Troubled Bank in Texas – Part II

The private $4.7 billion Industry Bancshares Inc. in rural Texas made the dramatic step in early November of asking for a meeting in December 2023 to solicit shareholder permission to issue additional ordinary shares and preferred shares. It’s unclear at this point whether they will get this permission or be able to raise additional capital. What is clear is that existing shareholders of Industry Bancshares are unlikely to end 2023 happy, no matter what happens next.

Industry_bancshares

There’s a straight through-line narrative from the rapid interest-rate hikes by the Federal Reserve in 2022, to a number of large bank failures this Spring in New York and California, to Industry Bancshares recently seeking permission to raise more capital. Rate hikes have caused a slow-moving banking crisis nationwide throughout 2023. This crisis has now come home to rural, central Texas.

Other banks and bond portfolio losses

Plenty of other better-known banks have suffered this year from their bond portfolio losses, with the same root cause of aggressive Fed hikes in 2022.

Silicon Valley Bank, which in March 2023 suffered the third-largest bank failure in US history, had almost exactly the same problem as Industry Bancshares, but on a larger scale. Like Industry Bancshares, it owned many ultra-safe long-maturity US Treasury bonds which dropped in value when interest rates rose. The differences in customer profiles, however, could not be starker. Whereas Silicon Valley’s Twitter-networked high net-worth depositors yanked their money quickly and brought down the bank in the course of a week, Industry Bancshares customers appear to move at a different speed. The key difference – and this has been an advantage so far for the Texas bank – is the slow pace of deposit banking among its customers.

SVB
They owned super-safe long-dated Treasurys

Bank of America, to name another well-known bank, has a huge bond portfolio-loss problem that has been a headache for national regulators ever since the beginning of 2023. In October 2023 Bank of America reported $131 billion in unrealized bond portfolio losses. Unlike Industry Bancshares, however, Bank of America has a highly positive net worth overall of $229 billion, on a traditional GAAP accounting basis, as of September 2023.

San Antonio-based USAA, the largest Texas-based bank, had a $10.4 billion loss on its bond portfolio in 2022 and reported its first negative earnings year in its 100-year history. USAA also had a substantial positive net worth at over $27 billion at the end of last year on a traditional GAAP accounting basis.

2022 was USAA’s worst year ever

So Industry Bancshares has plenty of company among the misery of banks whose bond portfolios got hurt by the rapid rate hikes of 2022. It stands uniquely apart, however, in its dropping into negative net worth territory throughout all of 2023, a valuation place no financial institution wants to be.

Illiquidity versus insolvency

In the normal model of banks at risk, we worry about a run on a bank because of illiquidity. Illiquidity arises because banks generally only keep a fraction of their total assets in cash or highly liquid equivalents. This is usually fine because they generally assume customers will not all demand their cash back at the same time. If customers did suddenly withdraw their deposits – as you probably watched in the fictional small-town bank run depicted in the Christmas classic “It’s A Wonderful Life” – no bank generally holds sufficient cash on hand. In a traditional liquidity crisis we understand that the problem is one of timing. Meaning, if you give the bank enough time to sell off its assets to raise cash, everything will be fine. The bank ultimately holds plenty of valuable assets well above the money owed to depositors and lenders. It’s illiquid, but not insolvent. Every modern bank worries about illiquidity risk because it can happen to any bank. FDIC insurance is a great solution for illiquidity risk, because it eliminates the need for smaller depositors – anyone below $250 thousand at the bank – to demand their money back quickly out of fear of a bank run.

its_a_wonderful_life
Our image of a bank run from the movies

In the more extreme model of banks at risk, however, we worry about a bank run due to insolvency. That could happen if a bank has a negative net worth – owing more money than it actually owns in assets. This is rare. Normally insolvency could be due to unexpectedly high losses on a bank’s real estate or business loan portfolio. Or as happened this past year, it could be because of an extreme drop in the value of a bank’s bond portfolio. The problem and the solution is not a matter of needing more time to sell assets – it’s a matter of the bank literally doesn’t have enough valuable assets to cover its liabilities, and then depositors realizing the risk they face in that situation.

Weirdly, as I wrote about a few months ago, just 15 out of 4,697 banks in the United States reported a negative net worth mid-way through 2023, putting them at risk of insolvency if too many depositors and lenders decided to ask for their money back. Even more weirdly, 6 of those 15 negative net worth banks are actually part of the same bank, the bank holding company Industry Bancshares. This holding company is made up of 6 small Texas banks with 27 branches located in rural counties between Houston, San Antonio, and Austin: Citizens State Bank of Buffalo, Bank of Brenham National Association, Fayetteville Bank, First National Bank of Bellville, First National Bank of Shiner, and Industry State Bank.

When I first wrote about the bank, each one of the six individual banks had a negative net worth. In total the six were collectively in the hole for $128 million, or $108 million at the bank holding company level. That value was based on public filings from the end of June 2023. Unfortunately, due to further interest rate rises and bond portfolio losses, each of the six individual banks now has a significantly larger, that is to say worse, negative net worth. Collectively that balance sheet hole ballooned to $401.4 million by September 30 2023, or $381.9 million at the bank holding company level.

$108 million reported negative equity in June 2023 for Industry Bancshares. Line 15 is the key. Line 3 is as of year-end December 2022. Bank management reported this position to regulators since at least late 2022.

The solutions

The last time I wrote about Industry Bancshares, I mentioned possible solutions management could pursue were to: 

1. Try to sell to a larger, better-capitalized, bank 

2. Raise new investor capital 

3. Do nothing, and hope to earn their way over time out of their negative equity position, or

4. Do nothing, and hope for bond portfolio values to improve.  

I don’t know if they are trying option 1. They reported to shareholders that they hired a financial advisor known as Hovde Group to seek strategic financial solutions. The December 2023 shareholder meeting is a necessary step in the direction of option 2. Option 3 is a longer-term strategy which requires patience on the part of regulators and depositors to overlook their negative net worth for a few years in the hopes that consistent profitability solves the problem. Industry Bancshares reported $19 million in net income through September 2023, so this is possible, but it would take a while. Option 4, which they elected to do by default, appears to have exacerbated the situation. 

Further bond portfolio losses led to negative $381.9 million equity capital position by September 2023. Line 12 is how much worse the bond portfolio got in Q3 2023 alone, as interest rates rose.

Interest rates jumped again in the 3rd quarter of 2023, and losses deepened. Option 4, doing nothing with the bond portfolio, has made their negative equity position 3 times larger than was previously reported, halfway through the year.

Bank Accounting v. GAAP Accounting

Because of a quirk in the way banks are regulated, banks can choose to have their portfolio losses on “available for sale” bonds ignored by regulators, when regulators look to see if a bank is solvent or has sufficient capital. Only when bonds are sold – and Industry Bancshares has not sold theirs – are the losses counted. And bonds don’t have to be sold, as long as depositors or other lenders do not request their money back. As a result, Industry Bancshares can state with a straight face that they meet regulatory standards for “well capitalized.” At the same time, in ordinary business terms and according to common sense, they have a deeply negative net worth.

An October letter to shareholders from management included this message: 

“You may have seen an article or two about the Company that have not been very favorable and have been very misleading in many respects. The articles have painted our Company and the banks in an unnecessarily poor light due to an accounting concept that requires banks to report unrealized losses and gains on a certain portion of their securities portfolios.”

I would posit that my article in September was not “very misleading in many respects” at all, although readers can render their own judgment on that. Bankers – who literally evaluate corporate solvency and business valuations for a living – understand very well what the difference is between positive and negative net worth, despite what regulators permit them to report and claim.

Dividends, valuations, and at-risk people and groups

It is notable that the bank paid $4.027 million in dividends via two payments to shareholders in April 2023 and July 2023, even though the bank as a going concern was worth less than zero dollars in the ordinary sense of a business enterprise.

Industry_bancshares_org_chart
Industry Bancshares Org Chart as of 2019

In January 2023, bank management communicated to shareholders that bank shares were worth an estimated $37.25 per share, down from approximately $44 per share in 2022. This despite a December 31 2022 equity capital position of negative $159.7 million across all six banks combined. Management has suggested that a new share offering after December 2023 would be in the range of $1.5 to $2.5 per share. Even before the issuance of new shares, existing shareholders are facing a 95% loss in value over the past year.

The owners of the more than $2 billion in more than 3,100 deposit accounts with balances above $250 thousand, employees who may have their net worth tied up in an Employee Stock Ownership Plan (ESOP), and ordinary shareholders should seek to more fully understand their situation at Industry Bancshares.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

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A Troubled Texas Bank, Part I

USAA had a very bad, no good year in 2022

It’s A Wonderful Life, a failed banker origin story

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A Troubled Bank in Texas – Part I

Editor’s Note: A version of this story ran in the San Antonio Express News and Houston Chronicle on September 17 2023. Since this is an ongoing (and soon to be updated story) I figured Part 1, although a few months late, needed to be posted here.

Following the 2nd, 3rd, and 4th largest bank failures in US history – that all occurred in Spring 2023 – a natural question is: What happens next? 

I’ve never thought it likely that only failed banks First Republic, Silicon Valley, and Signature made major errors last year when the Fed aggressively hiked rates, while the other 4,697 banks in the country did not. Only one other tiny bank in Kansas has failed since then. It’s the dog that, eerily, hasn’t barked in the night.

Industry Bancshares Inc is made up of 6 smaller banks in rural Texas counties

Industry Bancshares Inc, has 6 subsidiary banks and 27 branches just a few hours’ drive from each other in the rural counties between the Texas triangle formed by Houston, Dallas, and San Antonio.

The six subsidiary banks of Industry Bancshares, Inc are Citizens State Bank of Buffalo, TX, Bank of Brenham NA, Fayetteville Bank, First National Bank of Bellville, First National Bank of Shiner, and Industry State Bank of Industry TX.

Industry Bancshares Inc Org Chart, as of 2019

Since at least December 2022, and including through their latest public filing of financial data in June 2023, all six of the banks that together make up Industry Bancshares has reported a significant negative net worth, using traditional accounting standards.

Bank Solvency

I don’t mean to be alarmist. Like shouting “fire” in a crowded theater, shouting “insolvent!” in a crowded bank lobby is neither kind nor prudent. Hopefully you watched the movies “Mary Poppins” and “It’s a Wonderful Life” so you have an intuitive sense for the fragility of all banks, especially to the extent that the FDIC only guarantees deposits up to a certain point. 

its_a_wonderful_life
From: “It’s a Wonderful Life”

The people who should be alerted to the financial stats I’m citing, however, are the 3,216 depositors at these 6 banks who have a reported $2.2 billion in accounts over the $250 thousand FDIC guaranteed limit, as of June 2023. This post is aimed specifically at those folks with billions of dollars in under-insured deposit accounts. Shareholders and board members of course should stay alert as well.

A spokesperson for Industry Bancshares Inc responded to a series of my questions, “Industry Bancshares, Inc. and our six chartered banks have capital levels that significantly exceed the required regulatory minimums, are financially strong and well positioned in the current environment to continue to serve our customers throughout the communities we operate in Texas.”

Not credit mistakes, but interest rate mistakes

Unlike past banking crises, the banking crisis of 2023 is not about losses in credit portfolios, meaning loans banks made to businesses or real estate that went sour. Industry Bancshares in fact has a pristine loan portfolio, with each subsidiary reporting less than 0.25 percent of non-performing assets at the end of 2022. This is very clean.

Instead, banks are showing losses on their bond portfolios. Most banks hold lots of bonds, and most bonds lost money in 2022, when interest rates went up quickly. So most banks have losses to report this past year on their bond portfolios. Banks publicly report, every quarter, how much they’ve lost (or gained) on bonds that they hold. 

Says the bank’s spokesperson, “Over the past 30 years, our bond portfolio strategy has enabled us to maintain strong earnings and bolster our capital position. The bond portfolio is comprised of high-quality, performing investments such as U.S. government treasuries and agencies and highly rated Texas municipal securities. The current unrealized losses in our bond portfolio are just that – unrealized. Our high credit quality, highly rated bonds continue to perform as agreed.”

Federal Reserve of Dallas overseas bank holding companies

The bank declined to respond to my question about what changes if any have occurred in the bond portfolio, or the value of the portfolio, or hedging strategy, or interest rate posture since the bank last publicly reported numbers on June 30, 2023.

An outlier in AOCI

The losses that banks have on many of their bonds classified as “available for sale” are reported as an accounting line item called “Accumulated Other Comprehensive Income” (AOCI). In plain language this means “how much are our bonds worth today, if we were forced to sell them, compared to when we bought them?” If they are worth less today, then AOCI is a negative number.

Two other important accounting line items matter to this story, before I explain how much of an outlier Industry Bancshares is among US banks. 

First, banks calculate and report their net worth in two different ways. One is called “Total Equity Capital” and is calculated according to regular business accounting standards (aka generally accepted accounting principles, or GAAP.) You could think of this as the difference between what they own, and what they owe. Standard stuff for how we would calculate the net worth of any business.

A different calculation is called “Common Equity Tier 1 Capital” (aka CET1) which follows specific bank regulatory rules, and it basically allows banks (and their regulators) to more or less ignore bond portfolio losses, in most cases. When a regulator looks at CET1 instead of GAAP results, a bank will look fine, even as it reports extraordinarily negative AOCI numbers.

Here’s where Industrial Bancshares’ quarterly reports from June 2023 are very interesting. (What I mean is now is the point to unglaze your eyes from my accounting lesson, and sit up straight in your chair.)

Industry Bancshares’ Unusual Situation

Using data from official bank accounting reports, just a mere 15 banks in the entire country had a negative “Total Equity Capital” number at the end of June 2023. Interestingly, the top 5 worst banks on the list, or in other words the banks with the lowest net worth on the list of 4,697 banks in the country are actually part of the same bank holding company. Number 7 on this ignominious list is also part of the same holding company. Yes, you guessed it, they are the 6 banking subsidiaries of Industry Bancshares Inc of Texas. All 6 subsidiaries have a negative net worth, and as a result so does the consolidated bank holding company. All-in, Industry Bancshares is currently supporting $5.8 billion in assets but has a combined “Total Equity Capital” of negative $128 million, as of its June 2023 report, or $108 million at the holding company level.

Line 15 from June 30 2023 FR Y-9C for Industry Bancshares Inc shows negative $108 million net worth on a GAAP accounting basis

In the plainest language, what does negative total equity capital mean? It’s not just an accounting problem. If depositors and lenders to the bank all wanted their money back tomorrow, and if the bank managed to sell all of their assets (including their bonds) to give that money back, negative equity simply means there wouldn’t be enough money. In simplest terms, they’d be short $128 million. At current prices, their bonds lost so much value last year that there isn’t enough to cover depositors and lenders to the banks. And the bonds didn’t recover enough in the six months from December 2022 to June 2023. They reported negative $159.7 million total equity capital in December 2022.

The fact that there are only 15 banks out of 4,697 in the country with a negative net worth, but 6 of those banks are actually the same bank holding company, makes Industry Bancshares a strong outlier on this measure, according to publicly reported data in June 2023.

And look, I’m not your licensed financial advisor, and your mileage may vary, but personally I like to bank with an institution that has a positive net worth. Actually I’d be fine because, sadly for me, I don’t have balances over $250 thousand at my bank, but you know what I mean.

In response to my query about their $2.2 billion in 3,216 underinsured deposit accounts as of June 2023, the spokesperson for the bank replied “We have a growing, diverse, stable, and loyal deposit base. Our team of bankers use their experience and industry best practices to counsel our customers on how to safeguard their large cash balances…With six chartered banks we can increase FDIC insurance for customers across our affiliates. In addition, we utilize IntraFi Network, a solution that helps bank depositors access FDIC insurance above $250 thousand, to ensure our customers have access to FDIC insurance coverage.”

Another independent ranking

Bauer Financial, a bank rating group, assigns ratings every quarter to banks based on their financial strength.

In their June 2023 ranking, five out of 487 of banks in Texas merited 2 out of 5 stars, indicating a rating of “problematic.” Twenty-three banks out of 487 got 3 stars, indicating “fair” financial health. All 6 subsidiary banks of Industry Bancshares received 3 out 5 stars in June 2023. That’s a rating on par with San Antonio-based insurance and banking giant USAA. Although Bauer is indicating some cause for concern, they are not highlighting Industry Bancshares as an outlier the way the AOCI measurement I cited does.

Bank ranking company

So why haven’t regulators shut them down?

So if these banks are such outliers, when considering their bond portfolio losses and their overall business value, and this information is known and public, why do regulators allow them to be in business? 

I mean, one would assume and hope regulators are paying attention. The Dallas Federal Reserve would have responsibility for the bank holding company. In response to my query, the Texas Department of Banking replied formulaically that they could not comment, among other things, on “information related to a regulated entity’s financial condition or business affairs.” 

So I’ll speculate instead. The answer is likely a combination of: 

1. A bank accounting technicality,

2. A purposefully gentle treatment of bond portfolio losses by regulators, and 

3. Depositors over $250 thousand being blissfully unaware of the risks they currently run.

The bank accounting technicality issue is that regulators essentially have turned a blind eye to AOCI losses, and instead use the special banking health measure – CET1 – that ignores it. The thought process I guess is that as long as banks don’t have to sell their bonds at current market prices, they do not have to lock in their losses. And if depositors don’t flee, and the bank doesn’t sell the bonds at a loss, and other problems don’t crop up like credit losses, everything is fine in the long run. 

The regulatory treatment of CET1, which ignores bond losses, allows the spokesperson for the bank to truthfully say in response to my query: “We have increased our Tier 1 leverage capital levels in each of the last 15 years, and in 2023 those levels have continued to increase. As of July 31, 2023, Industry Bancshares, Inc.’s Tier 1 leverage capital is 11.7% and total risk-based capital is 29.7%, which is in the 99th percentile of our peer group and is well above the regulatory definitions of well capitalized.” The bank, like regulators, focuses on CET1.

Page 54 of June FR Y-9C. Showing positive CET1 capital of $676 million and healthy 11.5925% leverage ratio. This is likely why regulators have given Industry Bancshares a pass in 2023, as CET1 ignores bond losses.

In fact a special program called the Bank Term Funding Program was created in March 2023 in the wake of the Silicon Valley and Signature failures – failures due to their bond portfolio losses and subsequently depositors fleeing! – to save banks from having to abruptly sell their bonds if they started to lose depositors or needed liquidity for any other reason. It’s a program put in place on an emergency basis that shields banks from the consequences of their losses on their bonds. In plain language, under this program, banks can borrow from the Fed against their bonds in amounts just as if they haven’t had any losses. In the banking world there’s a concept called “extend and pretend” that banks sometimes offer to their borrowing customers who have trouble paying back their debts. This program is a bit like the Federal Reserve offering “extend and pretend,” but for banks with bond portfolio losses.

The positive case for Industry Bancshares

What could a bank like Industry Bancshares, Inc and its subsidiaries do in this scenario to improve their lot and protect their uninsured depositors? The prudent short-run solution is to either merge with a stronger bank or sell to a stronger bank. Were I the acquiring bank, I would look very closely at the negative net worth and bid accordingly. Acquiring banks understand bank accounting very well.

Another short-term fix is to raise more capital from investors, which can then be used as a cushion against losses or fleeing deposits. Industry Bancshares last raised equity capital in 2017, according to SEC filings. Were I a current or prospective investor, I’d want to know their current position, but maybe they already do? The bank declined to respond to my question of whether it had sought to raise additional capital to bolster its negative net worth.

Were I an uninsured depositor with a commitment to sticking with one of these banks, additional capital would be the main thing I’d demand. The bank did not to respond to my question of whether the bank had paid investors dividends in 2022 or 2023. Documents I reviewed showed the bank did pay dividends to investors at least from 2014 to 2019. 

The long-term fix, or no fix at all, is to wait. Given enough time, a successful bank franchise can earn money and climb its way out of a financial hole. Not counting their bond losses, the combined banks earned $76 million in 2022. At this pace of earnings, and assuming no change in their bond portfolio, they could climb back to a roughly breakeven, a zero net worth, in about two years.

Their bond portfolio may recover in time. As long as depositors do not flee and regulators give them time, these banks may eventually survive and thrive. But for anyone with more than $250 thousand in your account, you’ve been warned.

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