During every credit cycle, there is one national lender that all other lenders try to emulate. This is because a combination of rapid asset growth and elevated net interest margins leads to rapid earnings growth and share price appreciation. Unfortunately, in order to do that, you have to make a lot of risky loans and pretend they’re totally safe. Remember Countrywide Financial? They were the ones who’d lend to you no matter what; no income, no job, no assets - you’re approved!!! Anything to show growth. Everyone in the financial industry emulated them because they were growing so fast. Besides, when you have a fixed cost structure, you cannot exactly stand still and let others steal your market share.
That brings me to what may be this cycle’s Countrywide Financial, Bank OZK (OZK – USA), formerly known as Bank of the Ozarks.
It was a bit of a head scratcher when I first heard of these guys a few years back; why were a bunch of guys in Little Rock, Arkansas so focused on funding risky Miami condo developments? Aren’t there plenty of local banks who are perfectly willing to lose globs of money at this game?
I reached out to a friend in hard money lending for a perspective, “I wouldn’t touch the crap they’re lending on at twice the interest rate.”
I filed this all away in my head and forgot about Bank OZK until my hard money lending friend sent me this article in July. “Aggressive” and “innovative” lenders always blow up - especially when rates increase. If I shorted stocks, this would be at the top of my list.
On Friday, we learned that the implosion is already beginning. Two sizable legacy loans from 2007 and 2008 were just written down by 69%. This isn’t a small mark-down. Either they should have been marked down years ago (not good) or something went very wrong suddenly (even worse). In either case, I doubt these markdowns are isolated to Bank OZK or any other bank.
While US banks are in better financial shape than before the last crisis, core capital levels don’t particularly matter when interest rates rise and asset values decline. Remember, the move from a 2 cap to a 6 cap leads to a 2/3 loss of property value. Even a conservatively underwritten loan is likely underwater when that happens. Even worse for banks, funding costs are also increasing. A bank is an inherently unwieldy and leveraged financial structure. Financialized asset values (like property) are at all-time highs and rates are now rising. Due to the nature of most floating rate loans with interest rate floors in place, the first few rate hikes had no impact upon most borrowers. Now their cost of capital is lifting off those floors.
I expect more blow-ups and a dramatic curtailment of lending to follow. Even if it turns out that the guys in Arkansas were practicing responsible lending, I guarantee you that many of the banks that tried to emulate them acted foolish.
* * *
Thinking through all of this, I want to pare back my exposure even further to businesses that rely on low interest rates and development loans. St. Joe (JOE – USA) trades for 10% to 20% of fair value and that value is likely compounding at a rapid rate through a combination of development and buybacks. It is one of the cheapest large companies in America and the guys running it seem smart.
That won’t matter if banks start to tighten lending standards and homeowners get priced out of new developments. I want to own this company, but I don’t see what the catalyst is to unlock the value if rates keep rising. Therefore, I’ve been reducing the position over the past few weeks with most of my sales in the mid 16’s. It was 17.90 when I first wrote about JOE and it is 15.08 today, leading to a 15.8% loss from when I mentioned it (guess I should be doing these updates more often…) I hope to buy it back when the share-count is lower and the development plan is further along. I will be following it closely. JOE is a good company and I don’t see material downside risk—I just don’t see any near-term upside and I prefer to keep my capital available for washouts. I think something nasty is coming in the stock market.
I shall return…