I think one of the main reasons a lot of investor wholly avoid bank stocks is due to the preconceived belief that banks have complex business models. I myself have fell into this camp before. I mean it’s kind of hard not to think banks have complex business models given the variety of loans on the loan book, immense regulation in the industry and much different financial statements than your typical business.
One aspect of valuing banks that confused me from the onset was the different types of loans on a loan book and what these meant in terms of the future prospects for a bank. At first, these different types of loans confused me and shied away from banks. However, after learning more about banks and what each type of loan means, I gained more competence and knowledge with bank investing.
With this article, I would like to take some time to quickly elaborate my thoughts on bank lending.
Source: Time Business
There is a lot of arguments into what the least risky loan can be. Likewise, not everyone will come to the same agreement if loan X is more risky than loan Y; vice versa. Furthermore, a less risky loan in bank A may be a more risky loan in bank B, and thus depends on the circumstances of the underlying company/loan officers. Despite the never-ending quarrel on what type of loan is the least risky, in my opinion the least risky loan is a short-term loan, likely to be repaid.
In regards to risk management, short-term loans, typically are less risky and have a higher likelihood to be repaid. The issue with short-term loans is that the interest rate will be much less than a longer duration loan, putting pressure on a company’s net interest margin.
Another type of loan that is less risky is one with a lot of collateral. For an example, if bank A lends out $50,000 to the Smith’s on a mortgage loan with $50,000 in equity, the loan is less risky than the same monetary valued loan but with only $5,000 in equity. The more equity the better.
The issue with loans is that we as investors will not know the equity on a loan. This is a big problem and gives the investor an added complexity in his or her valuation. One way to offset this issue is to establish a relationship with the bankers. If you can trust the bankers and know his or her risk approach, the issue with not knowing the size of an equity position in a loan can be counterbalanced.
A further way to compensate for not knowing the equity value of a loan is to look at a bank’s historical losses on each loan you are analyzing. If for an example, bank A has historically done well lending out mortgages, it makes for an easier assumption that their strict and less risky mortgage lending practices will continue going forward. On the flipside, if bank A has little experience taking on commercial loans and just lent out a significantly high commercial loan, we cannot use historical data to evaluate the potential probability of this loan going down the drain.
A few loans that are on the higher end of the risk spectrum are consumer, auto, unsecured, and residential unsecured.
Consumer loans are risky because there is effectively zero equity involved. Consumer loans can be used for pretty much anything. From buying a new ATV to picking up some groceries. These loans have higher interest rates and have real potential to expand the bottom-line of a company, but with much more added risk than your equity backed mortgage.
Auto loans can have some equity attached to them. However, for the most part, they generally risky. Think about it, when you drive your car off the lot, it immediately losses value. Thus, it’s hard to attach an equity value on a car loan given the depreciating and value losing effects cars generally have.
Any unsecured loan is risky. Unsecured loans have a lack of equity and are not backed or secured by an underlying value. These loans will have higher interest rates, combined with much more risk.
Commercial loans are typically more risky. With commercial loans, the bank is betting on the success of a business. Furthermore, commercial construction is even more risky. With commercial construction, the bank is not just betting on the success of a business, but also on the company’s growth. For an example, if company X gets a commercial loan from bank A, in order to build a strip mall, the risk is derived if company X cannot fill any tenants in the lot.
Readers should be aware that some banks specialize in commercial loans and have historically done well investing the vast majority of their deposits into commercial businesses. If you are able to find a bank that has historically done well investing in commercial business, that bank may be less risky than the bank down the road who has never invested in commercial business but has taken hefty losses on their mortgage loans.
Construction and land is another very risky loan. These loans have high interest rates and can go south for a number of reasons. For an example, if the construction is not complete, for any reason, the loan will most likely take a loss, given that pure land, most of the time, doesn’t produce cash flows to pay the loan off.
C&I loans can also be quite risky. With these loans, a bank is betting that a company’s receivables are of good quality. Furthermore, if a company doesn’t have cash on hand to fund working capital or to buy inventory, the quality of that business, most of the time, is likely to be quite poor.
What makes for a good loan? It really depends on the bank. Business banks that focus on business loans, will most likely not have added risk lending to commercial customers. On the flipside, banks that focus primarily on mortgages, will have an added risk lending to commercial customers, if they don’t have the experience and track record of commercial lending.
As I stated before, the risk of a certain type of loan, without in regards to the type of lender lending the loan, can and will always be argued. Furthermore, the blatant question of; what is the least risky loan, is a loaded question. When evaluating banks, I believe the best way to measure the risk of a loan is to find out historically how well each type of loan that bank has lent out, has done.