Falling NIMs, Rising Mortgage Banking and two new bank stocks: Monarch Financial and PVF Capital Corp
One consequence of the quantitative easing campaign that was initiated by the Federal Reserve is that is caused a rise in mortgage backed securities, and a corresponding drop in interest rates for those securities. To illustrate, below is the 30 year Fannie Mae.
This drop in rates is bad for holders of MBS debt who depend on the yield that it returns. As a consequence many mREITs have been under pressure.
To varying degrees banks are in same boat. You saw this with the release of results on Friday from JP Morgan and Wells Fargo. The subject was discussed here in the Financial Times.
But I think you have to be careful before painting all banks with a broad brush. The extent of the damage depends on the percentage of assets that each bank has in securities in general and in mortgage backed securities in particular. This can vary quite a bit, especially among the smaller community banks.
I have looked at each of the banks I own. Most are not overly exposed to mortgage backed securities or to securities in general. The table below shows the total investment security exposure vs. loan exposure for each bank, and then breaks down the investment securities by type.
The one bank that does have somewhat worrisome exposure is PremierWest Bancorp. PremierWest has over 20% of their total assets in mortgage backed securities. However I think this represents more of a current problem, one that is already priced in, than it does a future problem. PremierWest is currently earning a paltry 2% on its investment securities. This is already extremely low, likely the result of the bank taking on short duration assets to insure it had the cash available to get through its rough patch. I wouldn’t expect the interest earned to fall much further, even as they roll over existing debt. If the banks nonperforming loans improve as I anticipate, they should be able to move a bit further out the curve, and invest more heavily in loans, which should offset the effect of dropping rates.
Bank Stocks with Mortgage Banking Business
Both JP Morgan and Wells Fargo reported earnings on Friday and while earnings were impacted by shrinking net interest margins, a consequence of the aforementioned rate squeeze, the impact was more than offset by mortgage banking revenue. The Wall Street Journal had this to say about the results:
Mortgage-lending revenue was up 57% at J.P. Morgan, the nation’s largest bank by assets, and more than 50% at Wells Fargo, which is the biggest U.S. home lender and No. 4 by assets.
My belief is that the mortgage banking business is not simply undergoing a temporary refinancing boom. I think there are a couple of secular tailwinds aiding the industry that should be beneficial to those with strong franchises. These are:
- An absence of the traditional operators in the business, many of whom have went belly up in the last few years, or as with the banks, have decided to de-emphasize the business in their portfolio
- Regulatory uncertainty and strict compliance criteria making it difficult for new entries to get a foothold in the market, particularly if they are smaller operators
I think that these changes will lead to a continuation of the current high margins for longer than anticipated.
Well, after spending a few weeks scouring around for another mortgage originator like Impac Mortgage to no avail, I have started looking for banks with strong mortgage banking franchises. So far I’ve found a couple, both of which I mentioned in my update on the weekend. Monarch Financial (MNRK) and PVF Capital Corp (PVFC).
The most interesting of the two is Monarch Financial. Monarch is trading at a little over tangible book value, only has about 1% non-performing loans outstanding, and should be able to earn about $1 per diluted share this year. The company derives over 60% of its gross income from mortgage banking:
On top of the growing mortgage banking business, there is earnings potential as loan losses wind down. While the bank appears to have been quite prudent with its loan book, the company has still had to take provisions for loan losses write-downs. While nominal earnings (based off of the fully diluted share amount) are running at a rate of $2 million per quarter Monarch has been taking some fairly substantial provisions for loan losses over that time ($1.6 million on average over the past 6 quarters). Without those provisions, earnings per share would be around $1.80. Below are earnings on a quarterly basis both with and without loan loss provisions.
PVF Capital Corp
A second bank I found with a strong mortgage banking franchise is PVF Capital Corp. I don’t believe that PVF has quite the same upside as Monarch, but I could be wrong.
PVF Capital is more of a turnaround story than Monarch is. Non-performing loans at PVF have dropped pretty dramatically over the past couple of years, from 11.14% of total loans in 2010 to 8.69% of total loans in 2011 and now to 3.6% in 2012-10-12. The bank appears to be headed in the right direction. At the price I bought it last week (~$2.15), it was at about 80% of tangible book value.
One reservation that I have to say I have with PVF Capital is that the executive pay is really high. The CEO of PVF takes in $300,000 per year in salary, and overall compensation is over $500,000. Three other executives take in between $150,000 and $175,000 salary. I don’t love that, because it means that they have less incentive to actually enact change. But I also am not going to get dogmatic about such concerns. Things are going in the right direction, that is enough for me right now.
The mortgage banking business at PVF Capital has increased over the past 3 years (from $4.6 million in 2010 to $6.6 million in 2011 to $9.1 million in 2012). It makes up about 33% of gross income. The company operates in the Cleveland-Akron area. The real estate market in Cleveland appears to me to be similar to most places in the US, off the bottom with falling inventory and slightly rising sales, but still some ways away from a robust recovery. The chart below is taken from this article, and while it is a bit dated (its from May), it still gives perspective to the general trend.
What I like about PVF Capital is that over the last 3 years, when real estate sales were depressed, the company was still able to grow its mortgage business significantly. I would anticipate that as the recovery strengthens, this business should strengthen along with it. I realize that the housing market in many areas where I am investing has only barely turned around. But really, that is kind of the point of why I want to invest in them. Had the housing market clearly turned, the winners and losers would also be clear, and the stock prices would reflect that. I’m interested in picking what I believe will be winners before the price begins to reflect that. I think PVF Capital has a reasonable chance of being one of these winners.
Mortgage Banking for the Banks I own
I put together the table below to help quantify the mortgage banking business of each of the banks I own.
You will note that in addition to Monarch Financial and PVF Capital Corp, Rurban Financial generates more than a third of its income from mortgage originations. And this doesn’t include the mortgage servicing business that the company is in. Really the one insight that I took away from this analysis was that I really should own more Rurban at these prices. The stock is down below $7, and I don’t think there is any way that it should be. Its another bank with a strong mortgage franchise that should be able to capitalize on the upcoming revival in the housing market.