Friday, May 22, 2009

What we can learn from the failure of BKUNA

As many of my readers know, I have been intimately involved in the regional banking sector for close to two years now. During that time I have seen the management of these banks go from bullishness, to denial, to despair, and most recently to cautious optimism. It is in the context of this recent optimism regarding the regional banks and the entire US financial system that I thought I should offer a sobering reminder of the potentially devastating impact of not fully appreciating the severity of this credit crisis and economic downturn.

Last May at the annual SunTrust "Unconference" in New York City I met the management teams of BankUnited (BKUNA) and BankAtlantic (BBX), two Florida-based banks with large exposures to the Florida real estate market that was quickly deteriorating. At the time both of the companies' stocks were trading at less than 35% of tangible book value and were at least 80% off their 52 week highs. Just like today, capital raising opportunities were the main topic of discussion due to the fact that both companies had non-performing loans at or above 4% of total loans. Also, with the value of Florida residential real estate falling virtually by the minute, investors were obviously concerned with BKUNA's $9.7B and BBX's $2.1B residential mortgage portfolios. However, despite similarly adverse circumstances, the tone of the discussion was very different between the two companies, a fact that I think provides a very relevant and pertinent example of the risk of unfounded optimism.

This is what I wrote about the meeting with BBX's management team:
"Things seem to be really bad in their footprint. They completely disagreed with BKUNA’s take on the Florida market. There is no question they are going to have to raise dilutive capital just to survive. It doesn’t look like they have any other levers to pull aside from a 100% dilutive equity raise. Their loan portfolio should continue to deteriorate as land/home values fall, more borrowers default, they continue to write down home equity loans and their homebuilder exposure gets nastier."

During the discussion, the company seemed to be taking a very realistic look at the current real estate environment in Florida. COO/SVP Lloyd DeVaux readily admitted that things in Florida were not getting better, not even in markets where people expected things to be improving. He commented that the Orlando market was still very weak and said that the Ft. Myers market wouldn't come back for years. As a result of widespread re-appraising of real estate, he claimed that BBX had begun to aggressively put loans on non-accrual and increased loan loss provisions, actions that would inevitably force the company to raise capital. In other words, given what was going on in the company's markets the management team was taking a very sober point of view.

Now, we have to contrast BBX's outlook with that of the recently-failed BKUNA. During the discussion with analysts, former CEO Alfred Camner focused on the positives. With a straight face he told us about BKUNA's strong deposit base within what he actually called a "vibrant" economy that had a lower unemployment rate than that of the nation as a whole. He also discussed the strength of the import/export market and explained the attractiveness of South Beach as place to live. What this meant was that BKUNA had the strongest franchise in Florida, a state that was still an attractive place to live and do business.

I understand that one of the jobs of a CEO is to put a happy face on and sell the company to potential investors. However, everyone in the room knew what was going on in the Florida real estate market. What we were looking for was a realistic assessment of the circumstances and what we got was the impression that this management team was completely out of touch.

Accordingly, here is what I (presciently) wrote about the meeting:
"In this case the management was very defensive and did not appear anywhere near as defeated as the management at BBX. They were trying to make the case that the stock was extremely undervalued based on their current loan book exposure. Sitting there I couldn’t imagine how two companies with similar footprints could have such different views... However, nothing can change the fact that close to 80% of their portfolio is in residential mortgages in a state where house prices have dropped precipitously. Also, the percentage of low doc and no doc loans is very troubling. Obviously this is another candidate to go to $0 eventually or raise massively dilutive common equity."

Whether or not the BKUNA CEO believed what he was telling us, I think there is lesson for investors here about assessing the quality of a management team and being skeptical of what appears to be misplaced optimism. While Camner did acknowledge that the company would likely have to raise capital, you can't help but wonder if the entire management team was somewhat blinded by the idea that Florida was (and maybe still is) a state that would benefit as the population of the US continued to move into the warm weather states. In contrast, the fact that the BBX management team was more focused on the potential downside may be one of the reasons the company is still independent. There is no question that BBX could also go away eventually, but for my investment dollar I would much rather bet on a company run by jockeys who not only carefully and conservatively evaluate the horse, but also the race track.

So, what does all of this mean about investing right now? Fast forward to this past Wednesday when I again found myself navigating the famous SunTrust Unconference. While there I had a chance to visit an old friend from Florida, Seacoast Banking Corp. of Florida (SBCF). SBCF is another single digit midget (a stock trading at under $10) that has been battered by the Florida real estate collapse. The company unfortunately had decided to make a number of real estate construction loans during the boom period that CEO Dennis Hudson described as being a disaster for SBCF.

However, what was really interesting and troubling to me as I try to assess how long and how severe this recession is going to be were his comments regarding the current state of affairs in the SBCF footprint. Specifically, Mr. Hudson told us that Florida has reached the point in the cycle in which the formerly concentrated problems of the residential construction sector are now starting to spread to the rest of the economy. From the beginning of all of this I had asked myself the same questions. What happens to the numerous commercial strip centers that were built alongside new residential developments in anticipation of each unit being sold? Can those businesses survive if those developments turn into ghost towns due to foreclosures or demand that never materialized? I think we now have an answer to that question. The contagion effects and the overall recession have started to cause vacancies in retail. What started in the industrial and warehouse portion of the commercial real estate (CRE) space has now begun to hit mom and pop stores and strip centers. Accordingly, while he did say that he was seeing clear signs of stabilization in the housing market, Mr. Hudson indicated that SBCF is very concerned about its CRE portfolio.

In conclusion, while I certainly appreciated Mr. Hudson's candidness and think SBCF will be a survivor in all of this, I am definitely not rushing out to buy shares just because he gave us a realistic assessment of the economic circumstances in Florida. In fact, I worry that what is happening in Florida is going to start happening in the rest of the country, especially in the areas where the housing markets have taken the biggest hits. I continue to have a negative outlook on the regional banking sector as a result of my opinion that loans for CRE and C&I (business loans) will start to go bad at higher rates and force even more charge offs and provisioning at the banks. Maybe my stance will change when I meet a management team that is optimistic for what look like realistic reasons. But, until then I will be waiting patiently on the sidelines.