Texas Ratio Predictor of Bank Failure - Maybe - Maybe Not

The Texas Ratio everyone is using to speculate on the health of the nation’s banks has a problem. The calculation belies a different conclusion in many cases and does not necessarily mean bank weakness.

Texas Ratio Defined

Gerald Cassiday of the RBC Capital Markets, coined the name for his calculation which grew out of the Texas S & L meltdown of the 1980’s.

The Texas ratio calculation Cassiday developed is calculated by dividing a bank’s non-performing loans, including those 90 days delinquent, by the company’s tangible equity capital plus money set aside for future loan losses.

ABC News did a story that is getting a lot of traction especially when they published a list of potential weak banks using the Texas ratio. (see list below).

bank failure texas ratio

Of course we all know about by now the failed IndyMac Bancorp which had a reported Texas ratio of 140 (which they disputed saying it almost half of that depending on which reserve number one used).

The Hidden Meaning

Here’s what I notice in the banks above and IndyMac. Over the last 15 years in the mortgage industry one gets to know the banks and their specialty in lending. Now I can’t testify to all the lenders above but I can talk about:

IndyMac - We received their solicitations and, at one time, were actually an approved broker.

Colorado Federal Savings Bank - Since we live in the Denver area we know about this local bank.

Eastern Savings Bank, FSB - A non-conforming hard money lender we attempted to broker loans to on at least one occasion.

What do these three banks have in common?

In addition to their residential lending, they are all big “construction and development” (C & D) lending institutions! My guess is if one cared to look the other banks listed fall into this category as well. These three banks all have local and sometimes national reach to help with the construction and development boom…exactly what a bank is supposed to do.

Construction and development loans fund projects like the building of strip malls, rehabbing bad neighborhoods, and the construction of office buildings. These C & D loans stay on the banks books since there is not a secondary market on Wall Street for these types of loans. If they go bad, the bank must deal with it.

Because of this, typically these C & D loans are done at very low loan to values (LTVs) usually between 50-70 percent and they are given to experienced builders and developers…not subprime borrowers.

In many cases, I think the Texas ratio is nothing more than an indicator of how aggressively a bank went after C & D loans…not subprime.

Are These High Texas Ratio Banks Safe Then?

Well the short answer is “Maybe”

If a bank has a high Texas ratio due to heavy C & D lending and they lent at low LTVs, then the answer is “yes”. The projects in default will be foreclosed on, sold to new developers, and the assets returned to the bank with no loss.

For example, if a bank makes me a C & D loan to rehab an office building at 50% LTV…and currently the building is worth $1 million…I get a $500,000 loan. If I default they get back a $1,000,000 office building. Sure they have some work to do…complete my rehab or just sell it as is…either way they get whole and maybe even make money. Even if values had dropped 50% since the loan was made, the bank would not sustain a loss.

This takes time but I believe those banks who stuck to smart C & D lending who are now showing high Texas ratios will come off the list once they liquidate their defaulted loan collateral.

So the Texas ratio is a “snap shot in time” calculation…give these banks more time and the “snap shot” looks different.

What Killed IndyMac?

What killed IndyMac along with their subprime lending in my opinion was their residential construction program called the “construction to perm” loan program. IndyMac had if not the only broker “one time close” program, certainly the most “successful”. They marketed this through brokers nation wide and didn’t keep the LTVs down…high LTV loans in their C & D portfolio would be the kiss of death for any bank given dropping residential home values.

Also having a Senator come out publicly against you could cripple or destroy even the strongest company. Thanks Mr. Shumer!

The other two banks I mentioned in my opinion did not make the mistakes IndyMac made. They stuck with low LTVs and used their C & D program only for well heeled commercial developers. Only time will tell if I am right, of course.

Don’t believe everything you read about the Texas ratio as a predictor of bank failures or the country’s worst bank…it only scratches the surface. It sure makes for great headlines though.

Good Luck!

PS: Here’s a CBS News Report on the Texas Ratio…they too get it wrong.