Description

Franklin Bank Corporation of Texas (FBTX) is a highly levered Texas thrift with a national mortgage and construction loan portfolio that has demonstrated fairly serious deterioration. The recent bounce provides an excellent entry point, as I think there is a strong to quite strong chance they go bankrupt.

FBTX has $5.5B in tangible assets and roughly $100M in tangible common equity, translating to a very highly levered TCE/TA ratio of 1.8%--about 1/3 to ¼ of most bank peers—I can’t believe the regulators haven’t forced them to raise capital already, although I think that will happen shortly. Below is a quick snapshot of FBTX’s balance sheet, which includes nearly $1.3B in builder lines (national construction portfolio with around 40% in Texas) and over $2B in single family mortgages (also nationally originated, it has $3M in non-performing loans and over $50M delinquent loans, indicating that they do carry some risk despite management’s claims): 

After recently announcing a large charge on November 26 (see below), FBTX still has only $37M in loan loss reserves (0.87% of loans) which is far too low, particularly given the high leverage and deteriorating asset quality. FBTX currently has about $70M in non-performing assets (NPAs), equal to 1.45% of assets, 80% of tangible equity, and more than two times its reserves. Additionally, it has $57.4 million of loans that were four payments or more delinquent and still accruing interest, mostly single family loans. I don’t think it would be unreasonable for the regulators to insist that FBTX boost reserves by another $40M, which would cost $1.60 per share pre-tax, and raise more capital, possibly doubling or tripling the share count.

Recent Charge

On November 26, FBTX announced it would be taking a large $20M loan loss provision charge for Q4 ($13.5M after tax). FBTX also disclosed that it failed to properly classify $13.5M in loans as “troubled debt restructurings” in its Q3/10Q, which will subsequently be included in the NPA total. (That is how I estimate $70M in NPAs versus the $55M that they reported at the end of Q3.) The company also disclosed that two of its developers recently declared bankruptcy. The $20M charge will likely drop FBTX’s tangible common equity from $106M at the end of Q3/07 to somewhere near $100M for Q4/07.

Management claims this charge will clean the slate and that it will be back to normal for 2008 and that earnings will return to $0.25-0.30 per quarter. I disagree and believe the regulators will force them to take more charges and raise capital.

Management

Management honesty is questionable. The misclassification of the troubled debt restructurings is a perfect example of this. They also insist on including its intangible MSRs when it calculates “common tangible book value” ($5.15 as of Q3/07 according to the press release) and insist on including preferred equity when it calculates “tangible equity to tangible assets” which while technically correct is not standard industry practice—at least in my book. They have also been evasive on the conference calls, in particular on questions about its construction portfolio. For example, when asked about the Tampa/Orlando market on the Q3/07 call, management said they were somewhat upbeat because they saw “inventories declining.” That differs slightly from Robert Toll’s recent “F-minus-minus” evaluation of the Tampa housing market. FBTX’s chairman is Lewis Raneiri of Liar’s Poker fame, but he wasn’t actively involved until recently—he hosted the call following the November 26th announcement. He and management previously sold the large Texas-based thrift, Bank United, to Washington Mutual in 2001, a deal that has been something of a disaster for WaMu. They were trying to follow the same playbook for FBTX, but I think any would-be acquirer will be far more skeptical given how much trouble WaMu has had with Bank United.

Valuation and Recent Stock Performance

In the last three weeks, FBTX has spiked up from its December 4th intraday low of $3.88, surged to an intraday high of $6.50 on December 11th (short squeeze) and has subsequently fallen to $5.33. Its current market cap is $134M ($4 per share), putting it at 1.3 times current tangible book, which seems very generous. If you consider that the regulators might force them to add to reserves (another $35M would cost $1 per share) and raise capital—they might be forced to raise $150M at $3.00 per share which would triple the share count from 25M to 75M—common tangible book value per share could drop to below $3, which is where I think the stock would settle, translating to a decline of over 40% from the current share price. Or the leverage and deteriorating asset quality soon causes a funding crisis and FBTX goes to zero.

Catalyst