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Red Ink in the Pink Sheets

April 20th, 2012 |

Henri Wedell has lost $2 million investing in community bank stocks during the last couple of years.

One particularly painful episode was his purchase of five bank stocks on an advisor’s recommendation a few years ago. Three of the banks failed when the Federal Deposit Insurance Corp. put them into receivership.

“People haven’t made any money in [community] bank stocks in five or six years,’’ says the former bank director and retiree, who lives in Memphis, Tennessee. “All these bank stocks are down 50 percent or 70 percent.”

That can mean bad news for a small bank trying to raise capital when times are tough. A huge divide has opened up between small, thinly traded banks that are successfully able to raise capital at decent prices and those that are not. California United Bank, for example, raised money at a premium to book value because it has good earnings, strong capital, management with a great track record and a specific plan for executing growth. Other banks haven’t been as fortunate. Premier Service Bank in California last year unsuccessfully tried to raise $10 million from accredited investors following a consent order from regulators and later ironed out a deal to be acquired by another California bank. Intermountain Community Bancorp, the holding company for Panhandle State Bank in Sandpoint, Idaho, tried to raise $70 million but two private equity firms pulled out of the deal and it ended up raising $46 million instead, diluting shareholders by 90 percent. BancAffiliated in Bedford, Texas, took five months to raise $13.2 million in a private placement, less than half of what it had planned. With decent earnings and asset quality, BancAffiliated managed to get a price just slightly above book value.

“You’ve created a class of stock that are winners and then there’s the [banks] who are not,’’ says Don Musso, president and chief executive officer of Finpro, a New Jersey-based management consulting firm that specializes in financial institutions. “In late 2009, the market seized up for community banks and it hasn’t really loosened up yet.”

There are about 1,180 publicly traded banks and thrifts, and about 800 trade on the OTC Bulletin Board or OTC Pink, what was formerly known as the pink sheets, according to Greg Dingens, executive vice president and co-head of investment banking at Monroe Securities, an investment banking firm in Chicago that also makes a market in community bank stocks. Many of them are not even registered with the Securities and Exchange Commission (SEC).

Non SEC-filers can and do trade on OTC Pink, an electronic quoting service owned by OTC Markets Group Inc., which facilitates trades between brokers of stocks that don’t meet the listing requirements for a stock exchange such as NASDAQ OMX. Since almost any stock can trade on OTC Pink, and some companies have been nothing but frauds, the “pink sheets” have a less-than-stellar reputation. Even the company that owns it calls it “the bottom tier” of the OTC market. There’s no requirement that companies on the OTC Pink file reports with the SEC and many of them have no news written about them, aside from their own press releases. They have no research analysts with any of the big investment firms following their stock. However, a few smaller firms that trade community bank stocks do publish reports on the universe, such as Monroe Securities and brokerage firm McAdams Wright Ragen.

One step up from the “pink sheets” is the OTC Bulletin Board, which was created by the Securities and Exchange Commission in 1990 as a way to provide transparency in the over-the-counter equities markets. Bank and thrift stocks quoted on the OTC Bulletin Board are exempt from filing regular reports with the SEC if the issuer is current with publicly available regulatory reports, such as the call report, and almost all of them also trade on the OTC Pink.

Volume is often miniscule on both quoting services and some small bank stocks go for weeks or months without a trade. They also tend to trade at a discount. Banks and thrifts trading on the OTC Pink or OTC Bulletin Board traded at a median 70 percent to tangible book value as of late February, compared to 97 percent of book value for banks and thrifts on the New York Stock Exchange and NASDAQ OMX, according to SNL Financial. There are many reasons why over-the-counter bank stocks are valued less than banks trading on a major exchange, and lack of trading volume is just one of them. Dingens thinks the lack of mergers and acquisitions in the sector is depressing stock values for over-the-counter community banks, because investors in that sector often make money when the bank sells at a premium to book value. That hasn’t been happening very much lately. Many community banks, whether they trade over-the-counter or not, also over-invested in commercial real estate and land acquisition loans and have been especially hard hit by the financial crisis. They tend to have lower profitability and more problem loans than bigger banks, according to research by Stifel Nicolaus Weisel.

Plus, institutional investors typically aren’t interested in putting anything less than $10 million to $20 million in a bank, Musso says. As a result, community banks have long relied on individual investors, many of them retirees, customers and business owners in their own communities, to buy their stock and fund their operations. For community banks with thinly traded stocks, the funding sources have been similar to those of private banks. But so many of those local and non-professional investors are no longer buying lots of bank stocks, whose values have plummeted so much and are now worth so little.

 “In a sense, we’ve lost a generation of community bank investors,’’ says Dingens. “These might have been older investors who made a lot of money over the years. Most of these banks aren’t paying dividends anymore and have [seen their stock values] fall dramatically and will need to dilute their shareholders. It’s been a rough haul, even rougher than for the big banks.”

“The words ‘bank stock’ have become bad words in the past few years,’’ says Derek Cunningham, a managing director at Commerce Street Capital, a Dallas, Texas-based investment bank for financial institutions.

Douglas Ferris, a retired former bank executive for National Commerce Financial Corp. in Memphis, Tennessee, says he sold most of his community bank stocks before the collapse of the stock market in 2008. “Unfortunately, a lot of community banks got their funding from CDs and money market accounts and their loans portfolios were heavily invested in real estate, and because of that, they got hit really hard,’’ he says. “There are banks that don’t fit that profile, but unfortunately, many of them do.”

The 68-year-old says banks have stopped calling him to invest.

Wedell, the 70-year-old investor, has mostly sold his small bank holdings—although he is still looking for bargains. One of his purchases lately was of Georgia-Carolina Bancshares Inc., the holding company for Augusta, Georgia-based First Bank of Georgia, which has just $493 million in assets and trades on the OTC Bulletin Board.

Wedell bought 60,000 shares from another shareholder for $7.50 each, about half the bank’s book value at the end of last year and about half the stock’s five-year high of $14 per share in 2007. “There was no other buyer in the world,’’ Wedell says. “I had no competition. They’ve worked their way through their problems but there was no interest.”

Remer Brinson, the bank’s president and chief executive officer, says there’s an overall reluctance to own bank stocks. “With our performance, I don’t know why we wouldn’t be trading at book value or above,’’ he says.

The bank never took Troubled Asset Relief Program (TARP) money, made $4 million in earnings last year and had a return on average equity of 8.45 percent last year, up from 3.41 percent in 2010.

“Investors are more fearful because of what they’ve been through and that’s understandable,’’ Brinson says.

Despite the dismal valuation, George-Carolina Bancshares still goes through the trouble of filing regular reports with the SEC, which can easily cost a bank upward of $100,000 per year in compliance and legal expense. Companies don’t have to register with the SEC and file regular financial reports unless they have least $10 million in assets and 500 shareholders. The U.S. Senate recently passed the JOBS Act, which will increase the level for banks to 2,000 shareholders. Banks don’t have to register with the SEC to trade on the OTC Bulletin Board or the “pink sheets,” but some, such as Georgia-Carolina, do anyway.

Brinson thinks his bank is providing shareholders liquidity by doing so.

At least, it’s a good idea to act like a filer with the SEC without necessarily becoming one—in other words, producing press releases that detail the bank or thrift’s financial condition, Dingens says. That way, investors have more information and will be more likely to buy your stock, he says.

“There’s no doubt that banks that don’t disclose much trade at a discount to those that do,’’ Dingens says.

Joey Warmenhoven, a senior vice president at McAdams Wright Ragen, a Seattle-based investment firm that makes a market in community bank stocks, says trading publicly provides value to a company and its shareholders, even if such trading takes place off a major exchange.

“At some point, a real public market needs to take place rather than a list of buyers and sellers sitting inside the bank,’’ he says. “You will have more options as an investor. Your company will get more exposure.”

Traditionally, the chief executive officer or chief financial officer of a private bank or thrift keeps a list of people who want to buy the stock and people who want to sell inside a desk drawer. If the private bank or thrift is closely held by a few individuals, that’s also a way to keep control over who owns the company and a way to try to control the price.

Yet, private companies often do end up trading over-the-counter anyway. It doesn’t cost the issuer anything to trade. Market makers earn commissions by trading the stock between buyers and sellers.

“You can end up trading without permission from the bank,’’ says Dingens. “If someone comes to us and asks us to trade stock for a private bank, we have to establish who they are and fill out a form through FINRA [Financial Industry Regulatory Authority], and we can get a ticker if we want to. It’s dumb to start trading without calling the bank and informing them and getting information. We try to work with the banks.”

One drawback for thinly-traded community banks when they trade publicly is the possibility that a shareholder who wants to dump the stock will cause the price to plummet in value, he says. Since trading is so infrequent, the depressed price can set the market for months. That leads some investment bankers and attorneys to advise their clients to avoid getting listed.

SecondMarket Inc., a New York-based broker-dealer that counted Facebook among its clients, is trying to capitalize off that uncertainty by charging privately owned community banks for a chance to have some control over the secondary market for their stock.

The company started a pilot alternative trading system this year for community banks in New York, New Jersey, Texas and Pennsylvania where bank and thrifts can pay $30,000 to create a market for their stock with a set price and a window that gets buyers and sellers together all at the same time. Sellers also pay a 3 percent commission to sell their stock.

“Investors weren’t interested [in community banks] because of the lack of liquidity of those shares,’’ says Caryn Feinberg, a senior vice president for SecondMarket. “No one wants to look [into] the future and not know when they can exit.”

Still, banks that are doing well financially have been able to attract investors, even though it can take longer than it did several years ago.

BancAffiliated Inc., the $230.3-million asset holding company for Affiliated Bank in Bedford, Texas, raised $13.2 million at slightly more than book value in a private placement last June, which was mostly sold to local investors, small business owners and depositors in the bank’s market.

“The folks attracted to your bank are local people,’’ says Garry Graham, the bank’s president and CEO. “They like the idea of investing in a bank. They don’t trust the big Wall Street guys. We basically told our story and how we’re going to build value.”

He says the goal of the capital raise was to build room to grow without diluting shareholders.

“We paid for the cost of capital raise and every shareholder was enhanced some,’’ he says.

BancAffiliated, which trades on the OTC Pink, said it planned to increase from just a handful of branches, is considering possible acquisitions and wants to grow its core commercial real estate loans, residential construction loans and mortgage originations. That might sound like cause for alarm in an age where such loans got banks into steep trouble, but Graham points out that Texas banks were relatively conservative and didn’t have the same housing bubble much of rest of the country saw crash a few years ago.

“What is happening in the Southeast is what happened in Texas in the ‘80s and I lived through that,’’ Graham says. “We were more conservative because we knew the rainbow came to an end.”

Still, the bank saw its stock price undercut in January of this year when 300 shares changed hands for $27 per share on OTC Pink.  That was a 25 percent decline from the $36 per share price that shareholders paid during the bank’s June 2011 private placement capital raise and the year-end 2011 book value of $35 per share.

“If some investors like to get what they want [on the OTC Pink], that’s great,’’ says Graham. “If buyers come to me, I wouldn’t sell it for less than book value.”

The bank had previously been an SEC filer, but deregistered in 2004 because the stock was so thinly traded, it didn’t seem worth the expense, he says.

However, even relatively healthy banks in Texas are finding that raising money takes longer than it did before the financial crisis, according to Cunningham, whose firm advised BancAffiliated on its offering.

The bank holding company announced in October 2010 it had hoped to raise nearly double the $13.2 million, but Graham says the bank was unable to get investor interest as it had planned in Dallas, about 30 miles away from the bank. It took five months of hard-core selling, whereas before the financial crisis, the capital raise might have taken half that time, says Cunningham.

“Community banks were a hot investment in mid-2000s,’’ he says. “It’s not a bad investment now. There’s still money to be made in banks.”

Raising money now means more cocktail parties, more lunches and more telephone calls than in prior years. Cunningham estimates it takes about eight contacts with an individual investor before that person decides to invest, whereas five years ago, it might have taken three.

“You meet with someone and the economy is constantly changing so you constantly have to resell it,’’ he says.

Cunningham says that the banks that have the easiest time raising capital are in good financial health with a specific growth story to tell.

“If you say ‘we’re buying two banks at a discount,’ that gets sexier,’’ he says. “If you are raising money to buy a zombie bank, or a branch of a failed bank, to hire a team around it, something like that, you can raise money. The more specific you can get, the easier it is to raise money.”

Raising money to pay off TARP? Not so easy, Cunningham says. Trying to stave off the regulators’ axe? Near impossible. “If you’re a bank on death’s door, and you’re raising money because the regulators told you you had to, it’s not a good thing,’’ he says. “There are a lot of sinking ships trying to raise money.”

As an investment banker in the Atlanta area, he frequently gets calls from those banks. “I look up their numbers online and say ‘I’m sorry, there’s nothing we can do for you.’”

Stephen Klein, an attorney with Graham & Dunn PC in Seattle, who advises banks on capital raises and other issues, says that if you work at a community bank in trouble “you can’t get an investment banker to take you out to dinner.”

Premier Service Bank in Riverside, California, which trades on the OTC Bulletin Board and has just $141 million in assets, tried to raise $10 million last year to meet regulators’ demands for increased capital, but failed. It later negotiated a deal to sell itself to First California Financial Group Inc., the holding company for First California Bank in Westlake Village, California, which has nearly $2 billion in assets and is trading on the NASDAQ.

The deal, announced in late February, gives Premier shareholders .38 shares for every one First California share, which was trading at about $5.39 per share in late March, and the deal is valued at $2 million. Premier has come down off a five-year high of $20 per share reached in 2007.

Klein says community banks have it particularly tough because they depend for profits on the spread between loan interest rates and deposit rates. With interest rates so low and growth so miniscule, profit margins are quite thin, while bigger banks tend to have more diversified revenue streams.

“Five or 10 years ago, they would easily have been able to work their way out of this [without raising capital from shareholders],’’ he says. “It takes too long to work your way out of this [now], because margins are too skinny.”

One of his clients, Intermountain Community Bancorp, the $934-million asset holding company for Panhandle State Bank in Sandpoint, Idaho, announced in April of last year that it planned to raise $70 million in gross proceeds from a private placement at $1 per share. The bank came back in January and said it had instead raised $47.3 million at $1 per share, led by private equity firms Castle Creek Capital and Stadium Capital Management LLC.

Two other private equity firms had backed out of the deal, saying they didn’t want to invest in banks anymore given the economy, says Klein.

The offering was about 90 percent dilutive to shareholders. Intermountain also plans to conduct a $5 million to $8 million rights offering that will allow existing shareholders to purchase common shares at $1 per share. Intermountain, which trades on the OTC Bulletin Board, was trading at close to $22 per share five years ago.

“It’s a volatile environment,’’ says Curt Hecker, the bank’s chief executive officer. “Private equity becomes the only viable means of obtaining capital for community banks.”

Intermountain said it would use the money to strengthen its balance sheet, reinvest in its communities and for general purposes. The bank, which took $27 million in TARP funds, had been struggling with problem commercial real estate and development loans, while spending several quarters taking them off the balance sheet and reducing the bank’s assets.

However, it announced a profit in the fourth quarter of 2011 for the first time in 12 quarters after spending years taking care of problem loans, many of them in speculative land acquisition and housing development loans in the Pacific Northwest. “We were persistent and the primary investors stayed with us,’’ Hecker says. “In the end, we still got a very good result.”

In contrast to Intermountain, one banking company that had an easy time raising capital was $800-million asset California United Bank, an Encino-based bank in the Los Angeles area. It raised $10.3 million in April in a private placement at $12.75 per share, 125 percent of its tangible book value.

The six-year-old bank is traded on the OTC Bulletin Board, didn’t take TARP money, made $1.47 million in net income last year and has seen loans and assets climb during the last year.

“It’s an experienced California team and they have been growing consistently year after year,’’ says Clark Locke, an Austin, Texas-based managing director with The Hovde Group, the placement agent for the California United Bank capital raise. “They have deep relationships [with customers] and a low cost of funds.”

The bank’s management team also planned to take advantage of troubled banks in the California market to make acquisitions at a discount. Many members of management had been part of a bank by the same name in the 1980s and 1990s and had made acquisitions before, most recently in 2010.

Following the capital raise, California United struck again, announcing a deal in January to buy Premier Commercial Bancorp in Orange County, California, for $38 million, in a one-for-one stock trade that will create a new holding company with more than $1.2 billion in assets. As of late February, the stock was trading at $10.16 per share, down from $10.25 per share when the deal was announced.

Some management teams have a good story, but no proven track record, says Locke.

 “If they were running a bank that ran into trouble with them at the helm, do you really want to invest in that?’’ he says. “It’s much easier to believe in someone who has executed well in the past and did right by their shareholders.”

Investors are definitely picky, but there may be signs that small banks will have an easier time raising money in the months ahead, says Warmenhoven.

He has noticed increased investor interest in community bank stocks and the industry has improved asset quality, earnings and valuations. The median deal price to tangible book value for all 2011 bank and thrift mergers and acquisitions was 162 percent, a slight improvement from 2010 and 2009, when it was 123 percent and 103 percent, respectively, according to SNL Financial.

The first couple of months of 2012 have been good for bank stocks, as investors have been less worried about the European debt crisis and the economy in general. The Keefe, Bruyette & Woods Inc. large-cap bank index (BKX) was up 23 percent this year through late March and the regional bank stock index (KRX) was up 12 percent.

Wedell thinks when big bank stocks go up, community banks follow.

“[Community banks] are starting to find buyers,’’ says Dingens with Monroe Securities. “It’s not a sea change. Everyone is still looking for bargains. I would say the market is firming up a little.”

Warmenhoven agrees.

“It’s an improving market,’’ he says. “It’s coming back from the dead.” 

 

nsnyder

Naomi Snyder is the managing editor for Bank Director, an information resource for directors and officers of financial companies. You can follow her on Twitter at twitter.com/naomisnyder or get connected on LinkedIn.