Mid May: Special Situations
Why shorting OZK has been hard, the CASS story, TD Bank issues, Sprott, early-stage credit starting to worsen faster
Typically when people think of special situations they think of spin-offs and unusual corporate structures; here I use it for a few financials that are not broadly understood.
Why Bank OZK keeps performing
Cass Information Systems (CASS) is a bank, and has opportunities
TD Bank’s serious issue
Sprott (SII) can complement a financials portfolio
Early stage credit indicators have been good the last few quarters, however this quarter shows notable worsening.
A brief reminder - these notes are typically a look into one aspect of a company or their shares, rather than a complete investable thesis.
1) Why Bank OZK is hard to short
Below is a chart of Bank OZK (OZRK) vs its two benchmarks since IPO over 25 years ago. If you don’t see the benchmarks, they are the blue and purple lines at bottom:
Key reasons for the chart above include a low starting multiple, the force of CEO Gleason’s will / intellect, and the ramp enabled by FDIC acquisitions.
Nonetheless, shorts have been betting heavily against OZK most of the past 15 of those years, and today the short interest at 11% of shares outstanding remains above most every other publicly-traded bank.
As you can see the thesis has only worked for short periods, and other times has ended careers. Why this happens is the topic of today’s note.
OZK typically runs 30-40% construction and construction loans can have terrible recoveries when they sour. Why haven’t we seen more protracted downside?
Again, Gleason’s skillset, but also
A misinterpretation of what makes a bad loan book, and
OZK’s choice of regulator.
In specific:
Gleason: Long ago when I was on the sellside, not long after the financial crisis I spent a day with OZK CEO George Gleason meeting clients. We traveled with his son, although unlike most bank CEOs taking their son to see management teams, the CEO was not prepping for nepotism - Gleason seems too focused on results to allow that. To this day he remains CEO, and remains among the more impressive managers I have met. In listening to perhaps 200 questions asked of him all day he was different in how he tackled problems and opportunities.
Gleason is detail oriented, holds a higher standard than most bankers, and he thinks. I recall when he described his 45% efficiency ratio (a top quartile number) as “terrible” in a call years ago. Most bankers would not have the proper idea of where the components of the efficiency ratio should be to form that opinion, much less be willing to describe that level as bad.
The loan book: OZK lends to funds and against boats and RVs but 65% of the book is from “real estate specialties”, which typically funds large construction. We will focus on that component.
In 2009 a general rule was that if a bank carried 25%+ construction, it either failed or recapitalized. The exceptions were a few banks, like ABCB, that were too damaged to easily recap but managed to slingshot themselves via FDIC acquisitions.
OZRK was in its own class, not losing money on its heavy construction allocation. We asked George over and over why this was and at the time it was due to the type of developer he banked. Custom builders or the very best capitalized tract developers had the capital to make it by a slim margin. As an investor it was almost impossible to know until after the fact.
Today OZK lends larger, competing with funds and in rare cases Wells Fargo for first lien trophy property construction. Their model is consistent: if you want to bring 60% cash, they fund the last 40% on a senior basis, even non-recourse except for carve-outs. Almost no other banks want to do this because it is labor intensive and seems very risky. What lender making $225k, or regulator, wants to put their job on the line for a $60 million loan?
Gleason takes advantage of this psychology.
Assume you want to build a building, you want to buy a mobile home park, or accumulate Ferrari 296s, corner the market for Pokemon cards or whatever. Suppose you are putting up the first 60%, and I as lender get first dibs on the asset the moment you slip, and I have some guy I trust (or two) give me a legitimate value, plus I have a team scope the developer and area. I also control disbursement of funds according to terms and timeline I lay out. In effect, the bank is running a small business micromanaging the developer. A proactive bank could be in better position, with better rate and fees, than with a 70-75% loan to value on a stabilized building that the rest of the lending universe wants to lend on.
Of course, large projects can go bad if the developer wastes money, plans poorly or tenant demand drops sharply. OZK can mitigate poor execution by bullying the developer, which they are known for doing and currently may do quite actively in exchange for time or concessions.
They can mitigate demand fall off by proper site and plan selection. Even today there is demand for first class downtown office. The empty office trading at 20% of par is in the wrong area (downtown St. Louis, San Fran etc) or the wrong era (70s-90s class C needing heavy rehab). A brand new Miami office building is not going to trade at 40% of cost.
OZK’s regulator. This is uncommon for a $36bn bank:
As banks get larger, they are typically regulated by the Federal Reserve and OCC. OZK dropped the Fed, and understands that if it were regulated by OCC, it would probably have to answer to more oversight - some of which may be warranted and some perhaps capricious. I doubt OCC would sign off on 65% of the loan book being large real estate projects, or trust OZK’s model of aggressive servicing and modification of construction. For example the little blue dot in the picture below at top left is an accruing loan(!), modified and aggressively serviced for 18 years after initial stress.
People can critique OZK’s loan extensions but in some cases it is shareholder friendly in both the short and long term. Many OCC banks are at a competitive disadvantage with real estate because their regulator forces them to act, in effect cancelling the bank’s call option on a project’s stabilization. As one example NYCB changed from Fed to OCC and while the OCC was correct to push NYCB to strengthen its processes, they also almost killed the company with the manner and timeline they chose.
On the other end of the spectrum, OZK competes with REITs and Funds who mark and extend their loans however they want.
The point is that regardless of regulator, a bank should deal in reality and OZK has demonstrated an ability to do so over time. To that end they should also be given “credit” for one of the better disclosures in all of banking as part of their 1Q results:
Again, I’m not telling you to buy or sell OZK. That decision would focus on the loan portfolio granularity, level of short interest, deposit base and ROE potential given capital levels at OZK among other factors. I’m simply interested in helping the masses think deeper than the construction balance when making a decision to short OZK.
2) There is only one CASS
Cass Information Systems (CASS) is an unusual bank in Missouri that few understand but some value investors occasionally tout as a found gem. This post describes how they are different and under what circumstances the shares make an attractive investment.