Description

I recommend taking a short position in The Bancorp (TBBK). At a high level, TBBK is trading at a stretched valuation despite unsustainable earnings, a vulnerable loan book, and signs of aggressive accounting.

Background

TBBK is no stranger to VIC, having been pitched as a long five times in the past, most recently in 2019. TBBK gathers deposits through its payments business, which is accessed by TBBK-issued prepaid or debit cards. TBBK, similar to its competitor CASH, benefits from a very cheap deposit base, which was 2.5% on $6.41bn of average deposits and liabilities as of 3Q23 (inclusive of $100mm of borrowings). TBBK makes money from transaction fees on these prepaid cards (i.e. non-interest income), as well as from interest income from interest earning assets. Interest income and non-interest income mix for 3Q23 was 77%/23%. TBBK lends money through its main lines of specialty lending:

1. Real estate bridge loans (REBL) – competes with Arbor Realty Trust (ABR)

2. SBLOC, IBLOC and Advisor financing – competes with TriState Capital and Goldman Sachs

3. Small business loans (SBL) – competes with Live Oak Bank (LOB)

4. Direct Lease financing – competes with Enterprise

SBLs consist of non-real estate (19%), commercial mortgage (78%), and construction (3%). In addition to TBBK’s $5.2bn loan book held for investment, TBBK holds $380mm in commercial loans, held at fair value, of which $253mm are non-SBA commercial real estate loans. TBBK also holds $757mm in investment securities, available-for-sale on its balance sheet. 43% of these investment securities are federally-backed student loans, 21% are RMBS, and 19% are CMBS. 

Interest Rate Impact

Over the past year, TBBK has benefitted from the rise in interest rates. Net Interest Margin has expanded from 3.69% in 3Q22 to 5.07% in 3Q23. I recommend reading TooCheapToIgnore’s long thesis on Pathward Financial (CASH), one of TBBK’s main competitors in prepaid debit card banking (the other being GDOT), as to why CASH and TBBK benefit from higher rates. The vast majority of TBBK’s loans are floating rate, so as rates have increased, so has the average rate on interest-earning assets, which increased from 4.79% in 3Q22 to 7.35% in 3Q23. Deposit costs increase, however, at a slower rate than 30-day average SOFR. This spread between deposit cost and SOFR flows through to TBBK’s NIM. As rates begin to get cut in 2024, as the market is pricing in, this spread should narrow, and so should TBBK’s NIM. TBBK’s earnings should follow. 

After 3Q23, TBBK gave a 2024 preliminary EPS guide of $4.25 without assuming the impact of share buybacks (18% y/y growth). TBBK did $0.92 EPS in 3Q23, so it seems to me that TBBK management expects NIM to remain elevated. In addition to rates remaining elevated, TBBK’s guide assumes no deterioration in their loan book. Given my suspicion of TBBK’s loan book, I doubt the company manages to hit their guide.  

TBBK’s CRE Exposure

There are two main scenarios that I expect to play out over the next year that will impact TBBK’s business - either rates fall, or they remain relatively restrictive. If rates fall, TBBK’s Net Interest Margin will decline, and so will TBBK’s earnings. This is the simple part of the thesis. If rates remain relatively restrictive, TBBK’s vulnerable loan book will come into question, which has ~40% of its loan book (excluding loans held at fair value) tied to commercial real estate, the vast majority being real estate bridge loans focused on multi-family (Class B and C properties, or as TBBK calls “workforce housing”). 

TBBK’s real estate bridge loans, which account for 36% of TBBK’s loan book, are mostly floating rate bridge loans with three-year terms, and two one-year extension options. TBBK has $1.85bn in real estate bridge loans held at amortized cost. These REBLs have an average 71% LTV with a 9.30% interest rate. There is also $256mm in CRE loans that are held at fair value. These CRE loans have an average 75% LTV and 9.24% interest rate. In all, TBBK has $2.1bn in CRE exposure on its balance sheet with a 72% LTV and 9.24% interest rate. Below shows the geographic exposure of TBBK’s CRE loans.

So why is a small portion of TBBK’s CRE loans recorded at fair value and the remaining, which is most of TBBK’s CRE exposure, held for investment and recorded at amortized cost? Well, before Covid, TBBK securitized these loans and recorded a gain on sale. In 3Q21, after having paused its real estate bridge lending during Covid, TBBK resumed originating these REBLs. However, this time, TBBK decided to hold these loans for investment. These loans would be part of their loan book and are recorded at under amortized cost. I cannot think of a worse time to begin holding REBLs for investment than 2021/22.

State of Multi-Family

With respect to REBLs, TBBK competes primarily with short sellers’ favorite company Arbor Realty Trust (ABR). The recent short reports, whether on VIC or from Ningi and Viceroy, highlight the ongoing stress in multi-family, particularly where TBBK has its highest exposure (i.e. Texas). Higher cap rates, incoming supply, and rising renovation costs have all plagued the sector. In November, The Real Deal did a story on the state of Texas multifamily, titled “Multifamily goes from darling to distress in Texas.”

https://therealdeal.com/texas/2023/11/21/texas-multifamily-sees-distress-on-horizon/ 

So how does TBBK see the current state of multi-family? In 3Q23 earnings call, TBBK CEO Damian Kozlowski addressed the state of multifamily, saying “we haven’t seen deterioration at all in the multifamily.” Perhaps TBBK has been a nimble lender and has avoided the problems reported on in the press or from ABR shorts. I highly doubt it, though.

TBBK Borrower Case Study

In September 2023, The Real Deal wrote a story on one of TBBK’s borrowers, Three Pillars Capital, suing the bank over “excessive forced insurance.” This lawsuit is also disclosed in TBBK’s 10-Q.

https://therealdeal.com/texas/houston/2023/09/19/three-pillars-capital-sues-bancorp-bank-over-excessive-insurance/

Three Pillars borrowed $47mm from TBBK in June 2022 as part of its purchase of the 413,000-square-foot property. While the business tactics of the insurance may be questionable, I would focus more on the commentary the borrower provides on the state of multifamily properties in Texas. 

“The force coverage that they’ve forced down our throats is resulting in negative cash flow. It’s unsustainable. The property produces certain income and after the expenses to debt service, the property is losing a decent coin. We’re in a tough spot here. If the lender had to operate this property themselves, with this insurance policy, they would not be able to operate it and make it financially viable.” – Three Pillars Capital founder George Goyal

The largest real estate loan as of 3Q23 had a balance of $45.5mm, so this loan is one of, if not the, largest REBL outstanding for TBBK. So, let’s check on how the apartment building is doing financially since the article was written. This is the website for Del Mar Apartments in October.

Now, the website, as of 12/6/23, is showing the chance to win 6 months free rent. I don’t even know how such a process can be ran in which you enter to win 6 free months, but to resort to such tactics seems like an act of desperation. According to Apartments.com, this apartment complex has 544 units. When I look at availability, I see that there are 143 units available (26%). Of these 143 units, 138 are available in December, three are available in January, and two are available in February. 

I just do not understand how TBBK’s CEO can say that he has not seen any deterioration in the multi-family space when one of TBBK’s largest borrowers, who is suing them, is crying to The Real Deal about how his apartment complex cannot generate positive cash flow.

Signs of Extend and Pretend

Still, even if Three Pillar Capital’s issues go against Kozlowski’s earnings call commentary, I recognize this is only one case to point to. Prior to this past quarter and excluding the Del Mar Apartments public fiasco, there has been little evidence in which I could point to signs of distress in TBBK’s CRE loans. It would have been mostly sector-driven, in which I could point to the ABR short reports (either on VIC or by Ningi and now viceroy), or The Real Deal’s story on stress in Texas multi-family. Still, there was little evidence pulled directly from TBBK’s financials. 

However, last quarter seems to indicate potential signs of extend and pretend going on. TBBK breaks out its CRE loans between those held for investment (and accounted for at amortized cost) and those held at fair value. The standard length on these bridge loans is three years with two one-year extension options. These loans were made prior to Covid, at valuations well below the 2021/22 peak. If a portion of these loans were bad, at some point you would expect this portion of CRE loan book to continue to remain on TBBK’s balance sheet. Up until last quarter, this loan book declined consistently each quarter, as shown below.

However, last quarter, only 1 of 18 loans was repaid, which was a $9mm loan. There could be reasons for this plateau, however, if there are issues with TBBK’s loan book, this is how it would play out. Again, these are pre-Covid bridge loans. So, if there are issues with pre-Covid loans given the valuations were much lower than the 2021/22 highs, just imagine the potential issues plaguing the 2021/22 cohort.

Accounting Issues

Perhaps my biggest issue with TBBK is in their allowance for credit losses. TBBK’s allowance for credit losses on their entire loan book is 47bps (as of 3Q23). Let’s assume that all their ACLs were 100% tied to REBLs, and the rest of their loan book was assumed to be perfect and have no losses. This would be 1.3% ACLs for their REBLs. I would note that in 2Q21, before TBBK’s loan book consisted of REBLs, their ACL was 52bps, so TTBK sees no increased risk of write-offs from REBLs versus their other lending lines. In comparison, ABR has an ACL of 1.4% on their loan book. Furthermore, CASH has an ACL of 91bps as of their last quarter, nearly twice as much as TBBK. And unlike TBBK, CASH has zero exposure to commercial real estate.

So why is TBBK’s ACL so low versus peers? This is how they describe their methodology:

“Management estimates the ACL quarterly and for most loan categories uses relevant available internal and external historical loan performance information to determine the quantitative component of the reserve and current economic conditions, and reasonable and supportable forecasts and other factors to determine the qualitative component of the reserve. Reserves on specific credit-deteriorated loans comprise the third and final component of the reserve. Historical credit loss experience provides the quantitative basis for the estimation of expected credit losses over the estimated remaining life of the loans.”

TBBK explains that historically, the collateral on the loans was enough to prevent any significant charge-offs. I would point to cfavenger’s writeup on ABR and the example provided, which highlights the impact rising rates has on borrowing and refinancing. Cfavenger writes:

“Let’s use an example to illustrate what this means. Assume that projects financed in the 2021/2022 time-frame were purchased at a 4.25% as-is cap rate. If the buyer paid $100 and borrowed at an 85% LTV there is $85 of bridge loan debt. The 4.25 cap rate implies the project throws off $4.25 in annual NOI. Current GSE multifamily rates run around a 200bps spread to the 10-year Treasury yield or approximately 5.75%. As mentioned, the most generous GSE financial programs require a 1.25x DSCR. Therefore, before even considering principal amortization, $4.25MM in NOI could support $59MM in debt at a 1.25x DSCR. But remember, Arbor extended $85 in bridge financing which is now $26 underwater or 30% of the loan’s principal balance.”

If we update this example for TBBK, using 71% LTV and 6.1% (using 10-year from 12/6/23), the most that can be borrowed is $55.6. This would put TBBK’s bridge financing at 22% underwater. This assumes no deterioration in NOI. While in the past collateral was enough to prevent significant charge-offs to TBBK’s loan book, I expect over the coming years these ACLs will prove to be far too low.

Risks

So what’s the biggest risk? If rates collapse, and earnings fall alongside a drop in NIM, the short should play out relatively quickly. The other scenario in which rates remain elevated may require more patience. TBBK can continue to earn a high ROE without having to take a write-off on its loans. They also doubled their buyback this past quarter from $25mm per quarter to $50m, so there is a chance the stock could continue to move higher in the short-term. Again, the REBLs held for investment do not begin to roll off until 3Q24, and even then, those loans can be extended. However, the real estate loans held at fair value (i.e. pre-Covid real estate loans), if they continue to remain on the balance sheet, that should be clear evidence that TBBK’s REBLs held for investment are in trouble. While this scenario may require more pain to be endured, it probably provides a greater return for when TBBK’s loan book is significantly impaired.

In terms of valuation, TBBK’s closest peer CASH trades at 2.1x P/B and 8.7x LTM earnings. TBBK trades at 2.7x P/B and 11.4x LTM earnings. Relative to CASH, TBBK has high exposure to CRE, a significantly lower ACL, and lower non-interest income growth (29% for CASH vs 14% for TBBK for their last reported quarter). Given this, I think TBBK deserves to trade at a discount. Even at the same P/B and P/E as CASH, TBBK would be valued at ~$30. Again, I think that warrants the high-end in terms of valuation. 

Going through earnings calls, it appears sell-side cares very little about their high exposure to the multifamily space. Eventually, this portion of their loan book will come into focus, just as it has for ABR. And if their loan book is somehow saved by a rapid decline in rates, their earnings will collapse. Either way, with the stock trading near all-time highs and near its richest valuation on a P/B basis, I think TBBK offers a compelling short opportunity.

Catalyst

- Change in ACL

- Loan Impairments

- Fall in Rates