  They are paying above average rates for unattractive deposits and below average rates for attractive ones, which explains why the deposits are what they are.  They are just desperate and short term oriented.  Since I can't frequent their branches to verify this, I interpret this as a sign of poor customer service and poor banking in general.

I realize it might sound ludicrous to say a bank shouldn't be paying as little as possible for funding.  The reality is so much more complicated than that.  A small bank that seeks to differentiate itself should be paying a nice rate on its core deposits (non-CDs).  While not a perfect proxy, it does indicate a management's focus on the consumer first rather than the bottom line, which will follow.  There will be different scenarios that call for different approaches, but in the case of small thrifts I think my assertion is correct.  From my limited to non existent knowledge of banking, a superior consumer experience is a key part of what really generates strong profits over an entire cycle.  That's how a small bank can differentiate itself from a behemoth bailed out bank and get people to turn to them for loans and repay them to the best of their ability in hard times.

There are plenty of customers who are actively pursuing higher interest rates on their money and are called rate shoppers.  They aren't attractive customers.  That doesn't mean that an ordinary customer can't expect a decent yield on all their deposits.  While people generally remain passive about rate shopping, if you schtup them hard enough, they will leave and never come back.  Then you are left with what it is the banking equivalent of what Keynes called hot money.  These depositors are gone when the next new best thing comes around in the form of a high rate CD.  This is not an absolute truth of banking, but this fairly consistently applies to a vanilla S&L type bank.  A company like Bank of Internet or Beal Bank (neat little bank) has different advantages such as low costs or high yielding assets .  I'd also like to point out that BofI was paying 2.30% on their CDs as of last quarter, which is less than NVSL, although still high (and they specifically target rate shoppers).  Their ROE is about 7x that of NVSL though, so clearly deposits are not the only thing that matter.  

First Connecticut Bancorp (FBNK), which converted a day after NVSL, is a much more interesting bank that fits the mold of thrift conversion worthy of further investigation.  Just looking at the deposit mix, they manage to have about 15% of their deposits with no interest, which is different than offering an interest bearing deposit with an insultingly low rate (the bigger this balance the better - while not potentially better than free money like insurance float, banks don't have tail risk from catastrophes - since it it is free money they get to lend out).  For instance, there is no limit on deposit insurance for these accounts, which is a clear trade off between risk and reward.  While First Connecticut pays a 4x higher interest rate on checking accounts (0.30%), they pay less than half the interest rate that NVSL does on CDs (1.18%).  The same idea holds true for their other deposit products.  They still have a good amount of CDs in their funding mix, but not nearly to the same overwhelming degree or at the same expense as NVSL.

This isn't a paradox, it's just better banking.  It's a pretty quantifiable way of figuring out how a bank treats their customers, although not a surefire trick.  Clearly if the bank has little to none CDs on its balance sheet, the bank is doing something right.  If you have a better idea for how someone in Kenya can assess the customer service of a bank in Idaho though, I'd be interested in hearing it.

While I am interested in turnarounds of companies that are simply adapting their formula within reasonable parameters, I have a hard time considering thrift conversions turnaround candidates.  I would differentiate between an improvement in operations from which many conversions benefit and a turnaround which implies that operations suffered from past mismanagement.  A bank can be a turnaround in the sense that the economy turns around so reasonable loan growth can resume and NPLs go down since most banks are priced for a continually stinky economy.  There are far too many moving parts that are not easily identifiable for a bank to turnaround its fundamental approach to lending or deposit gathering in a way that I could identify and profit from.  I can try the new fries at Wendy's (meh, but I never was a fan of potato sprinkled sodium) and get an idea of how store remodeling and traffic is coming along, but I can't figure out if a bank has lowered its costs or has started to insist on and receive higher down payments on loans.  By the time this comes through in the numbers, the stock price would likely respond faster than I would notice.

For NVSL to be attractive, they would really need to alter their fundamental model.  Joe Stilwell, an activist investor involved in another bank I've mentioned, filed a 13-D on NVSL that seems to pushing for such.  The CEO had stated a desire to use proceeds from the conversion to expand.  While I've just passed on this opportunity to invest into an expanding empire of high cost deposits, Stilwell is capable of rattling the cage for change.  Stilwell is very against potential expansion if you couldn't tell by him stating:

"If the Issuer opens even a single branch while non-performing assets remain above 2% or return-on-equity remains below 8%, or if the Issuer pursues any action that dilutes tangible book value per share, we will aggressively seek board representation."

While this is possible, I would question their basic ability to earn an 8% ROE since their funding costs are going to be persistently high and their underwriting and efficiency don't compensate for this.   There isn't a newfound incentive post-second step.  Management had a share price to be interested in well before that.  Maybe I'm not brimming creativity or I'm overly fixated on the deposit base, but I have a hard time fathoming how a bank goes about fundamentally altering its approach to deposit gathering.  I wouldn't expect it to happen in a year, but even on a longer timeline a bank faces constant competition to make an improvement in deposit gathering difficult.  Deposits are just one factor that can make a bank a great investment or an easy pass.