Puking out HIFS after the nibbling (re-thinking HIFS)

‘Banking is a very good business, unless you do dumb things‘.  It almost seems HIFS did a dumb thing.

This is not investment advice. Please read the disclaimer. I might own discussed stock(s) currently or at a later time. I might transact in any securities at any time.

I recently bought a small stake in HIFS, a perceived high-quality bank with a bunch of patterns I like at a rather low P/B. I bought a small position since there are obvious risks in the banking industry currently. The asset side, ie loan quality, seems good and loan losses should be low once again. But:
• Adjusting the reported equity value (386m) for the difference between carrying and fair value of loans (141m or 4% of loans net) the adjusted equity is 245m and adj BVPS $114. Thus, I bought my shares at an adjusted 2x BVPS (225/114).
• Fair value loans should result in a ‘fair’ forward return, alas current market rates plus credit spreads as of the reporting date (Dec’22). These fair forward returns are rather good if funding costs remain way below ‘fair’ market rates, and thus at ‘unfairly’ low rates. But, if funding costs stay low is debatable. No adjustment for funding is a bit ‘unfair’ as well.
• Rising interest rates impair loans FV and adj EQ further.

Un-adjustable adjustable loans are a costly problem besides fixed loans and will be painful. Since loan volumes grew strongly over the last years, and most importantly over the last five and two years, we can assume a relatively big volume of net loans outstanding is within the inital fixed-rate period (think ITM option for customers, whereas in recent years past the floor rates was an ITM option for HIFS). Thus, I guess the next few year will be painful.
• Most assets are commercial mortgages (2,974m), and most ‘commercial real estate loans generally have […] an initial fixed rate period’ which ‘is generally five years’ and longer for some loans.
• In a few year the initial fixed-rate periods will run off and adjustments set in, based on whatever index rates may prevail then. Until then, profitability might just disappear.
• The interest rates over the different maturity buckets for adjustable loans barely moved up comparing Dec’21 to Dec’22.

New business volumes might be depressed for some time. Loans with higher rates based on todays rates, might be low, and only pick up in a few years, and would probabaly have to be funded with expensive money. So not accounting for new business might not be extremely off.

Near term seems painful/unprofitable and looking a few years out seems difficult. My opening section was about buying a great business when (short term) issues arise. It seems the business is not that great but mostly appeared so based on cheap short term funding which produced great results (high ROEs) in the prevailing environment. The environment was mostly low rates or at least, and more importantly not, strongly rising rates and/or inverse curves. Like today! I presented HIFS as a bet on normalizing yields but it seems worse than I realized.
• Funding mix shifted to more expensive wholesale deposits and borrowings compared to retail and commercial deposits to fund strong loan growth (with all the negatives attached)
• These funding sources are more expensive and should be much more sensitive to offered interest rates.
• Since most retail deposits probabaly come from affluent or wealthy customer they might also be more sensitive to interest rates (why bother if you have $100 at your bank. Actually a disadvantage to the likes of CZBS)
• Presentations from HIFS include the Buffett quote ‘Banking is a very good business, unless you do dumb things’. It almost seems that HIFS did things apparently not exactly smart today.

Trying to look a few year ahead seems difficult. But one simple scenraio I think of here is they do not earn any money for the next 2 years during a mild recession resulting in lower interest rates and a normalized yield curve with almost no credit losses (overall a rather good outcome). After that it is back to ‘normal’ or at least HIFS is again earning good ROEs and is ‘fairly’ valued at 1.5-1.75x P/B. Returns would not be bad but not great either for risks involved here, I guess.

How might next year roughly look like? Annualized Q4 diluted core net income per share ($4.42) comes out at $17,68 for an earnings yield of 7.5% and ROE of 10%. I deem this as likely too favorable and more realistic scenarios might be, depending on when most of the 1yr deposits and FHLB borrowings mature, repricing, etc. …
• Almost 7% ROE if the <1yr deposits do not reprice, and I assume no fee income, 22m OpEx and 25% tax.
• About 3.6% ROE if they reprice for 3.5% and maybe worse.
• A positive scenario would be many customers flocking to HIFS due to the double deposit insurance and accepting very low interest rates for their money on top. But how likely is that?

Certainly there is a high chance that I will look back in a few weeks, months, or years time and think why did I sell? Thiking this would have been a nice trade and regretting my sell decision. A way forward would also be waiting for Q1 results. But I did not feel comfortable holding HIFS here. I should have looked more at the interplay between assets and liabilties and less on historically strong profitability. Of course, there is a real chance that I am doing the dumb thing here (selling) instead of HIFS managment, speculating on (prevailing) low interest rates. Who knows, how quick we will see zero interest rates once more. Personally, I think our politicians got to know zero interest rates and ever more debt as a standard tool, esp. in Europe.

Nibbling at and puking-out HIFS. I sold my small position for a tiny gain on March 23.

(I read and highlighted the below but focused primarily on other topics initially)

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