Local Banks: Time to Short

The recent subprime CDO plague has clearly cut down the stock prices of major banks. However it is the small local financial institutions that have the least financial strength to weather the storm. Many of these smaller banks did not get caught up in the residential loan fiasco because they were not focused on this market. However, the other shoe is about to fall. Many of these local institutions focused their lending activities on commercial real estate development. A good number of these loans to sub-division developers, builders, and commercial property developers are about to turn sour, leaving these small banks holding the bag.

A number of these local banks have holding companies that are traded on the OTC Bulletin Board and do not generate significant analyst coverage. Naturally these banks are lightly traded, many with only a few thousand shares in average volume per day. A candidate list of potentially under-performing stocks over the upcoming twelve months should include banks with the following attributes:

• The bank must do lending in a state or market under tremendous downside housing pressure and significant new development over the past few years (e.g. California, Florida, Las Vegas, etc.).
• The bank must not be more than 25% off of its highs over the past year – need downside price space.
• The bank must have a D or below safety rating.

Fortunately there is a free resource online that allows investors to screen on the safety ratings of banks. The Street.com screener can be found here.

Simply tab over to the Banks and Thrifts tab at the top. Select a state such as California and the Rating to be D (weak) or lower. In this example a list of 99 banks in California are produced. When a bank in the results is highlighted than the full rating summary report for the bank can be downloaded in a link to the right.

Not all banks are publicly traded however. So an investor must analyze these results against the banks that offer holding company stocks to the investors on the exchanges. At least two banks of the first 20 on the list generated for California trade on the OTC – Alliance Bank (ABNS.OB) and Bank or Santa Clarita (BSCA.OB). While these two banks pass two of the criteria above, they flunk the third in that they are already more than 25% off their peaks. Many of the candidates may face this issue because the entire financial sector has tanked in the market. The basic idea is to search for local banks that have unexpectedly held up in price despite their safety ratings indicating that they should be in the flusher; these are candidates that may still have significant downside potential and are worth investigating as shorts.

After generating a list of possibly candidates the next step is to read their filing information to determine the level of outstanding commercial loans associated with real estate. The concept is to hunt for the banks that have the largest exposure.

As commercial loans sour, the local banks with large exposure and low financial safety ratings are likely to flounder. A good number of these banks are probably excellent short candidates over the coming months.

Disclosure: The author does not have a position in any of the equities mentioned in this article. The information provided does not constitute a solicitation to buy, or an offer to sell securities.