How To Spot The Opportunity In The Problems For Small Banks

By Tim Melvin

In his 2010 book, Bye Bye Banks, 50-year industry veteran Robert H. Smith outlines the obstacles and issues facing the bank industry today.

Smith points out that it is the small banks that are disappearing from the financial landscape either via failure or merger, and sees a long list of obstacles. These obstacles include the Federal government, which sees banks “as their vehicle to engineer society, thereby satisfying their political and social expectations.” Smith addresses the competitive and regulatory environment that is practically forces banks to see merger partners and become larger.

It is eye opening to see everything laid out on one place.

Everyone knows that banks have faced increasing completion for both deposit and lending businesses, but when you see them listed in one place, you realize just how difficult it has become for smaller banks to remain relevant and profitable.

Credit unions, stock brokerages, insurance companies and mutual funds are just part of the folks going after the deposit business by offering consumers alternatives to checking, savings and retirement accounts. Of course, the current low interest rate environment gives them an opportunity to offer high yielding (although uninsured) products to yield starved savers.

It is just as bad on the lending side with stand-alone mortgage firms, leasing companies, retailer and affinity credit card programs and a wide variety of finance companies competing directly with banks to offer loans of one type or another.

Consider the limitations

It is mind boggling to see the list of legislation and regulatory actions taken before the latest banking crisis that the smaller banks had to deal with. Bankers have to consider restrictions and limitations placed on them by everything from the Patriot Act to the anti-internet gambling legislation passed in 2006.

In the aftermath of the meltdown that began in 2007 we now have more regulatory agencies and legislation popping up with new consumer protection agencies and the Graham Dodd Financial reform bill. Even the larger banks are having a hard time keeping up with the increasingly complex regulatory situation and it is crushing to smaller institutions to keep up much less comply with everything.

When you consider the competitive and regulatory environment and then add in a slow growth economy with very little potential for organic growth it becomes obvious that many smaller banks will simply not be able to survive in their current form. The smaller banks will either need to be acquired by a larger bank or combine with similar sized institutions to spread out costs and increase their deposit base.

While Mr. Smith quite correctly pointed out the unattractive social and economic consequences of this trend investors have to be aware that it also represents an enormous and long lasting opportunity.

The individuals running the small banks recognize the need to merge into a larger institution

After five years of operating under what can best be described as difficult conditions, many of the smaller banks want to be acquired and get out from under dealing with credit problems and regulatory burdens.

However, most of them have also seen their stock price drop substantially since the 2007 peaks, and they need to get a fair price for the shares. The officers, directors and leading members of the communities in which they are based often have significant amounts of money tied up in shares of the smaller banks. They are willing to sell, but need to get a price that allows them to trim their losses if not turn an outright profit on their shares.

Right now there dozens, if not hundreds of smaller banks trading below their tangible book value. In past post crisis consolidation waves, such as the S&L crisis in the early 1990s and the Long-Term Capital Management (LTCM) meltdown in 1998, takeover premiums were initially around 1.25 times book value before peaking at somewhere near two times book value at the peak. There is no reason to assume that the multiples will not be very similar this time around although most observers and analysts think that this wave of merger activity will last far longer than earlier period.

Investors that buy the smaller stocks while they are trading at a discount to book value and are able to sell at decent premiums stand to make a significant amount of money. As real estate markets stabilize and credit conditions improve, it is also reasonable to assume that dividend payments will increase and book values will rise over the next couple of years so the total return can be much higher over a longer holding period.

The problems and difficult conditions facing the smaller banks create an opportunity for patient investors who buy these shares and ride the consolidation over the next several years.

Tim Melvin is a value investor, money manager and writer. He has spent the last 27 years in the financial services and investment industry as a broker, adviser and portfolio manager. He has also written and lectured extensively on the markets with his work appearing on RealMoney.com, DailySpeculation.Com as well as several print publication including Active Trader and the Wall Street Digest. Learn which 3 low risk, high yield stocks Tim owns for the trade of the decade.