Popular: AOCI Is Eating Up Equity

Popular, Inc. (NASDAQ:BPOP) is the largest banking institution in terms of both assets and deposits in Puerto Rico. It is also among the top 50 banks in the United States by assets. Since the release of Q3 2023, Popular has seen a positive market reaction, experiencing a price-per-share increase of about 10 percent despite the recent decline in the S&P 500.

Overall, profitability is still down, but loans continue to increase as do unrealized losses.

Financial highlights Q3 2023

Net income was $137 million, $14 million less than the previous quarter. At the same time, net interest margin was 3.07%, down 7 basis points from the previous quarter.

From an earnings point of view Q3 2023 was not so positive when compared to Popular's past results, in any case, the market was already discounting such a scenario after the banking crisis that arose in early 2023. EPS estimates were so low that it only took a little to beat them.

The main problem remains the same, which is that money market rates are very high and do not incentivize depositors to accept a low yield. In fact, the average cost of deposits continues to rise and reached 1.84 percent, 27 basis points higher than the previous quarter.

Comparing the increase in the yield on loans and the increase in the cost of deposits, we can see that there is a divergence from last year. The former increased by 85 basis points and the latter increased by 146 basis points: almost double. So, not surprisingly, the net interest margin has been steadily declining and has gone from 3.71 percent to 3.24 percent. Total loans increased by $998 million from the previous quarter.

In any case, while loans have increased their yield slightly, their quality has increased. Since Q3 2021 NPLs are becoming less and less important, and this is positive.

Regarding total deposits, there was a decrease of $667 million from the previous quarter mainly due to the Puerto Rico public sector: the latter has deposits with Popular of $17.80 billion. Overall this is a significant decrease but I do not think there is any cause for alarm.

This is a decrease in line with historical trends, therefore expected by management. In fact, public deposits have remained even higher than originally forecast: the new estimates for the end of 2023 are between $16-$18 billion, the previous ones between $14-$16 billion.

Excluding Puerto Rico's public deposits, the group's customer deposit balances increased by $46 million, mainly due to an increase in time and savings deposits.

Finally, non-interest bearing deposits remained stable at 24 percent while interest-bearing deposits experienced a higher cost than the previous quarter, however, this increase differs by customer. Public deposits have adjusted quickly to the Fed Funds Rate since the beginning, while retail and commercial deposits have a significantly lower cost. In addition, a clear cost difference is visible between Puerto Rican and U.S. retail/commercial customers: the former has a considerably lower cumulative beta than the latter. Thus, the major increase in the cost of deposits is mainly due to U.S. customers.

Securities portfolio and AOCI

Popular's LTD ratio is only 54 percent, which means that deposits largely cover loans. At first glance this is synonymous with a more flexible financial structure, however, one needs to understand where the remaining deposits have been allocated. In fact, Popular has a huge securities portfolio.

Money market and investment securities are worth $36 billion, about 48 percent of earning assets: that is why the LTD ratio is so low.

Over the years, management has used the growing cash from deposits to invest it in fixed-rate, mainly risk-free securities. The point is that risk-free securities are not risk-free in general; in fact, rate risk is still present. As interest rates rose, the Fed triggered huge unrealized losses on Popular's balance sheet, as fixed-rate securities suffered large write-downs.

Compared to last quarter, considering both AFS and HTM securities, unrealized losses increased by $186 million, reaching $2.56 billion. This is a huge figure and represents just over one-third of equity. Until the securities are sold the losses will not be realized, but we cannot know if Popular will be able to carry such a large amount of securities to maturity. The banking industry is often unpredictable, and it only takes a little to wreak havoc. After all, we noticed this at the beginning of the year with the sudden SVB failure.

According to CFO Carlos Vazquez's estimates, by the end of 2024 - assuming no change in rates - AOCI will be reduced by about a third and will bring oxygen to Popular's balance sheet. In the next 3 years, about 64 percent of bonds will mature, but agency MBS/CMOs will remain a problem since their average maturity is 7.5 years. In short, it will take years before the problem fully resolves, unless the Fed unexpectedly lowers interest rates.

All this is obviously having a major bearing on the tangible book value per share, now at $50.20 and far from the $64.69 of December 2021. In any case, despite this sharp decline, Popular's price per share has not plummeted dramatically since the 2021 high, a signal that the market has confidence in the process of recovering unrealized losses. Indeed, if recovered, that $2.56 billion would radically change the valuation of this bank.

Be that as it may, even if written down, these securities generate significant cash inflows. Each quarter Popular gets $1 billion in interest and maturities, and this money will be reinvested to make new loans at current market rates. For the time being, this remains the preferred way to allocate capital inflows.

It's about $1 billion a quarter still that matures in the bond portfolio. And I think, this quarter is a nice example where we did everything you mentioned essentially because we mostly funded loan growth, which is our preference. And then some of the cash also went to repayment of the senior notes. Now we don't have an immense amount of high-cost debt in our balance sheet. So that option is not huge. But the preference would be to fund client activity to the extent we can, and hopefully, the demand will be there for that to occur.

CFO Carlos Vazquez

Second, should demand not be sufficient, cash inflows could be used to pay down debt or reinvested in Treasury Bills since they yield more than 5 percent today.

Finally, Popular fully complies with minimum capital requirements. CET1 of 16.80% is above average, but it should be remembered that this ratio does not take into account unrealized losses and is affected by the huge amount of risk-free assets on the balance sheet. From a prudent perspective, Popular must necessarily keep CET1 high.