Texas Capital Bancshares: AOCI Weighs Too Heavily On Equity

Since the release of Q3 2023 Texas Capital (NASDAQ:TCBI) has suffered a fairly significant decline albeit still well above the $43 per share reached during the panic moment triggered by the SVB bankruptcy.

Overall, the quarterly cannot be considered negative from an earnings perspective, in fact, both EPS and revenues beat estimates by $0.17 and $9.12 million respectively. In my opinion, however, the market primarily did not like the unrealized losses, which rose to nearly 20 percent of equity.

Q3 2023 highlights

Before talking about the main topic, I would like to show you what Texas Capital achieved in terms of income in Q3 2023.

Net interest income was $232.10 million, almost unchanged from the previous quarter, denoting a stalemate in terms of growth. This situation has actually lasted since Q3 2022, practically since the Fed began aggressively raising interest rates.

The net interest margin fell 16 basis points from the previous quarter but remains firmly above 3 percent. This is not an exciting result since the industry average is 3.27 percent, but the market was already discounting a similar scenario.

What weighs negatively on the net interest margin is the composition of deposits, which has changed extremely over the course of a year. The best deposits for a bank are the non-interest-bearing ones, but for Texas Capital, they also represent the most declining ones: from Q3 2022 to Q3 2023 they declined by as much as $2.80 billion.

Since the bank needed to replace this liquidity, non-interest-bearing deposits were replaced by interest-bearing ones: the result is that the cost of total deposits increased significantly. In general, this is a problem that affects all banks since money market rates are too high not to offer full-bodied interest on customer deposits.

In a single year, the cost of interest-bearing deposits has risen 268 basis points and are 103 basis points distant from the upper band of the Fed Funds Rate. Also, from the chart above, it can be seen that the rise in these costs has been explosive for Texas Capital. Basically, in 6 months there has been an increase of 184 basis points. This is why this bank has been stalling for so long in terms of revenue growth: the cost of deposits has been rising too fast. For other banks, this process has been more gradual, or, the yield on assets has been able to offset this downside.

In the case of Texas Capital this has not been possible, partly because since rates have been high, the bank has been struggling to increase its loan portfolio.

Finally, the bank's exposure to rate risk has varied significantly. In the event of an upward shock, net interest income is expected to rise more than in the previous quarter, but in the event of a decline, it is the exact opposite. Management's choice is supportable, not least because a further increase is more likely today than a decline.

AOCI continues to increase

Rising interest rates are creating quite a few problems for the financial system, which is no longer used to an environment where money market rates yield 5 percent. In previous years Texas Capital has purchased a significant amount of fixed-rate securities, but these securities today have suffered large devaluations due to the Fed's restrictive monetary policy.

Since these securities are experiencing unrealized losses, they must be accounted for in accumulated other comprehensive income (AOCI), a reserve that negatively impacts equity.

For a bank, equity is the most important component, as it must meet minimum criteria subjected by the Basel Accords, as well as being the key element in calculating fair value.

In the case of Texas Capital for the moment CET1 is still quite high, but if these losses reach too high a level the bank may need liquidity in order to increase CET1.

On the other hand, unrealized losses also affect Tangible Book Value per share, which has been stalled since Q1 2023. This indicator is critical in calculating the intrinsic value of a bank, and if it does not show growth, consequently we cannot expect Texas Capital's price per share to increase.

As of the end of September, AOCI weighs -$505.90 million in equity, almost 20 percent. This figure was improving at the beginning of the year when T-bond rates were declining, but it has been a few months since the trend reversed. Moreover, just in the last few days, long-term Treasury bond rates have surged, leading the TLT (TLT) to reach a low it has not touched in almost two decades. This movement is not discounted in the figure obtained in this quarterly report, and if the trend continues, I would not be surprised if unrealized losses increase in Q4 2023.

Texas Capital predicts that should the Fed Funds Rate be reduced by 100 basis points it would improve AOCI by $150 million, but this breath of fresh air may not come soon. The Fed remains committed to its restrictive monetary policy and has never hinted that there will be even the slightest downturn in the coming months. In fact, there may be the last uptick as the labor market remains very resilient.

Finally, I would like to point out that this bank does not issue dividends, so it has the ability to retain in percentage terms a larger measure of earnings, yet it is not enough to offset the negative effect of unrealized losses. In Q3 2023 tangible book value per share fell by $0.12 despite retained earnings increasing by $57.40 million. This is because unrealized losses increased by $65.60 million. As of today, AOCI per share is $10.54, almost one-fifth of the current price.

Conclusion

Texas Capital has been struggling to improve its net interest income for about 1 year now, in fact, the cost of deposits has been rising fast and the loan portfolio has not been able to offset this increase.

In any case, I think the main problem is about unrealized losses, especially considering how fast T-bond yields have risen in recent days. Expecting rates at 6 percent is no longer a utopia, and this would make the situation even worse. Be that as it may, as long as the bank is not selling at a loss, there is no tangible problem; but if it needs liquidity urgently, the matter changes. The banking sector is extremely dynamic, and banks sometimes have to react very quickly to sudden shocks, such as what happened at the beginning of the year. In this case, since the Fed will keep rates high, Texas Capital's main ally is time: once the securities portfolio tends toward maturity the unrealized losses will gradually become less. But it will take a while: the duration of the securities portfolio is 4.4 years.