Reggie Middleton's Boom Bust Blog

This is the 16^th installment of Reggie Middleton on the Asset Securitization Crisis series. It was supposed to end at 15 parts, but by popular demand and partially due to the fact that I can't count, we will be extending it considerably past 20 parts. This is part is a drill down on Doo-Doo 32 member, Sun Trust Bank.

The Asset Securitization Crisis Analysis road-map to date:

• 1. Intro: The great housing bull run - creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble - A comparison with the same during the S&L crisis
• 2. Securitization - dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble - declining home prices and rising foreclosure
• 3. Counterparty risk analyses - counter-party failure will open up another Pandora's box (must read for anyone who is not a CDS specialist)
• 4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue

•5.     Municipal bond market and the securitization crisis - part I

• 6. Municipal bond market and the securitization crisis - part 2 (should be read by whoever is not a muni expert - this newsbyte may be worth reading as well)
• 7. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
• 8. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
• 9. More on the banking backdrop, we've never had so many loans!
• 10. As I see it, these 32 banks and thrifts are in deep doo-doo!
• 11. A little more on HELOCs, 2nd lien loans and rose colored glasses
• 12. Will Countywide cause the next shoe to drop?
• 13. Capital, Leverage and Loss in the Banking System
• 14. Doo-Doo bank drill down, part 1 - Wells Fargo
• 15. Doo-Doo Bank 32 drill down: Part 2 - Popular

And here we go...

SunTrust Bank observations

Loan Portfolio:

Large exposure to real estate loans: SunTrust Bank (STI) has a significant exposure to real estate loans which together stood at around 60% of its total loans of around $124 bn as on March 31, 2008. Within the real estate category, residential mortgages accounted for the largest share at 27% of the total loans while home equity lines and real estate construction loans accounted for 12% and 10% of the total loans, respectively. Such a high proportion of real estate loans in the loan portfolio makes STI highly susceptible to rising troubles in the real estate market which have not shown any signs of waning over the past few quarters. Further, in spite of the bank's balance sheet asset/liability and risk management strategies, there has not been any significant change in its loan composition over the last year. This causes me to significantly question the capability of management to whether, or even to recognize, the coming storm. The real estate loans have only marginally declined to 60% as on March 31, 2008 from 61% a year earlier, which makes no sense unless the company believes that the real estate market will turn positive some time soon (see graph below for the likelihood of that happening).

Increasing NPAs and charge-offs are on a very strong uptrend in just the one past year, one that cannot and should not be ignored:

 STI's nonperforming assets (NPAs) as a percent of loans have been increasing consistently over the last few quarters, having gone up to 1.88% in 1Q08 from 0.64% in 1Q07 - considerable 294% increase.

 Non-performing loans in real estate construction category have recorded the most significant upward movement from 0.39% of total real estate construction loans in 1Q07 to 4.01% in 1Q08 - a NIGH UNBELIEVEABLE 1,028% increase!

The increase in residential mortgages NPLs has also been noteworthy, with NPLs as a percent of residential mortgages rising to 3.95% from 1.30% over the period - an alarming 304%.

Gross charge-offs in the real estate loans have also witnessed a stupendous rise over the last year commensurate with rising delinquency levels in the US economy. Gross charge-offs in real estate loans as a percent of real estate loans increased to 0.31% in 1Q08 from 0.04% in 1Q07 (775% - nearly an 8 fold increase) with most significant increases recorded in home equity lines, real estate construction and residential mortgages.

STI's loans 90 days or more past due and still accruing have also witnessed significant increase over the last year, doubling from 0.32% of the total loans in 1Q07 to 0.60% of the total loans in 1Q08. Be aware that this figure is susceptible to manipulation by management - ala Wells Fargo. I haven't encountered any firm evidence of such, but I haven't looked for it with a fine tooth comb either.   

Higher provisions have diminished the bank's net earnings: As a result of rising NPAs and charge-offs, STI has been forced to increase its provisions to cover its expected loan losses which seem to be on a consistent rise. STI's provision for loan losses has increased nearly 10 times to $560 mn in 1Q08 from $56 mn in 1Q07. STI's rising provision levels are eroding its income levels as is apparent from the fact that while the bank's net interest income before provision for losses in 1Q08 has fallen a nominal 2.1% over the last year, its net interest income after provision has dipped a drastic 47.7% over the period. Consequently, STI's diluted EPS has declined 43.8% to $0.81 from $1.44 in 1Q07.

STI's provision for losses as a percent of NPAs has more than tripled to 24.14% from 7.57% over the period indicating the bank's rising expectation of its NPAs converting to losses. However, STI's reserve for loan losses still seems inadequate considering its large exposure to real estate loans. The bank's end-of-the-period allowance for loan losses has dipped to 66.61% as at the end of 1Q08 from 138.61% a year earlier which indicates that rising charge-offs are fast eating up the bank's reserve cushion which is not being sufficiently compensated by the provision charge to the income statement.

Rising Texas ratio a cause for concern: As a proportion of shareholders' equity, STI's NPAs have risen from 4.2% in 1Q07 to 12.6% in 1Q08. Owing to corroding cushion of shareholders' equity and loan loss allowance to cover rising NPAs, STI's Texas ratio (NPAs including 90 days past accruing loans to the sum of tangible shareholders' equity and reserve for loan losses - a measure that proved to be quite predictive of failures in Texas during the S&L crisis) has risen steeply over the past few quarters as depicted below. Keep in mind that I have not performed a full blown forensic accounting of STI, thus I am sure there is a lot of trash in the published, spam out-o-the-can tangible equity figures that would not be in my home brewed calculations. Thus, this Texas ratio is quite possibly understated (100%) means effectively insolvent). I will update these figures for the full Doo-Doo 32 and add my own twist to it in order to make it more realistic in today's environment.

Declining trend in real estate construction and consumer loans off set by growth in other loans: Over the last four quarters, STI has witnessed continual decline in its real estate construction loans which have gone down 5.8% in 1Q08 over 4Q07 following a 4.1% decline in 4Q07 over the preceding quarter. However, the other classes of real estate loans have each witnessed a nominal growth with a result that the total real estate loans have increased 4.5% in 1Q08 over the level one year before. This has resulted in the bank's total real estate exposure to total loans remaining nearly same over the year. The continual deterioration in the housing sector has now spread to the other categories of loans as well, including commercial loans, home equity and consumer loans, besides bringing the entire US economy in its ambit. Under such worsening conditions, STI faces a serious threat to its future earnings in the form of rising loan losses. Why this company has not reduced its balance sheet exposure and unadjusted leverage ratio of 6.9x (most likely greater when economically adjusted) is beyond my reckoning! I may not be a successful bank exec, but I can sure see a train wreck coming when that beaming bright light starts to bounce off of my forehead!

On an overall scale, STI's total loans are 5.8% up from 1Q07 levels primarily off growth in commercial loans, home equity loans, and residential mortgages. We believe that the strategy of offsetting exposure to real estate construction and consumer loans through higher commercial and residential mortgage loans would not help the bank in mitigating the overall risk to its balance sheet in the form of risky loans prone to higher delinquencies.  My analysts wrote that last bit. You know I'm much more of a smart ass than that. They put it nicely. My take is, "Their out of their damn minds!"

See the following for my take and research on the prospects of growing your balance sheet in those "other" loan categories:

• 1. Intro: The great housing bull run - creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble - A comparison with the same during the S&L crisis
• 2. Securitization - dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble - declining home prices and rising foreclosure
• 3. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
• 4. More on the banking backdrop, we've never had so many loans!
• 5. A little more on HELOCs, 2nd lien loans and rose colored glasses

1. Capital, Leverage and Loss in the Banking System
2. The Commercial Real Estate Crash Cometh, and I know who is leading the way!