Exchange Bank: Solid Bank With Exceptional Potential

Exchange Bank (Santa Rosa, CA) (OTCPK:EXSR) is a $3.4 billion community bank serving the region north of the San Francisco Bay area. We’ve previously written about Exchange Bank’s attractive attributes, including its:

• low market valuation (0.85x tangible book value and 5x earnings);
• high loan loss reserves (2.9% of total loans);
• robust dividend yield (5.2%);
• high proportion of non-interest bearing deposits (38.8%);
• low overall cost of deposits (0.06%); and
• highly conservative nature.

The performance of the shares over the last several months, however, has defied our expectations and been downright disappointing. Nonetheless, the significant decline in the share price over the last several months and particularly in the last week in the face of distress in the banking industry, presents an even more compelling opportunity for both income and value-oriented investors.

Indeed, our projections suggest that forward average annual returns for shareholders in coming years could approach or even exceed 20% based solely on the bank’s ability to maintain current operations. This projection does not rely on any herculean assumptions about future operating performance. We arrive at this view – as detailed in this article – based on our assessment of the company’s deposit base, investment securities portfolio, and potential forward operating results, tempered by a perspective on what we would consider to be an unlikely worst-case scenario.

Deposit Withdrawal and Failure Risk

In the current environment one of the first questions about any financial institution is whether the institution would survive in a distressed market environment. In this regard Exchange Bank is well positioned to withstand a loss of confidence in the banking industry. We assess this through consideration of the company’s adjusted deposit composition, portfolio liquidity, and adjusted capital adequacy ratios.

First, we assess the risk of significant deposit withdrawals in the event of a loss of confidence based on the proportion of deposits represented by uninsured deposits which are typically the first to flee. Exchange Bank’s proportion of uninsured deposits to total deposits (as of December 31, 2022) was approximately 32.2% (or $988.5 million) according to the company’s filings with the Federal Financial Institutions Examination Council. The relatively low level of uninsured deposits, versus uninsured deposit ratios of around 50%-65% for typical regional banks and an astounding 86% for the recently failed Silicon Valley Bank, limit the probability of significant withdrawals based on concerns about the financial institution’s financial condition. A key driver of the failure of Silicon Valley Bank (SIVB) was depositors’ concern about the safety of uninsured deposits and the resulting rush for withdrawals.

Second, in the event significant withdrawals, we assess the institution’s ability to meet withdrawals through available liquidity. In this assessment, let’s assume a worst case scenario where confidence is lost and Exchange Bank experiences the withdrawal of all of its uninsured deposits. In this case the bank would need to have sufficient liquidity to meet significant withdrawals (about $1 billion) without impairing its financial condition or capitalization ratios.

Exchange Bank passes this test due to its significant investment security portfolio even before considering the recent Federal Reserve lending facility providing loans against federal government securities at face value. Exchange Bank held $1.57 billion in investment securities at the end of the fiscal year (stated at market value which including $145.6 million in unrealized losses after taxes) comprised primarily of highly liquid federal government and federal government guaranteed securities. In the event Exchange Bank was required to meet significant withdrawals the sale of highly liquid government securities would be more than sufficient to cover withdrawals.

However, we can’t ignore the unrealized losses on investment securities since regulatory capital calculations don’t include the impact of unrealized gains/losses but do incorporate those gains/losses once realized by an institution. In the case of Silicon Valley Bank, while the company reported being well capitalized, this assessment excluded consideration of the company’s significant losses on held-to-maturity investment securities which were not reflected in the company’s financial statements or regulatory capital ratios. Indeed, incorporating those losses would have clearly shown that as far back as the middle of last year Silicon Valley Bank was essentially insolvent with unrealized losses in held-to-maturity securities actually exceeding the company’s reported shareholders’ equity. The bank may have intended to hold those securities until maturity but intent only matters up to the point where the assumptions upon which that intent is based fail to apply.

In any event, Exchange Bank does not hold any held-to-maturity securities. The bank’s unrealized losses on its investment securities portfolio are therefore at least already reflected in the company’s shareholders’ equity and book value calculations via accumulated other comprehensive income. However, how would a forced sale of the company’s investment portfolio and realization of the currently unrealized losses impact the company’s regulatory capitalization ratios which also exclude unrealized gains and losses on investment securities? This assessment is the third component of our assessment of failure risk.

The answer partially depends on what proportion of the investment securities portfolio would need to be sold to meet withdrawals and the magnitude of losses associated with the sold securities. However, for our calculations, let’s assume the rather unlikely scenario that all of the investment securities would need to be sold and the bank would realize all currently unrealized losses.

Exchange Bank would remain well capitalized per current regulatory capitalization standards even in this extreme situation. The realization of all currently unrealized losses on investment securities would reduce the Tier 1 capital ratio (using figures as of December 31, 2022) from 18.3% to 10.8%. In comparison, in order to be considered well capitalized, an institution needs to maintain a ratio of 8.0%. The other regulatory capitalization ratios would also decline by roughly proportional amounts but all would all remain comfortably above the respective minimums for well capitalized institutions even including the additional capital buffer requirements being phased in under Basel III. Indeed, Exchange Bank’s current regulatory capitalization ratios are so high that incorporating unrealized losses merely brings the company’s capital ratios much closer to those of peer institutions.

In reality even the ratios calculated above are too conservative and the actual ratios would be somewhat higher for a couple of reasons. First, the sale of the entire investment securities portfolio to meet the withdrawal of all uninsured deposits would not be necessary since the portfolio fair value exceeds uninsured deposits by about $575 million. Second, the estimates are overly conservative since a portion of the investment securities portfolio ($241.3 million or 15.3% on a fair value basis) is comprised of municipal bonds which carry a regulatory risk category weight of 20% to 50% under Basel III. The sale of these municipal securities would simultaneously reduce risk weighted assets from the denominator of the capital adequacy ratio calculation and boost the capitalization ratios. The exact composition of the municipal bond portfolio is not defined in the bank’s financial statements. However, we estimate a minimum actual Tier 1 capital ratio closer to 11.1% and possibly higher depending on the proportion of revenue bonds to general obligation bonds.

Regardless, while any number of assumptions could be made the critical conclusion is that under all probable scenarios the bank remains well capitalized even after accounting for all unrealized losses on investment securities. The same cannot be said for many financial institutions in the current market environment. Exchange Bank remains even under distressed conditions a highly liquid and well-capitalized institution with minimal, if any, failure risk.

So, if the risk of failure is minimal what is the potential forward return opportunity?

Future Potential

In our assessment of potential future returns we have bracketed the range of outcomes between two scenarios. The base case assumes that the company’s operations are largely unaffected by the current turmoil and no significant changes occur within deposits or the investment portfolio. The second, which we considered a rather improbable worst case scenario, assumes that substantially all of the bank’s uninsured deposits are withdrawn and investment securities must be sold at a loss in order to meet withdrawals. In either case we don’t anticipate any significant change in net interest margin.

In the worst case scenario we estimate that the bank’s annual earnings per share going forward would decline to approximately $11.99 to $13.30 largely due to the loss of interest income associated with the sold securities. The range results from an assumption of which securities within the investment portfolio would be sold and the respective yields on those securities. The calculation also includes a decline in projected earnings regardless of other factors due to the runoff of fee and interest income associated with Paycheck Protection Program (PPP) loans which totaled $2.26 million in 2022.

In comparison, the base case scenario results in projected annual earnings per share going forward in the range of $20.00 to $20.87. The decline in projected earnings from prior years, as above, also reflects the runoff of fee and interest income associated with Paycheck Protection Program (PPP) loans but assumes all other basic operations remain consistent with prior years.

In comparison with the current market price per share of $100 all of these metrics result in attractive price/earnings ratios. However, in order to assess potential forward returns to shareholders we need to take into account the company’s historical market valuation multiples.

Exchange Bank has historically carried a valuation discount to peer institutions in part due to the bank’s ownership structure. The Doyle Trust, a legacy of co-founder Frank Doyle, owns 50.44% of the company’s outstanding shares. In combination with the fact that the bank’s directors/officers serve as two of the trust’s three trustees this effectively means that management controls the company via the trust. The structure essentially ensures that there will never be an acquisition of the company except under the most extraordinary terms (precluding a hostile acquisition) and thus eliminates the potential for the bank to be acquired opportunistically should the market value deviate significantly from the intrinsic value. The valuation discount based on book value has historically been quite wide – ranging as low as 70% at points in time – although the discount recently has been closer to the 80%-90% range.

We therefore separate the projected earnings per share into dividends (which we account for at 100%) and retained earnings (which we account for at 80%-90%) to calculate potential forward returns. In the base case scenario this results in a total annual return to shareholders in the range of $17.00 to $19.30 per share for an annual return of between 17.0% and 19.3% including dividends. In the worst case scenario, in which earnings decline significantly, the potential total annual return to shareholders is still a rather decent 10.6% to 12.5% - reasonably robust given the improbability of this outcome.

However, the significant unrealized losses on investment securities noted earlier presents an additional opportunity for forward thinking investors. Exchange Bank’s investment security portfolio, unlike some institutions recently in the news, has a relatively short mixed duration. A quarter (25.5%) of investment securities are scheduled to mature within the next five years and nearly half (45.2%) within the next ten years. These figures are before considering any principal payments on the $752.9 million portfolio (at fair value) of mortgage-backed securities with no specific maturity date. This maturity schedule means that, if held to maturity, the company will recover approximately $37 million (or $27 million after tax) in unrealized losses over the next five years and approximately $100 million (or $75 million after tax) over the next ten years simply through maturities even if interest rates continue to move higher in the interim.

The reversal of unrealized losses will not flow through the bank’s income statement but will further boost shareholders’ equity on the balance sheet due to declining losses recorded in accumulated other comprehensive income. The result, again assuming the market only values Exchange Bank’s shareholders’ equity at 80% to 90% of book value, is a boost to the previously calculated potential returns of an additional $2.50 to $4.00 per year. The timing of these reversals is obviously uncertain and could be quite volatile but, if incorporated into the base case scenario, could boost average annual forward returns as high as 19.5% to 22.3% annually for at least the next few years. Moreover, assuming interest rates remain stable or continue to move higher, the bank will be able to reinvest the proceeds from maturities at higher interest rates further boosting net interest income and net earnings potential on the margin.

The risk does exist that the market could discount the company’s shareholders’ equity below 80%. The outcome would be lower projected returns but even then, under the base case, forward returns would still exceed 15% - a relatively high potential return given the exceptionally limited apparent business risk.

Conclusion

Exchange Bank’s market performance over the last several months has not been consistent with our view of its underlying value. The significant recent decline in the face of uncertainty across the banking industry presents an exceptionally compelling opportunity in a solid financial institution for patient income and value-oriented investors. The nature of the bank and its ownership may dampen to some degree future returns but given the magnitude of the current discount it’s difficult to develop a reasonably likely scenario under which the company’s shares do not outperform in coming years simply by continuing on its current operational trajectory.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.