Description

Introduction: If you saw $20 lying on the street would you pick it up? Of course you would, you are a proud card-carrying member of the Value Investor Club not some academic sitting in an efficient market ivory tower!

You want that free money? Then short Eurobank (EUBK) if you can get the borrow. This bank is a shuffling, leprous zombie and Buffy the FDIC-examiner is about to drive Mr. Pointy in the undead thing's heart.

Background: Eurobank is a small, terminally ill bank based in the balmy financial Mecca of San Juan, Puerto Rico. In a word, the banking system on the island is a mess. We shouldn't be surprised; a building boom to compete with Miami was quickly followed by the longest and most severe Recession in the US. 'V'-shaped recovery? Not in PR: the stated unemployment rate tops 16% and the true rate is likely closer to 20%. Scores of high-end beachfront apartment buildings have recently been completed in Condado and Ocean Beach that are eerily dark at night. A trickle of stimulus aid has made it to the island but its impact is swamped by natives returning from their places of unemployment in Orlando, New York City and Miami. The largest employer is the bankrupt and job-shrinking territorial government. Don't get me wrong, I really like the people and vibe of Puerto Rico but the economy is a mess.

Of the seven independent banks on the island, 3 are operating under Cease and Desist Orders and are about to be closed and of the three, Eurobank is the sickest of the lot. Note the discussion of the situation from the following two papers:

WSJ: http://online.wsj.com/article/SB10001424052702304198004575172300332007216.html?KEYWORDS=puerto+rico+bank

American Banker: http://www.americanbanker.com/issues/175_66/pr-forces-fdic-to-scramble-1017334-1.html

Most who look at banks use something called a 'Texas' ratio to figure out if a bank is going to fail. This ratio grew out of the 1980s banking crisis in the Lone Star State where banks tended to fail when this ratio rose to above 100%:

Texas Ratio =               Non-Accrual Loans + OREO + Loans Past Due +90 days/Tangible Equity + Loan Loss Reserve

Eurobank is almost off the scale on this score:

And if we take a look at the composition of the problem loans, things look even bleaker. Construction loans have had the worst loss severity across the US this asset quality cycle running north of 50% loss rates for many banks. When it comes to Construction loans, well, EUBK has a lot of 'em:

So you can see that even if EUBK didn't have any other problem loans, a 30% loss rate on non-accrual construction loans would wipe out more than 100% of the Loan Loss Reserve and eat into equity. Unfortunately, only half of EUBK's problem loans are in the construction segment and the bank doesn't have much equity left either:

And don't forget that EUBK has been losing money every quarter and 1Q10 will continue the trend and these ratios have only deteriorated further YTD.

So you might ask why haven't the adults shown up and closed this thing down yet? Why haven't WHI and RGFC (the two other +100% Texas Ratio Puerto Rican banks) been closed down either? The problem is that the FDIC didn't want to tank the sick, but not terminally ill lenders on the island as well which would lead to an even larger loss to the Deposit Insurance Fund (the DIF, or more simply, your wallet Mr. Taxpayer). Many of the banks have shared (participated) loans with each other and when the FDIC closings take place EUBK/WHI/RGFC's loans will get written down which will force everyone holding pieces of these credits to take mark-downs as well.

So the FDIC (with its advisor, Deutsche Bank) has come up with a plan which is now becoming apparent. (You might ask why the US government has hired a German investment bank to give pointers on how to close down banks in the Caribbean. You might, but I doubt Shelia Bair would tell you). So hear is what I believe is the plan:

1) Get ready to close the three sickest banks

2) Identify which banks will 'buy' these sick banks in an FDIC-assisted transaction

3) Make absolutely sure these buying banks will be able to consummate the deals by getting them to raise the required capital in advance to absorb the influx of assets.

4) Strike, and take out all three sick banks on Friday, April 30^th, so you can quickly reposition your FDIC resolution staff up to Chicagoland where about 40 banks need to be put down.

So where are we in the process?

1) The news has certainly leaked out that the FDIC is soon to close EUBK/WHI/RGFC. I'm sure the lawyers/appraisers/investment bankers/auditors who will only get paid when the transactions take place were not the source of this press. The stories in the papers have led to good customers of these sick banks voting with their feet and switching their business to the more solvent banks. The longer the government waits the larger the loss to the taxpayer.

2) OFG raised $100M on 3/16/10, BPOP raised $1B on 4/14/10 and finally, on 4/19/10 DRL announced the completion of its capital raising. All three bank managements spoke openly about their intention to leverage this new capital to acquirer one of their island competitors in an FDIC-assisted deal. All three were explicit on this point in their offering prospecti as well. As the Puerto Rican economy is shrinking, there is no need for this additional capital except to engage in an acquisition. OFG has expressed its interest in acquiring a seized EUBK, BPOP a seized WHI and DRL a seized RGFC.

Note the asset sizes involved:

Sick Bank        Assets            Over-Capitalized Bank             Assets

EUBK                $2.5B             OFG                                          $6.5B

RGFC                $6.0B             DRL                                         $10.2B

WHI                $11.9B             BPOP                                      $34.7B

Each deal would strengthen the new larger surviving bank but the increase in size would be not overly large so as to limit the complexity of integration.

3) Where do I get the April 30^th date? Well, of course this is only an educated guess but a) unless a bank's clientele is dominated by Orthodox Jews (as with LibertyPointe bank earlier this year), the FDIC generally closes banks on a Friday. b) the three 'buying' banks have now completed their capital raising exercises, c) Spring Break vacation is over and hotel rates have dropped for housing the temporary FDIC staff influx, and d) when WHI announced earlier this year that it would not be able to publish an annual report/10K, for among other reasons that its management was too busy, it mentioned in the press release that its auditors questioned the bank's ability to remain a going concern and that the FDIC had given the bank a waiver to continue rolling over its Brokered CDs until...April 30^th.

Of course I don't know for certain if 4/30/10 is the date but we know the time in nigh and that's my story and I'm sticking to it. Also, one other important point - it is against the law to say a bank is going to fail as the regulators can claim the bank failed due to your scurrilous rumor-mongering (I'm sure the +300% Texas Ratio had nothing to do with it). So for the record, I am not saying Eurobank is going to fail - I am saying the Wall Street Journal, and the American Banker say Eurobank is going to fail.

A $20 bill - ok, so I realize this isn't the biggest trade of all time and Michael Lewis isn't going to be contacting me regarding this idea for inclusion in his next book. Eurobank has a market cap of $7M. You aren't going to be able to retire on this trade. But the risk/reward is fabulous and the time until you get paid is very short. I was able to get a borrow on a few hundred thousand shares for a very low rebate and if you can get them from your broker you should as well. After all, just because that $20 is right there on the ground doesn't mean it doesn't exist.

Regards, Grumpy.

Catalyst

Eurobank will be seized by the FDIC in the very near future (likely April 30th). Equity value will be wiped out.