It's a Wonderful Buy: Peter Lynch on Savings and Loans
Book: Beating the Street by Peter Lynch with John Rothchild | ISBN: 978-0-671-75915-5
Mention savings and loans in the early 1990s and people grabbed their wallets. The $500 billion bailout. 675 bankrupt institutions. 10,000 fraud cases pending with the FBI. The word “thrift” used to remind people of Jimmy Stewart in It’s a Wonderful Life. Now it reminded them of Charles Keating in handcuffs.
Peter Lynch saw the same headlines. And then he went out and bought S&L stocks. Seven of them, actually, for his Barron’s recommendations.
Here’s why: while the media focused on the crooks and the failures, more than 100 S&Ls were financially stronger than J.P. Morgan, the most respected bank in the country. People’s Savings Financial in New Britain, Connecticut had an equity-to-assets ratio of 12.5. J.P. Morgan’s was 5.17.
The good S&Ls were being punished for the sins of the bad ones. And that created a buying opportunity.
Three Types of S&L Operators
Lynch breaks the entire S&L industry into three categories. Understanding this is the key to everything that follows.
The bad guys. These were the con artists. The scheme was simple. A group of people would put up $1 million to buy an S&L. With that million in equity, they could take in $19 million in deposits (backed by government insurance) and make $20 million in loans. They’d lend to friends, relatives, and associates for dubious construction projects. The up-front fees got recorded as “profits,” which boosted equity, which let them make even more loans. The system fed on itself until the money ran out. This is how tiny S&Ls like Vernon in Texas became billion-dollar operations. And yes, there were Lear Jets and parties with elephants.
The greedy guys. You didn’t have to be a criminal to sink an S&L. You just had to be envious. The directors at First Backwater Savings would watch their competitors getting rich on commercial loans. They’d hire a Wall Street consultant (Lynch calls him “Mr. Suspenders”) who’d tell them to borrow as much as the rules allowed and jump into commercial real estate. Then the recession hit, the developers defaulted, and 50 years of accumulated net worth evaporated in less than 5.
The Jimmy Stewarts. These are the ones Lynch loves. Honest community bankers making old-fashioned residential mortgage loans. They take in deposits from the neighborhood. They don’t build Greek temples for their main offices or hire expensive consultants. Travel posters on the walls are fine.
A money-center bank like Citicorp spent 2.5 to 3 percentage points of its loan portfolio just on overhead. A Jimmy Stewart S&L could break even on a spread of just 1.5 percent. It could theoretically make money without issuing a single mortgage, just by investing deposits in Treasury bonds.
The model for all Jimmy Stewart S&Ls was Golden West in California, run by Herb and Marion Sandler. They had “the equanimity of Ozzie and Harriet and the smarts of Warren Buffett.” No automated teller machines. No toaster ovens for new depositors. No construction loans. Residential mortgages made up 96 percent of the portfolio. At their headquarters in a lower-rent Oakland district, visitors announced themselves by picking up a black telephone.
How to Rate an S&L
Lynch devised his own scorecard. Here’s what matters.
Equity-to-assets ratio. The single most important number. It measures financial strength and survivability. An E/A below 5 is the danger zone. Average is 5.5 to 6. Lynch won’t invest unless the E/A is at least 7.5. Some Jimmy Stewarts have E/A ratios of 15 or 20.
Book value. Since most of an S&L’s assets are loans, and most of a Jimmy Stewart’s loans are residential mortgages, the book value tends to be reliable. Many of the best S&Ls were selling well below book value when Lynch was buying.
Price-earnings ratio. Some S&Ls with 15 percent annual growth had p/e ratios of 7 or 8. That’s incredible when the S&P 500 was trading at a p/e of 23.
High-risk real-estate assets. This means commercial and construction loans. When these exceed 5 to 10 percent of total assets, Lynch gets nervous. The safest approach is to avoid S&Ls that make these kinds of loans at all.
Nonperforming assets (90-day delinquent). Loans that have already defaulted. You want this below 2 percent. If it’s rising, that’s a bad sign. A couple of extra percentage points of bad loans can wipe out an S&L’s entire equity.
Real estate owned (REO). Property the S&L has foreclosed on. This reflects yesterday’s problems since the losses have already been written off. But if REO is increasing, it means the S&L keeps repossessing properties it can’t sell.
The Setup Nobody Noticed
When Lynch was doing this research, Wall Street had almost completely stopped paying attention to S&Ls. Fidelity’s Select S&L Fund had shrunk from $66 million to $3 million. Brokerage houses cut analyst coverage. At Fidelity, one of the two S&L analysts left for grad school and wasn’t replaced. The other got assigned to cover GE and Westinghouse on the side.
Nearly 50 analysts tracked Wal-Mart. Only a handful followed the entire S&L sector. Lynch says:
When even the analysts are bored, it’s time to start buying.
Lynch spent his evenings reading The Thrift Digest, a phone-book-sized publication from SNL Securities that cost $700 a year. His wife started calling it “the Old Testament.” He made a scorecard of 145 of the strongest institutions, checking every column.
His final picks were five strong Jimmy Stewart types and two long shots he called “born-agains.” The Jimmy Stewarts scored well on every metric. Four of five sold below book value. All had equity-to-assets of 6.0 or better. Low delinquencies. Minimal real estate owned. Single-digit p/e ratios.
The born-agains were risky. Terrible numbers in some areas. But they still had high equity-to-assets ratios, giving them a cushion to work through their problems. Their stock prices had dropped so far that if they survived, the upside was enormous.
The Takeover Angle
Lynch saw another reason to own strong S&Ls. Commercial banks coveted them. An S&L with excess equity, excess lending capacity, and a loyal deposit base was a prize. Banks could take in deposits only in their home states, but they could lend anywhere. Buying an S&L with cheap deposits gave a bank raw material for profitable lending anywhere in the country.
Between 1987 and 1990, more than 100 S&Ls were acquired by bigger institutions. Lynch expected that trend to continue. The U.S. had over 7,000 banks and thrifts. That was about 6,500 too many. Consolidation was inevitable. And shareholders of the strong little S&Ls would get bought out at premium prices.
His favorite example: Home Port Bancorp of Nantucket, Massachusetts. A 20 percent equity-to-assets ratio. Captive island market. Crusty New England depositors who weren’t going anywhere. Possibly the strongest financial institution in the modern world. And almost nobody on Wall Street had heard of it.
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