Hard times still upon us; bank failure proves it

Investor’s Corner with Jack Brown

Friday’s failure of banking and mortgage-lending giant Colonial BankGroup (“CNB”) represents the largest bank failure of 2009 and the sixth largest bank failure in U.S. history. CNB’s demise reminds us that we are still in the midst of a severe credit crisis. The lending excesses of the past decade have led many banks to take on excess leverage, which can be thought of as a high ratio of assets-to-shareholder-equity.

In CNB’s case, as is the case with most banks, balance sheet assets typically represent the sum value of loans outstanding, investments, and to a lesser extent other assets (i.e. equipment). Liabilities are typically represented by bank customer deposits, CDs, debt, etc. The difference between assets and liabilities represents a company’s Shareholder Equity.

For your average bank a ratio of assets-to-equity might be 10 times, which compares to your average non-financial company of 3 times. Banks typically have higher leverage ratios because historically money they lend out (which gets counted as assets) has been returned to them in a timely fashion. With the credit crisis, more loans have become non-performing or have defaulted. This forces banks to mark down their assets in turn equity (liabilities are unchanged).

Leverage accelerates the problems related to marking down loans (assets). For example, a 2% mark down in assets would represent a 20% mark down in equity for a company with a leverage ratio of 10 times (2% times 10).

In my calculations, CNB has (had) a leverage ratio of 31x as of March 31, 2009. This means for every 1% decline in assets, shareholder equity would fall 31% in value. A rapidly shrinking shareholder equity value causes a freeze in CNB’s ability to function given banking regulations (this might be explained a slightly different way by industry experts).

Higher leverage ratios are still plentiful especially among some of CNB’s larger brethren. Therefore, even as mortgage default rates return to normal levels, I expect a higher than normal number of bank failures/intervention to come.

Jack Brown, CFA

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