Andres Sandate: 

Welcome everybody to another edition of the Asset Backed podcast. I’m your host, Andrei Sundate. I am excited to bring back a former client and, and also, an expert in financials, Derek Pilecki, the founder, CEO, and portfolio manager of Gator Capital Management based in Tampa, Florida, is my guest today on Asset Backed. Welcome, Derek, to the Asset Backed podcast.

Derek Pilecki: 

Thanks, Andres. Great to see you.

Andres Sandate: 

Yeah. It’s great to see you. It was good to catch up offline. I’m glad to hear that, the kids are going gangbusters like mine. Today is the official start of summer for me here in Atlanta.

Andres Sandate: 

So, hopefully, nobody will jump up here, with a surprise and interrupt our show. But, I’m I’m glad to hear that that you and the family are doing well, and, I can’t wait to hear, you know, more about what’s going on at Gator. Before we, talk about financials and and I know we’re gonna spend a lot of time today talking about banks and what’s going on, in, you know, the boardrooms at banks with, respect to the interest rate environment. Tell us a little bit about your backstory.

Derek Pilecki: 

Yeah. So, I mean, I I’ve been running my firm for 16 years. It’ll be 16 years next month. And, you know, prior to starting my firm, I worked at Fannie Mae, the the big mortgage giant, you know, the hated mortgage giant.

Andres Sandate: 

Yeah.

Derek Pilecki: 

You know, back in the nineties, it was one of the smart companies. I worked in their mortgage portfolio doing interest rate risk analysis. And so it was a great first job in finance. You know, they’re long mortgage backed securities and CMOs and short agency debt, including a ton of structured notes. And so I got to learn about almost every type of fixed income instrument.

Derek Pilecki: 

And so that was great. And I went back to business school to make the transition to equity research and came out covering financial companies, worked for a couple small value oriented investment firms, and then was recruited to GSAM and work for their growth team. So I covered financials for Goldman’s growth team for 5 years before launching my fund.

Andres Sandate: 

Yeah. And, you know, financials for many people, who are not in the financial world day in, day out, like like you and I, it’s, like, you know, complicated. Why is it so complicated? So many acronyms. I wanna ask you some fundamental basic questions about what attracted you to financials with the complexity and with a lot of, you know, a lot of the things that attract people to the investment industry and asset management.

Andres Sandate: 

But then within that, financials could be even more complex. You just talked about agency, CMOs, etcetera, working at Fannie Mae and understanding all the fixed income products and strategies. What what what is it about, financials, that got you excited, you know, if you go all the way back to, you know, your days right out of Duke?

Derek Pilecki: 

Yeah. I mean, I I am just attracted to the the business models within financials. I think there’s a variety of business models. You know, a capital markets firm versus an asset manager, an insurance company, banks, they all have different business models, different income statements, and I just find it’s find it fascinating. You know, growing up, my dad would work for the Federal Reserve.

Derek Pilecki: 

He was a bank examiner for the Philly Fed, and they put him through law school. We moved to DC, and he worked as an attorney for the board of governors of the Federal Reserve. And so, you know, the dinner table conversation was always kinda around banking. So it was kind of a natural thing for me to, you know, not be scared away from banks. Right?

Derek Pilecki: 

You know, we talked about bank regulation and bank mergers. And and I remember when I was in college, we went through the SNL crisis. And by that time, he was in private practice and just the some of the stories of the of what was going on with banks and what made a good banker, you know, just really attracted me to the industry.

Andres Sandate: 

Yeah. So sort of like being being the coach’s, son or daughter. Right? You just sort of grow up around the game and and you you you sort of are exposed to it. And and I I can completely think back to that first time we met in Nashville, Tennessee, at an industry event, and, you know, you stood up and talked about your strategy.

Andres Sandate: 

And at the time, I was coming out of working, in banking myself, at SunTrust and Regions for 4 or 5 years and was starting in the industry. And I thought that’s somebody that I need to go meet and talk to. And then lo and behold, we worked together for a few years, and, I’m just excited to have you back, on the show or on the show to talk about this 15 plus year run you’ve had with your firm, Gator Capital Management. But but, you know, more selfishly with the asset backed podcast, I’d love to ask you, you know, about just the health of the overall financial sector. And I know banks is not the only thing that you do at your firm in terms of of research, but it certainly has has had, you know, bigger parts of the portfolio over time.

Andres Sandate: 

So let’s start there. Let’s let’s talk about, let’s talk about banks, because it is, you know, top of the news channel, makes the headlines. But there’s 2 narratives. Yeah. There’s 2 narratives.

Andres Sandate: 

There’s there’s the main street narrative of bad office loans and, you know, credit risk, and then there’s maybe a second narrative that isn’t often talked about. What is often missed when people think about banks?

Derek Pilecki: 

Yeah. I mean, I think banks are still recovering from the regional bank crisis of last year. Right? I mean, we we just had this huge shock to the system of, the the 3 big bank failures in last March. And what we’re still dealing with is the interest rate risk that these banks still have.

Derek Pilecki: 

That, you know, there’s they made a ton of fixed rate loans and bought a ton of low coupon securities during the 2021, 22 time frame, and those those loans and securities are sticking on the books for a long time. You know, we all know talk about people with low coupon mortgages. You know, they’re not gonna leave their house. They’re not gonna prepay that mortgage. Then you you have a 3% mortgage.

Derek Pilecki: 

You’re not gonna leave your house. So the banks are stuck. A lot of banks are stuck holding that paper. And so I really think that, you know, when people talk about you know, bank stock investors are most focused on interest rate risk right now because we’re all concerned about credit risk. Right?

Derek Pilecki: 

I mean, it’s topical. It’s obvious. We hear about the the office buildings that are vacant and that are going to foreclosure auction for 83% discount to the previous sale. That’s all happening. Right?

Derek Pilecki: 

So a lot of those buildings are in commercial mortgage backed securities or owned by foreign or, you know, lent against by foreign banks. The the credit metrics for the regional banks aren’t that bad right now. Like, they they’ve improved their disclosure. They show us what their office loans look like, what their multifamily loans look like. It’s not a huge problem currently.

Derek Pilecki: 

It could become a problem later this year or next year. I think the the central issue right now is interest rate risk. There’s a bunch of banks that have too many mortgage backed securities, too many fixed rate loans. And with the competitive deposit environment, they’re really getting squeezed. And they’re just sitting there waiting for these loans and securities mature, and it’s gonna take a long time.

Derek Pilecki: 

And so I think that’s the real issue when we we look at these net interest margins that have compressed, how long will it take to rebound? I think it’s gonna be a while. So I think that’s the thing that, you know, investors generalist investors aren’t really as focused on or compared to the credit risk.

Andres Sandate: 

Yeah. So when when you when you talk about a a bank investor versus, maybe just a general equity investor,

Derek Pilecki: 

If you

Andres Sandate: 

look at the bank sector, you talked about how there is a really competitive environment for deposits, and that net interest margin is compressed. And so where are banks that you are looking at and saying there’s a constructive, set of activities happening at these institutions versus maybe another subset. What are you seeing? What are the things that, I I don’t wanna call them growth banks, but more attractive from the standpoint of, their balance sheet, their fundamentals.

Derek Pilecki: 

Yeah. I mean, I think there are some bankers who wisely did not load up their balance sheet with mortgage backed securities during the pandemic. So right during the pandemic, there was huge deposit flows. You know, quantitative easing just flooded the system with liquidity. The bank saw a huge deposit growth, like way above trend deposit growth.

Derek Pilecki: 

And it was a question of what did the bankers do with all that excess liquidity. A lot of them just invested in mortgage rec securities like Silicon Valley. But, you know, other solid banks did too. Like Glacier Bancorp in in Montana, great franchise. They saw a flood of liquidity, and they bought mortgage backed securities.

Derek Pilecki: 

They’re not the only bank like that. There’s a lot of banks who just took that exit excess liquidity and invested it out the yield curve. And but there are some bankers who didn’t do that. And those bankers who didn’t do it are in the catbird’s seat. There’s the spreads of widened on loans.

Derek Pilecki: 

They can can continue to grow at these wider spreads at these higher rates, and they can continue growing. And so it’s a small subset of these banks that you wisely sub sidestep the the low interest rates, and now they’re in a very good position to continue lending. What they need is a little bit more loan growth or loan demand. You know, loan growth demand is really down because obviously, real estate investors aren’t buying new buildings now or new properties because the the numbers don’t pencil with high interest rates. But there are there is some loan demand out there.

Derek Pilecki: 

And these these bankers who sub side stepped low interest rates are able to take advantage of it.

Andres Sandate: 

Yeah. I there’s a lot of, themes that I wanna sort of talk about. 1 one, selfishly because of the show, the asset backed show, you know, we are, we are constantly, trying to sort of understand this narrative around the growing asset backed finance market. Right? It should be everything from student loans, aircraft loans, all the way to mortgages and auto.

Andres Sandate: 

And, and I wanna talk about, that. But before we do that, I wanna ask you back back to banks for a second. When when you look back at the career you’ve had of of looking at banks and and getting to know bank management teams and understanding, you know, the the characteristics and the qualities as a as a you know, I don’t wanna say you’re a value investor, but certainly trained at Chicago and trained at some of these organizations, that you that you, that you came up in. When you look at banks and you say, okay. Finding loan growth, competing for deposits, what are some of the different levers?

Andres Sandate: 

Because when you look at 5, 6000 banks, how many do we have in the US? It is such a different just playing field than, say, Europe, right, where there just aren’t as many banks. And I always ask the question to bank investors, do we have too many banks? But but what are the levers that these management teams can pull in this type of an environment? And as a growth invest you know, as an investor that’s looking for for growth and looking for those sort of proverbial diamonds in the rough, what are the what are the things in those management teams that really stand out?

Derek Pilecki: 

Yeah. I mean, I would say one thing that really stands out is, like, not being distracted. Right? So organic growth is the most valuable growth the bank can have. So and the way you get organic growth is from your existing teams making more loans, hiring, bankers, you know, you can steal bankers from the the bigger the bigger banks or, you know, some of these failed institutions had great client facing bankers.

Derek Pilecki: 

You hire them. And if you’re not distracted, you can make those additions to the team. Where you get distracted is if you have problems in credit, or if you do an m and a transaction. So m and a, although it seems pretty attractive, like, put 2 banks together, cut out a bunch of costs, returns go up, it’s a huge management distraction for a 2 year time frame. And then you can’t really grow organically while you’re in that integration period.

Derek Pilecki: 

And so you’re internally focused, you’re not externally focused. So, you know, I think that’s why when you see deals, even though the accretion on deals is very seems very high, the the stocks don’t react because I think investors just are like, that management team is gonna be distracted for the next 2 years. Like and we you know, it’s gonna be hard to to value the bank. And so I think that distraction, you know, avoiding the the companies that are going through m and a that are potentially distracted is is one thing to to look for.

Andres Sandate: 

Yeah. Let’s let’s, I wanna ask you about, about CRE as well. I know that the popular narrative is, yes, post COVID, you have all these empty office buildings, and, you know, you you you a lot of these, you know, a lot of these mortgages, are are either upside down or you have leases that you’ve restructured. All the leases you can restructure, there’s just less demand, etcetera. What do you see, at the banks that you are following when it comes to CRE?

Derek Pilecki: 

Yeah. I mean, we’re seeing some some stress on the on the office portfolios. But what what we’re seeing generally across the industry, office is about 4% of bank loan portfolios. So not a huge number, like but, you know, significant. And then generally, in a generic bank, of that 4%, about half is somehow related to medical.

Derek Pilecki: 

So, you know, doctor’s offices are in better use than a typical office building. Right? And then Yep. And then you break it down further to then there’s suburban office and then owner occupied office. And so there’s categories you can kinda cleave off to say, okay.

Derek Pilecki: 

Those loans are probably fine. Like, if, you know, a company owns their office building and they have a loan against it, they’re less likely to default rather than an investor owned property. And so we are seeing some issues especially in Chicago. Right? I mean, the there’s Chicago downtown core is really problematic, and we’re seeing across all the gateway cities with long commutes.

Derek Pilecki: 

You know, New York, San Francisco, LA, people just don’t wanna get spend an hour and 15 minutes commuting to an office downtown. To counter that, we’re seeing return to work. Right? I mean, so people companies are saying mandate people’s showing up in the office.

Andres Sandate: 

Mhmm.

Derek Pilecki: 

What they when they do return to work, say, it’s 3 days a week, it’s Tuesday, Wednesday, Thursday. You have everybody there Tuesday, Wednesday, Thursday. You still need the same amount of office space. You it’s not like you can do a hoteling arrangement. Some people show up on Monday Friday if you have everybody there the same day.

Derek Pilecki: 

Now certainly, some back office operations, you won’t mandate to come back to the office. So, like, I think that the natural demand for office has to be lower going forward. New supply is also close to 0, so we have that offsetting a little bit. But, you know, certainly, there’s gonna be problematic issues within the office portfolios. But I don’t at this point, I don’t think it’s gonna be, you know it’s it’s certainly not a capital issue.

Derek Pilecki: 

It might be an earnings issue for 1 or 2 banks occasionally, but we’re coming from such a low level of credit losses in 20, 21, 22 that we’re kinda just normalizing here. So it’s what we’re not clear on is will we got come back to a normalized credit loss ratio and that’ll it’ll stop there, or will it keep going to, a more problem a higher problem level? I would say these things take a long time to play out, and they’re not it’s not going rapidly. So we’re not seeing, like, a sudden surge in in credit losses in the bank portfolios as of right now, but that doesn’t mean we can’t see it as we get in back half of this year or next year.

Andres Sandate: 

Yeah. And and, you know, the the the conversation started with interest rate risk and that being, you know, probably more of a prominent, part of your underwriting and certainly the discussion amongst management teams and boards. I wanna ask you about as as as a as a bank investor, again, it’s not the only thing that you do at Gator. You look at all different parts of the financials from insurance and capital markets and asset managers, etcetera, and even Fintechs. And I wanna talk about some of those other areas.

Andres Sandate: 

But on on on the subject of banks, a couple more questions. You you made the comment in our preshow about this is the first cycle with private credit really having a a seat at the table. And, you know, for the longest time, banks were the only game in town largely. Now you have private credit, asset backed, the podcast. We interview a lot of private credit investors, and you hear different things from different investors.

Andres Sandate: 

You know? Some work a lot with banks, and bank partnerships are really big part depending on the size of the the private credit firm and franchise. But when you think about banks and private credit in the same conversation, what are some of the initial thoughts that come to mind, as you think about where we are in the cycle?

Derek Pilecki: 

Yeah. I mean, I think that whole aspect of having private credit involved this time is is really interesting, especially from a, even a more macroeconomic view. Like, the the worst recessions, like, say, take 9091. That recession was terrible because we had a liquidity crisis amongst the banks, and there was no alternative. The banks just stopped lending.

Derek Pilecki: 

There was nowhere else to get loans. Kinda same thing in the great financial crisis. Right? I mean, it was liquidity crisis. Lack of lending makes a very deep recession as opposed to 0102 where the banks were in pretty good shape.

Derek Pilecki: 

They continued lending through that recession, and it was a pretty shallow recession. So, like, to the extent that banks are pulling back and not making new office loans or CRE loans, and but we have credit private credit stepping in, you know, at a higher price, but still you can still get credit. Will this make, any potential recession we face more shallow? Right? It’s not like you can’t get a loan at all.

Derek Pilecki: 

You can get a loan at the right price. Yeah. And so I see banks working with private credit. I mean, the the regulatory environment, the regulators want the banks to take less risk. Right?

Derek Pilecki: 

And the bankers would rather provide leverage to private credit than make a direct loan themselves. So to the extent that private credit can make the make the commercial, mortgage and then get some financing from a large regional bank. I mean, I think that makes the banking system safer. The private credits taking the first loss risk. They’re, you know, they’re experts taking credit risk, and they’re not beholden to the same regulatory issues that the bankers are.

Derek Pilecki: 

I think that’s a a pretty elegant way for the system the banking system to take on less risk while still funding these projects.

Andres Sandate: 

Yeah. So you you raised, the the the the notion of the regulatory environment, and the regulators want the banks to to to take less risk, which does, if you will, play into the hand, if you will, of of the growing private credit, asset class, and and industry. You’ve seen some gigantic funds raised, and you seem to be, you know, able to pick up almost any paper these days and read about the golden age of private credit, and there’s a insatiable demand for yield. With that said, what you know, you you have a little bit of a regulatory background. Right?

Andres Sandate: 

You you mentioned, you know, your your your dad worked at the Federal Reserve, and I would love to get your perspective on the regulatory environment as it relates to banks. And what is this looking like for them over the next, you know, 3, 4, 5 years? Because I’ve heard from numerous private credit firms that have said, you can’t walk into a bank and get a loan anymore. Now, you know, I I don’t know how much of that’s conjecture, how much of that’s reality. You said, you know, regulators are saying they want banks to take less risk.

Andres Sandate: 

What is what does the reality look like on the ground?

Derek Pilecki: 

Yeah. I mean, I think it’s hard to get loans these days. Like, I think it’s, you know, I think there’s a lot of bankers who are just taking care of their core customers that they’re not looking to expand into new relationships. They’re certainly not looking to add on credit without any deposit relationship, which a lot of real estate investors don’t have deposits. Right?

Derek Pilecki: 

I mean, they’re they just they’re asset rich and cash core. So, you know, I don’t think that bankers are looking to really ramp up their commercial real estate lending at all. And so I think that’s you know, I think there’s a when you think about the banking industry, like, 30 years ago, 30, 40 years ago, every bank looked like JPMorgan. Right? I mean, a commercial mortgage, commercial bank, you know, a little bit investment bank, trust bank, credit card, mortgage, and now regional banks have been shrunk down to they do small business lending and they do CRE.

Derek Pilecki: 

And so when you look at some of the metrics of CRE as a percentage of loans or percentage of capital, there’s a lot of banks that are over their skis on having too much CRE. And I think the regulators wanna bring that down. And, you know, CRE is a risky a risky business. You know, we’ve had pretty clear sailing for a number of years here, and I think regulators I think that they get back to your original question of what’s the regulatory environment. Like, I think the regulators are under a lot of stress.

Derek Pilecki: 

Like, I think those bank failures last year embarrassed the regulators.

Andres Sandate: 

Yeah.

Derek Pilecki: 

And I I think that environment’s gonna persist. Like, the regulators are, they’re, you know, they’re defensive. Right? Like, bank failures are no good. And the way those bank failures went down where it was a pretty obvious risk of interest rate risk, you know, it’s unacceptable.

Derek Pilecki: 

And so I think the bank regulators are under a lot of stress, and I think in turn, the bankers are under a lot of stress because the regulators are not, you know, they’re trying to protect themselves by making sure the banks don’t take any unnecessary risk. So

Andres Sandate: 

Yeah. We can’t we can’t have another SVB or another weekend where a Sunday night rescue has to happen. Right? Not at all. Because it just keeps spooking the markets.

Andres Sandate: 

Yeah. Yeah.

Derek Pilecki: 

For sure.

Andres Sandate: 

Just when you think you’re on solid footing.

Derek Pilecki: 

I I would say that, like I mean, I know this is asset backed for podcast, but, like, the deposit insurance system is still vulnerable. Right? I mean, we still have there haven’t been enough changes to the deposit insurance system since SED that, like, there could still be a massive run on the banks because we have everybody has a app on their phone, and you can zap all your money to your Schwab account if you’re worried about your bank. And so you could have a run on the bank still. And so, like, I think we you know, regulators and legislators really need to take a look at deposit insurance.

Derek Pilecki: 

And, I mean, I’m in favor of unlimited deposit insurance, like or massively increasing the deposit insurance level. There’s

Andres Sandate: 

plenty 250,000 just isn’t, yeah, isn’t sufficient for even consumers on some cases.

Derek Pilecki: 

I mean, exactly. Like, there’s plenty of 75 year old or 80 year old people who have more than 200 $50,000 who can evaluate their bank. Like, look at SVP. It had $16,000,000,000 market cap to 48 hours before it failed. Any depositor would look at that and say, they’re fine.

Derek Pilecki: 

You know? And so, like, I I just think it’s unreasonable to have such a low deposit insurance limit.

Andres Sandate: 

Yeah. No. It’s a great point and something that hopefully, you know, when the, when the regulators, can get back to focusing on, regulation, it’s, it’s something that I think is gonna be important, particularly, you know, given that we’re in an election year. Let’s let me ask you about, you know, when you think about the the overall investment landscape of financials, one thing that, I I recall about your approach and strategies, you look for the inefficiency. You look for the you look for the areas that are harder for the maybe the generalist analyst, who who dabbles in banks or dabbles in financials to to really uncover.

Andres Sandate: 

Is it fair to say that that complexity and that, inefficiency and just the the the large number of publicly traded banks creates a pretty attractive playing field in which to look for ideas. Is that is that fair?

Derek Pilecki: 

Yeah. I think that’s exactly true. Like, in the small mid cap financial area, there’s a lot of unique business models that, you know, you need some specialized study to understand. You know, take student lending for instance. There’s 3 publicly traded student lenders.

Derek Pilecki: 

You you have to invest some time to understand student lending, and and and you the benefit is you only get to cover 3 companies. And so but I’ve done that, and, I just I don’t see a lot of more people, you know, dusting off the the playbook to see, like, oh, let let me dive into student lending and see if there’s an opportunity there. But, you know, especially with the given the the headlines of, you know, free college or Sure. Or giving student loans, like, why would you even bother? And but, you know, there’s some pretty interesting companies in this.

Derek Pilecki: 

You know, those 3 companies are pretty interesting, and there’s, you know, pretty, inexpensive valuations amongst those 3 companies. But that that’s just an example of, like, within financials, there’s a lot of nooks and crannies of small to mid cap financials. You know, one of my favorite ones is a couple years ago, you know, Genworth we purchased shares in Genworth. And, you know, Genworth’s a life insurance company, they wrote a lot of long term care policies and long term care is just a terrible business because you’re writing policies for 60 year olds for when they might go in a nursing home at 85. And so everybody underestimated the cost.

Derek Pilecki: 

And so Genworth has been really struggling with these policies. They also have a mortgage insurance subsidiary. And so they went through a long transition where they are trying to raise rates on their long term care policies and moving the, mortgage insurance subsidiary out from under the life insurance company into its own subsidiary under the holding company. They finally made progress, IPO’d 20% of the mortgage insurance subsidiary and it’s publicly traded. It’s called EnAct.

Derek Pilecki: 

And so when I bought the shares a couple years ago, if you valued Genworth’s life insurance subsidiary and all their long term care policies at 0. Saying that, hey that’s ring fenced. And then their the value of their publicly traded mortgage insurance subsidiary, you’re buying Genworth at a discount, like 20% discount to the value of its mortgage insurance holdings. And that mortgage insurance companies continue to grow. They had some tax assets that reduced their cash taxes and, you know, that stock had worked.

Derek Pilecki: 

But it’s the complexity of, like, okay. This long term care business is terrible, but there’s this mortgage insurance subsidiary. Should this trade at a discount? And, you know, when they started they announced they’re gonna start buying back stock, that’s when I I took my position in Genworth. But that’s an example of the complexity that’s out there within financials that, you know, Genworth is not a a highly trafficked name amongst investors.

Andres Sandate: 

Yeah. When when you think about the, the the additional, nooks and crannies, to use your term, of of the financial sector, there’s some there’s some areas I’d love to ask you about. One of those is fintechs and and just how we saw you know, before 2021, 20 yeah. I would say 21, you saw a lot of Fintechs, getting a lot of VC, and they were gonna disrupt banks. And they were gonna, you know, claim to be a better version, and a and a more efficient version of a bank.

Andres Sandate: 

And you saw a lot of VC give a lot of capital to to these these tech, startups. And then sort of like they woke up and realized, wait. This is a different business, you know, than this is a lending business, not necessarily about just grow, grow, grow it at at, you know, at at any price. And I don’t know that they’re gonna keep funding these these businesses, and I think we’ve seen a lot of pressure on some of these fintechs, and some of them will probably go away or have gone away. What did that whole, maybe you’re not investing.

Andres Sandate: 

You’re clearly not investing, in in in IP pre IPOs and and VC. But what did what did that tell you about the tech community? I’m just curious when you saw sort of that happening, because I’m sure there are, lots of examples over your long career of, you know, we’re gonna go disrupt banks, and we’re gonna do this better and cheaper. But what what what comes to mind when you think about that episode?

Derek Pilecki: 

Yeah. I mean, I think there was a lot of innovation to come from that episode. Like, there there’s a lot of, you know, outside the box thinking. And so, specifically, when I think about Venmo and Cash App. Right?

Derek Pilecki: 

I mean, those are pretty interesting businesses, and they were able to take a lot of share, and they were able to get a lot of consumers to participate in those those platforms and it forced the banks to come up with Zelle. And Zelle has been growing. It has very high payments, but, you know, Cash App and Venmo are gonna stick around for a while. I guess, so I think those are there’s interesting businesses that come out of that and they’re, you know, good customer innovation. You know, I think we have all benefited from having money, you know, peer to peer money transfer.

Andres Sandate: 

It’s

Derek Pilecki: 

easier to to live life to Yeah. You know, share expenses with friends, whatever. I think, you know, I I guess the area where I was most skeptical, you you mentioned the the personal lending. I guess the area I was most skeptical about disruption was on insurance. So auto insurance.

Derek Pilecki: 

I mean, I I think that the big auto insurers like State Farm, GEICO, Progressive, Allstate are are very very good companies and, you know, they spend a ton of money on advertising. So to think that, like, they’re lazy companies that you could disrupt, I I I thought that was a stretch. So, like, these these, personal auto insurers that were gonna come and take over the insurance comp insurance world, I thought was was a little bit of a stretch. And you those companies have had a harder time. You know, personal loan companies, I mean, I I think it’s I think they’ve done a good job and have served to, fill the need there.

Derek Pilecki: 

But, you know, personal lending, it’s a low multiple business. Like, look at Discover and Capital 1, they trade it, you know, best case, they trade it 8 times earnings. You know, 1.2 times book or 1.4 times book. Like, it’s, you know, for a Fintech to get a higher valuation on personal lending, I mean, it’s just not a high multiple business. Like and, you know, getting this is a little tangential, but, like, Goldman entered personal lending too, and they’ve exited it.

Derek Pilecki: 

But it was like, why is Goldman getting into purse consumer lending? They could just buy Discover at 8 times earnings and, you know, you have the you have the greatest investment banking franchise of all time, which is a high multiple business. Why dilute it with personal lending? So, you know, I agree with you. Like, these fintechs who are trying to use their balance sheet to to grow, it’s it just lowers their valuation.

Derek Pilecki: 

What you really want is a a Fintech that had some asset light business model which, you know, Square and and PayPal have done. Yeah. You know, they’re for asset based businesses that are payment oriented.

Andres Sandate: 

Yeah. Yeah. And they they scoop up transactions. I wanna ask you about some other areas that, that that I that I think, you know, are quite interesting. The first one is property and casualty.

Andres Sandate: 

You know, it just seems like every time you turn around, there’s another major natural disaster, there’s a major, you know, storm or fire, and it just seems like rates, not that there’s as much home buying. We saw the numbers come out yesterday. I think the April numbers for for home buying, it were down again for the 3rd consecutive month, but but a big part of this, reset is insurance. In Florida in particular, you live in the state of Florida. I can only imagine how much premiums are going up in the state of Florida.

Andres Sandate: 

But overall, property casualty, maybe you have exposure to it today, maybe you don’t, but just curious about your take on that sector.

Derek Pilecki: 

I mean, I I think, climate change is real and their insurers are pricing for it. Right? And so I think pricing has been going up. You know, I think on property, reinsurance prices didn’t go up as much this year as they had in previous years. Certainly on casualty reinsurance prices are going up.

Derek Pilecki: 

And I think there’s there’s a lot of underpriced casualty business from the 2015 to 2020 time frame that, you know, people need to raise prices going forward. They generally the industry generally underpriced casualty business. So I’m and I think it’s an interesting area. You know, we’re not involved in a ton of insurance companies right now. We we own one homeowners insurance company that’s focused on the state of New York that, you know, is kind of benefiting from the big companies exiting Long Island.

Derek Pilecki: 

And so that coastal exposure on Long Island is, you know, there’s a lack of capacity there. And so that’s the the really the only insurance company that we’re we’re involved with at the moment.

Andres Sandate: 

The 2 areas, that, you know, I know you’ve you’ve you’ve, been involved in these areas for a long time, and you are one of the first ones, one of the the first financial specialists that that got, real constructive on the publicly traded asset managers, particularly alternative asset managers. So I’d love to spend a little bit of time talking about, asset management in general. So you have a deep background, as as as do I in asset management. And then I wanna talk for a minute about capital markets. So let’s start with asset management.

Andres Sandate: 

When you think about the the the universe of asset managers, you you have this notion of traditional versus, alternative. You also have passive versus active. I’ll let you pick where you would like to start, passive versus active or traditional versus alternative or maybe both. Yeah. But when you think about asset management, these are gigantic forces that are disrupting this industry, changing this industry.

Andres Sandate: 

And we even saw yesterday, I think, KKR announced, a partnership with Capital Group, you know, the the, you know, the sponsor of the American Funds. Long a bastion of portfolios for financial advisors announcing that they’re gonna partner up on a couple of of offerings, which is just fascinating. So what comes to mind when you when you think about asset management?

Derek Pilecki: 

Yeah. I mean, I think private equity managers are a great business model. For a long time, I’ve told investors, you don’t invest in Blackstone or KKR’s fund. Just buy their their GP. You know, just own KKR KKR stock.

Derek Pilecki: 

Now that being said, we’re at a interesting point where there’s a lot of big institutional firms that are are institutional investors who are over their skis on their allocations to private equity. Distributions aren’t coming as quickly as they expect, especially in VC, and so they don’t wanna make new allocations because there there’s a little bit of liquidity crunch there. So, like, are we at a temporary place where fundraising is gonna be harder for the big private equity firms? Not really clear to me what which way to go there, but I I know generally, I think those firms are gonna continue to grow and, you know, have very good business models. The one that I’m really involved with at the moment is Carlyle Group.

Derek Pilecki: 

I really like the new CEO. I think, you know, the previous CEO transition had been botched by the firm.

Andres Sandate: 

Yep.

Derek Pilecki: 

I think that I think the new CEO has a a huge canvas to work on. Like, there is a there’s a huge expense cutting opportunity at Carlyle. Carlyle It’s Harvey Schwartz,

Andres Sandate: 

the new CEO?

Derek Pilecki: 

Exactly. So, you know, You know, Carlyle would always run their business of, you know, we’re gonna run the business on the management fee and pay ourselves on the carry. And, you know, the when the other publicly traded managers came out, Carlyle and I mean, Blackstone and KKR, all of a sudden they were earning 20 or 30% margins on their management fee and Carlyle has, like, how we we’re breakeven on our management fee. So, like, there was an just a a heavy spending culture at Carlyle that I think Schwartz is gonna, you know, not clamp down on, but just, like, make intelligent choices about Yeah. Improving the margins there and reducing some of the spending.

Derek Pilecki: 

And then there’s a lot of opportunity on the, investment capability side of Carlyle and great brand name and, you know, great at raising money. They they just have some some gaps in their, investment arsenal that he can fill and grow the firm. So I think and, you know, the valuation’s way cheaper than the its peers even with those opportunities. So Yeah. And when you

Andres Sandate: 

yeah. When you think about them, you think, you know, private equity, defense, government. I mean, the that’s a a a sort of a gold plated franchise. But when you think about them, you necessarily don’t think credit. You don’t think, secondaries, you know, in some of these other areas.

Andres Sandate: 

And I think all of them, and I’d love to get your take, seem to really, from a from a capital flows perspective, really are eyeing not only foreign markets, as a source of growth, but also the retail investor as as a source of growth. And when I say retail, I mean, you know, trying to go after that high net worth, retail investor that’s being served by a financial adviser. It seems like all of the more successful ones that are growing, number 1, have product, and they have a way to distribute that product to retail, both globally, but also importantly in the US where that average investor is woof not woefully, but they’re under allocated to alts relative to, you know, their their family office or institutional peers.

Derek Pilecki: 

I mean, we’ve had a bull market for the past 14 years. Right? So the there’s a ton of investors who have historically not invested in alts that have a lot of money now. And they’re, you know, they’re people with, you know, 5 to $25,000,000 or even more that historically have not invested in alts. So the, like, the access that the private equity managers are trying to get to those people are coming through investment advisers or financial advisers.

Andres Sandate: 

Yeah. Let’s talk about capital markets. When when you talk, capital markets in the context of of Gator Capital Management, what what does that universe look like? I’m curious.

Derek Pilecki: 

Yeah. I mean, it’s the investment banks. Right? So it’s the Okay. Goldman’s and Morgan Stanley’s, Barclays, you know, UBS.

Derek Pilecki: 

The, you know, the capital markets really hit hit the cover off the ball in 2021, you know, with the SPAC craze and the IPO boom. You know, those businesses really were busy and had a lot to do. And then there was, you know, the pullback in 2022 really, you know, capital markets revenue is really at a cyclical low. And we’re just starting to see, like, that’s coming back a little bit, late 23, early 24. And, you know, 24 has been a good year for capital markets growth.

Derek Pilecki: 

You know, the a lot more trading, a lot more business being done. I think, you know, when rates were going up so much in 2022, there’s a lot of on the debt capital market side, things were pretty quiet. So now we’re, you know, I think the stable rates, you know, 10 years staying here around 4.50 makes a a better environment for issuance, and people are like, okay. This is, you know, there’s not as much volatility. We have business to do.

Derek Pilecki: 

Let’s let’s raise some debt and, you know, lock in some funding. And so I think capital markets businesses are in a a nice recovery mode from the the cyclical lows of, you know, 12 to 24 months ago.

Andres Sandate: 

I wanna ask you about securitization. You know, it it it up until 2008, you know, a lot of folks didn’t know what a CDO was, didn’t know, maybe they don’t know, but, you know, you saw so much innovation, in the asset backed securitization markets. And then it was I would say largely, you know, the veil was lifted with the GFC, and we saw a lot of banks suffer. And there was just it it it exposed just how interconnected the global capital markets really were. I had a guest on last week who talked about there’s there’s somewhat been a loss of innovation in the securitization markets because you saw this talent leave, and you saw some of these securitization markets sort of seize up.

Andres Sandate: 

And you have private ABS. You have public ABS. But, obviously, and some of the bigger, areas like auto, student loans, mortgages, etcetera? I mean, are origination volumes just generally down, and that’s why we don’t hear as much about securitization? Why has there been, for example, such a a more and more chatter and talk about private ABS?

Andres Sandate: 

I’m curious, like, do you traffic in in these in these, universes, or does it touch the capital markets names that you follow?

Derek Pilecki: 

Yeah. I mean, it’s it’s very my exposure to that is pretty small. So, like, the

Andres Sandate: 

Okay.

Derek Pilecki: 

I I think there has not been a lot of innovation because there’s been some regulatory changes and about what risk retention is. And so I I I think that there’s not been you know, people haven’t been paid to take more and more risk or come up with more innovative structures. And so there’s just been lack of innovation there, and it’s been more it’s it’s boring because it’s like this the structures are tried and true, and there’s not much innovation there. And so it’s Yeah. You’re just basic business.

Derek Pilecki: 

And and

Andres Sandate: 

that would that would explain why some of it’s maybe moved to to the private markets. Let’s talk about, we we touched on this earlier, but I wanna ask you. When you when you talk about nonbank lending, in that universe, you know, you talked about Stripe and Venmo and Cash App. And the I look at those as more transactional, like, processing and the technology. When you talk about nonbank lending, a source, you know, 10, 15 years ago, it was Prosper, and it was all these peer to peer type of lendings.

Andres Sandate: 

I’m not thinking that’s what you’re you’re talking about when you say nonbank lending. So I’d be curious, like, how big is this market? Who are the players, and who seems to be doing a decent job at it?

Derek Pilecki: 

Yeah. So I mean, non bank lenders on the consumer side are, you know, OneMain Financial. It’s a subprime lender. It’s the old Citi Financial, AIG, American General Business, you know, or I mentioned Sallie Mae, the Mhmm. The student lender.

Derek Pilecki: 

You know, I I think it’s lenders like that, like LendingClub, Upstart, or currently non bank lenders SoFi. And so those are the companies that are non bank lenders. On on on the commercial side, there’s some commercial mortgage rates. There’s some commercial finance companies that are are non bank lenders.

Andres Sandate: 

See? It wasn’t my kids today. It was my dog.

Derek Pilecki: 

I was hoping to get to see one of your kids today. I’m I’m bummed I’m not showing

Andres Sandate: 

up yet. You you might you might see one jump in. I mean, that’s that’s the nature of it. So so there’s a number of nonbank lenders across mortgages, across student loans, and these other areas.

Derek Pilecki: 

Yeah. I like I like nonbank lenders. They tend to be monoline. They they tend to Yeah. Have higher returns on equity than banks.

Derek Pilecki: 

They tend to grow a little bit faster, but they don’t have as much stability, right, because they don’t have the deposit franchise. So they, you know, a lot of times they’re funded in the capital markets and it it, you know, they can run into problems with the the balance sheet if they’re not more stable on their funding side. But they’re interesting businesses and they’re innovative and and they they can grow faster than a typical bank. And so I think they’re interesting businesses from time to time.

Andres Sandate: 

But like you said, earlier in our conversation, the complexity, the inefficiency, they can run into problems just because they don’t have the deposit base. All the more reason why, you know, only specialists probably are really starting, you know, to really be constructive on doing the underwriting, doing the work, and the research.

Derek Pilecki: 

That’s right. I mean, I think it’s, you know, a specialized area that, you know, it’s trafficked in by a lot of financial sector specialists, not necessarily generalist investors.

Andres Sandate: 

Yeah. How much, you know, when when you look back, at the time that you have been running Gator Capital Management, and and you’re doing that away from, you know, call it Wall Street in New York. You’re doing that in Florida. And and I know you used to get this question from investors, and I’d love to get your take on it now, you know, years removed. How much does being outside of kind of the trading of ideas amongst other funds, other PMs, like, how much has that benefited you?

Andres Sandate: 

I’d I’m curious, where you can really, you know, sort of burrow in and concentrate and not be caught up in the noise and the hype. How much has that impacted, your business and your approach? I think I

Derek Pilecki: 

I think it’s an interesting question. Like, I definitely talk to other investors some, but not to the my network amongst my peers is not extensive. Like, I’m not, you know, I’m not in touch with other investors on a daily basis. So, you know, I I see them at conferences a couple times a year and we’re we’re cordial. But, you know, I just kinda march to my own beat and, you know, do my own research.

Derek Pilecki: 

There’s a few few people that I talk to that, you know, to share ideas, but really it’s, you know, a lot of my own research and, you know, just doing my own independent thinking away from what’s fashionable amongst, you know, bounce amongst the financials crowd. So

Andres Sandate: 

I think that’s

Derek Pilecki: 

a huge benefit.

Andres Sandate: 

Yeah. It sounds like it is a benefit. And, you know, without talking about your book and and and the strategy, you’ve always, operated the beat of your own drum. Right? You you tend to not hold the names that the sector or the index is hold.

Andres Sandate: 

You tend to do a lot of your own idea generation and research independent, and and successfully, relative to, you know, your index and your peers. I wanna ask you, you know, kind of couple of final questions. As you think about, you know, financials, we’re we are in an election year. It seems like you can pick up any newspaper, turn on any news channel these days, and get an opinion one way or the other depending on what you’re looking to hear. But, you know, financials and you talked about this at the beginning of the conversation.

Andres Sandate: 

A lot of the things that get talked about in the media that make headlines aren’t necessarily the things that you’re paying attention to, and one of those things you talked about was interest rate risk. So I’d love to ask you in an in an election year with the Fed attempting that soft landing, what’s your, you know, what what’s your outlook, for the sector? You know? Yeah.

Derek Pilecki: 

How

Andres Sandate: 

do you sort of assess how Powell and the Federal Reserve have done given, you know, a a quite tricky hand to play? And, clearly, this is gonna have a big impact on on the names that you follow.

Derek Pilecki: 

Yeah. So I guess one thing that I’m trying to reconcile is the, you know, my portfolio when I look at my portfolio now, not by design, but just when I try to be objective and say, would my my portfolio benefit from a Biden victory or a Trump victory? I think it would benefit from a Trump victory. The problem is I think Biden’s gonna win, which and I know that’s not a consensus view. Like, I think especially amongst financial people, everybody clearly thinks Trump’s gonna win.

Derek Pilecki: 

But, you know, I guess my reasons for why I think Biden’s gonna win is I think the polls are wrong. I think, you know, people with landlines who get called for polls are 10 skew older and Republicans. So I think overstates Trump’s support. I think, number 2, I think there’s gonna be a turnout issue for Trump. You know, just we saw it in, you know, that primary in Indiana where Nikki Haley dropped the race months ago, and she still got 20% of Republican vote.

Derek Pilecki: 

Like, I just think Republicans, there’s enough Brian O’ Republicans that they just won’t show up to vote for Trump. They just won’t vote at all. And then, you know, I I think there’s some social issues, I mean, namely abortion that are gonna really swing towards Biden’s favor. So, like, when I look at the election objectively, I think Biden’s gonna win. My portfolio is set up for a Trump win, not because I said Trump’s gonna win and I’m gonna buy there just naturally banks will be do much better under a bank, a Trump regulatory view.

Derek Pilecki: 

And and so I don’t have that reconciled. Like, how am I gonna approach the election here with, who’s gonna win? I’m kinda waiting to see we have to get more into the need of the race before Yeah. I guess the one thing I would say about the election year, like, usually, election year, the market doesn’t do much until the election happens. Right?

Derek Pilecki: 

And so, like

Andres Sandate: 

That’s right.

Derek Pilecki: 

We we’ve actually had a pretty strong market for an election year so far. Like, S and P is up 10%. We’re at sitting here at close to all time highs. That’s a little bit surprising. So, like, is the mark and how how do I interpret that?

Derek Pilecki: 

Is the market looking through the election? Does the market already know who’s gonna win and it’s comfortable? Or is it just a a fed phenomena where we’re expecting interest rate cuts and the economy is stronger than everybody expected and and, you know, so the market can power through an election year because so it’s not clear and just trying to sift through that and, you know, you ask me tomorrow, I’ll have a different answer for you. Right? Yeah.

Derek Pilecki: 

Yeah. Like, I’m trying to figure it out. Like, it’s it’s an open question in my mind. They’re like, why why has the market been so strong in the face of an election year?

Andres Sandate: 

Yeah. That that that makes a lot of sense. I mean, you have to keep your your head on a swivel. Last question. You know, when you think about, the Federal Reserve and you think about Jerome Powell, you know, chairman of the Federal Reserve and trying to, trying to determine, you know, are we gonna see a rate cut this year?

Andres Sandate: 

Are we gonna not see a rate cut at all? Are we gonna see a rate cut a a a rate rise? What what is your overall grade that you’d give, the Fed? You know? I’m I’m just curious because I would imagine, you know, you’re paying attention to this as much, if not more so than most of the people that I talk to.

Andres Sandate: 

Certainly, the people that I have on our show, are paying a lot of attention to what’s going on in the macro economy, what’s going on in their portfolio. So I’m just curious what what kind of grade and assessment you would give him because it’s an incredibly difficult job.

Derek Pilecki: 

Yeah. It’s a very hard job. Like, it’s, you know, in and I’m also looking at it with hindsight here. Right? I mean,

Andres Sandate: 

it Yeah.

Derek Pilecki: 

There’s some things like did qt or q quantity of easing have to continue? Did they have to continue to buy all those mortgage backed securities and treasuries Yeah. Into 2021 when the the market was red hot and that we had this back craze. Like, I don’t there’s some things that, in hindsight, I wish I bet they wish they could have a redo on. Right?

Derek Pilecki: 

So it’s a very hard job. I guess I didn’t agree with the last couple rate increases. Like, I felt like, going to 4 and a half percent on the Fed funds was enough. Like, I didn’t think I didn’t think that they needed to do the last three rate increases. So, like, could they cut 3 times and go back to where I thought they should be in the first place?

Derek Pilecki: 

Yeah. I think this inverted yield curve is really hard for the banks. I think it’s, you know, but I I think the Fed also wants the 10 year higher. I mean, I think the the Fed would like I guess the other thing about the where where interest rates are is I kinda agree with some of the people who are saying the higher rates are causing inflation because, you know, if you think about housing supply, we’re short housing. We need more housing.

Derek Pilecki: 

Higher rates does not promote more housing. Right?

Andres Sandate: 

That’s right.

Derek Pilecki: 

So, like, rents are gonna go up because there’s not enough housing. And so what are we doing here? Like, let’s and every time I see a solution from the administration, it’s let’s create more housing demand. Let’s lower the cost of mortgages. Well, that doesn’t create more supply.

Derek Pilecki: 

We need to address housing supply. That’s the issue. And more housing supply will lower, prices, lower rents, and so and lower inflation. So, like, we have to figure out housing supply, and I don’t know that higher rates is fixing housing supply. Yeah.

Andres Sandate: 

So that yeah. Interesting. This has been a really great, you know, tour through the financial markets. I you know, we’ve talked about so many sectors within financials, you know, including banks, insurance, asset management, capital markets. I wanna give you the last word, though.

Andres Sandate: 

You know, we we’ve known each other for, you know, a a number of years. You’ve been running Gator now for 16 years. Congratulations. When when you think about, you know, where, the next 15 or 20 years with with Gatorgo, and where you wanna take your platform and financials, You’ve built your team up, and, and you’re in Florida and you’re doing this. What what are the things that come to mind?

Andres Sandate: 

Like, as far as, you know, these are the challenges I wanna tackle. These are the areas that are most exciting. You know, these these are the things as a as a CEO, as a portfolio manager that get me excited to get up and focus on this really highly complex area every day.

Derek Pilecki: 

Yeah. I mean, I’m just excited about compounding my investors capital over the next 16 years. Like, you know, I’ve been doing it for 16 years. In 16 years, I’ll be 70. I think that’s a, you know, a nice career and, you know, I’m excited.

Derek Pilecki: 

The firm’s at a decent size now. We compound investors capital for another 16 years. We’ll be, you know, bigger than I ever thought we would be. And so, like, that’s just the focus of, like, continue to put up good investment performance, find the opportunities in these small and mid cap financials where we can put up excess returns for our investors. And and, you know, I think with the I think it’s a very dynamic industry, and I think there’ll continue to be opportunities, for our investors there.

Andres Sandate: 

That’s great. Well, Derek Pilecki, portfolio manager of Gator Capital Management, headquartered in Tampa, Florida. Thank you for joining me today on the Asset Backed podcast. Tell us how people can learn more about you, where can they, get in touch with you, and, hear more of of your views on financials.

Derek Pilecki: 

Yeah. So our website’s gatorcapital.com, and you can send me an email. My email address and phone number are listed on the website. And, You’ll you can also follow me on Twitter under the handle Gator Capital. Fantastic.

Derek Pilecki: 

For having me, Andres.

Andres Sandate: 

Yeah. Derek, it was a pleasure, and, I look forward to having you back on to get an update on what’s happening in financials. Thanks for joining me today on the Asset Back podcast.

The recent turmoil at New York Community Bank (“NYCB”) has dragged down the stocks of small-to-mid-sized banks again this year. The exchange traded fund for mid-sized banks, the SPDR S&P Regional Banking ETF (“KRE”), underperformed the ETF for large banks, which is the Invesco KBW Bank ETF (“KBWB”) in the 1st quarter. The KRE was down 3.33% while the KBWB was up 10.01%. The underperformance of the mid-sized banks versus the large banks continued in April. Large banks are perceived by investors as having less credit risk, more robust credit reserves, and more liquid balance sheets.

Gator Capital Opportunity in Regional Banks

There are obvious headwinds that the banks are facing: tepid loan growth, competitive deposit environment, and an uncertain credit environment; however, we see opportunity in selected small-to-mid-sized regional banks (“SMID banks”). We think stock investors are overly pessimistic in their assessment of SMID bank credit concerns. We believe the larger issues for SMID banks are interest rate risk and loan volume growth. Regarding interest rates, we see banks having a wide disparity of performance based on the positioning of their securities portfolios, their percentage of fixed rate loans, and how they manage their deposit franchise. Many banks have navigated the move in higher rates well and remain well-positioned for the current environment. We also see differences in how banks manage their loan growth. Some banks continue to grow loans and deposits and accept that margins in the near-term are narrower due to the inverted yield curve and competitive deposit environment. We think these banks will be rewarded when the yield curve normalizes, and they realize wider net interest margins on a larger book of business.

 

Within SMID banks we group our favorites into three buckets: Puerto Rican banks, growth banks, and small banks with unique stories.

 

Credit Risk

 

Credit risk is perilous for banks. The current environment poses four areas where banks may experience heightened credit losses. The first area is office buildings. The second area is rent-regulated apartment buildings in New York City. The third is commercial estate properties (“CRE”) where the rapid rise in interest rates has caused the value of CRE to decline. The fourth is rapidly rising debt costs for borrowers with floating rate debt.

 

So far in the Q1 bank earnings season, banks have reported better than expected credit metrics. The increases in non-performing assets and criticized loans are not alarming given that bank credit metrics were at record lows in 2022 and 2023. We’ll have to remain vigilant about credit risk to see if metrics deteriorate in the coming quarters. In the meantime, we will stay focused on banks with historically strong credit cultures. As we meet with bank management teams, we remain alert for any changes in risk appetites. Many market participants have a negative view of bank managements’ ability to see pending problems in their loan portfolios. We note that risk management and monitoring of loan portfolios has improved from when we started investing in bank stocks. We realize that bank stock investors may need to see the other side of the credit cycle before putting higher multiples on bank stocks and this contributes to the current opportunity we see.

 

Interest Rate Risk

 

Market participants are divided on the outlook for banks. Some investors see an opportunity because banks are cheap and poised to benefit from interest rate cuts. Others are concerned about potential credit losses or rising interest rates. We believe selective opportunities exist, with certain banks offering attractive valuations and potential for earnings growth, while others are at risk as they have significant holdings of fixed-rate loans and securities on their books.

 

Banks benefit from higher reinvestment yields, but some banks have more near-term opportunity. If a bank has a lot of loans and securities maturing in the next year at low yields, they can take the proceeds from the loan payoff to make a new loan at today’s higher yield. Unfortunately, many banks made a lot of 5-year and 7-year fixed-rate loans in 2021 and 2022 that won’t mature until 2026 or as late as 2029.

In a more robust deposit environment, banks would generate loan growth which would allow new production to be put on the books at normalized spreads.

 

In 2022 and very early 2023, almost all banks paid aggressively low deposit rates even as the Federal Reserve raised the Federal Funds rate. Most bank customers had become accustomed to the zero-interest rate environment and were not in the habit of managing their excess cash for higher yields. The media focus on Silicon Valley Bank’s failure in March 2023 caused many bank customers to change how they managed their excess cash. This change in customer behavior forced banks with weaker deposit franchises to raise deposit rates to retain customers and deposits.

 

Banks have deposit franchises with varying degrees of strength. Many different factors can create a strong deposit franchise such as a long history in a marketplace, a strong branch and ATM network, a strong sales culture within the bank of asking for additional deposits from customers, and the size of the bank. Banks with weak deposit franchises use higher rates to attract price sensitive customers.

 

When Silicon Valley bank failed, the banks with weak deposit franchises had to raise their deposit rates more aggressively to retain their deposits. During Q2 and Q3 of 2023, these banks raised deposit rates to a level that stabilized their customer bases. We estimate this level is about 3.75% to 4.00%. Although these banks have weak deposit franchises, their net interest margins (“NIM”) have already compressed. In a stable rate environment, they should have loans and securities repricing to higher rates as they mature and their NIMs should gradually widen. In a declining rate scenario, they should be able to reprice their deposit rates lower. This will lead to wider NIMs. There is also the possibility that they will strengthen their deposit franchises and attract less rate sensitive deposits. We think this scenario is less likely, but there are a few banks where this is a possibility.

 

Banks with stronger deposit franchises are experiencing continued deposit cost pressures. They have not had to raise deposit rates as aggressively because their customers are not as price sensitive, however, with money market rates above 5%, even customers of these banks with strong deposit franchises are looking to better manage their excess cash. This has put continued pressure on these banks to retain deposits. Even JP Morgan Chase has not been immune. On its most recent earnings conference call, the CFO said that the bank expects to see continued movements by customers to seek higher deposit rates.

 

We believe the current high level of interest rate risk will dissipate with time. We believe the inverted yield curve and the significant rate increases by the Federal Reserve is causing the small-to-regional banks to under-earn compared to our estimate of their normalized earnings power. Despite this under-earning, we observe that the small-to-mid-sized regional banks trade at the low end of both absolute and relative valuations. It is a classic value situation of the market assigning a low multiple on stocks with depressed earnings.

 

New York Community Bank

 

At the end of January, New York Community Bank (“NYCB”) reported Q4 earnings. The surprisingly bad earnings report caused the stock to decline 37% in one day. The stock has continued to slide despite a $1 billion recapitalization led by former Secretary of Treasury Steven Mnuchin.

 

NYCB’s poor earnings report and stock price decline in January was a catalyst for the entire regional bank sector underperforming so far in 2024. Through March 31st, the SPDR S&P Regional Bank ETF (“KRE”) was down 3.33% versus the S&P 1500 Financials Sector Index which rose 11.67%. The January earnings season was constructive, but NYCB’s report changed investor sentiment on the regional banks. The question presented to us as bank investors is “Are NYCB’s problems idiosyncratic or systemic to all banks?”

 

We believe NYCB’s issues are idiosyncratic to NYCB. NYCB has long been a New York City apartment lender. Their track record over many decades has been spectacular with near zero losses. But, in 2019, NYC passed a law that limited how much landlords could raise rents. In the current inflationary environment, landlords’ costs are rising, but they can’t raise rents, so investors are concerned that landlords will get squeezed so much that they will default on their loans.

 

The NYCB acquisition of Signature Bank highlighted a potential regulatory oversight. NYCB crossed the $100 billion asset threshold, placing it in a new regulatory category with stricter capital requirements. Regulators should have recognized this deficiency in capital and forced NYCB to raise its loan loss reserves and raise additional capital instead of reporting a bargain purchase gain. If regulators were more proactive, the issues with NYCB purchasing Signature could have been avoidable.

 

We think the regulator’s treatment of NYCB was idiosyncratic because of NYCB’s concentration in NYC apartment loans and its crossing $100 billion in assets with the Signature Bank purchase. We think SMID banks underperformed their large bank peers starting on January 31st because of NYCB’s unique issues.

 

 

 

Best Opportunities in Regional Banks

 

Within SMID banks we group our favorites into three buckets: Puerto Rican banks, growth banks, and small banks with unique stories.

 

Puerto Rican Banks

 

Banking in Puerto Rico is an oligopoly. In 2006, there were 11 banks in Puerto Rico and the economy had just entered a recession that would last 15 years. Through bank failures and consolidation, there are just three commercial banks operating in Puerto Rico. We have seen the Puerto Rican banks expand their margins and improve their returns. We also see early signs that bank stock investors are taking note by placing higher valuations on the Puerto Rican banks. We’ve owned First Bancorp and OFG Group for several years and continue to think they have attractive upside.

 

Growth Banks

 

We have written about Growth Banks in the past. We continue to like this group of banks. They have cultures that foster organic growth. For banks to grow, they must generate capital through retained earnings. So, many of these growth banks also have high returns on capital. One way to identify these banks is to screen for banks with the highest tangible book value per share growth over a 10-year or 20-year timeframe.

 

The banks we hold that fall into this category are First Citizens, Western Alliance, Pinnacle, United Missouri, Esquire, Axos, Customers, and Webster.

 

Small Banks with Unique Stories

 

We also own smaller banks that have unique stories: NYCB collateral damage (DCOM & CNOB), small cap M&A banks (OSBC, BANC, & BFST), ultra cheap but solid banks (FBIZ, OPBK, & UNTY), and a purchaser of loans from other banks (NBN).  While each of these positions is small due to liquidity considerations, we think each will generate attractive returns.

 

 

Andrew Walker:

This episode is sponsored by tegu, the Future of Investment Research. From the beginning, Tegu has been committed to creating efficiencies in the research process by making it easy to access the content that investors need to get differentiated insights today. They’re taking it one step further by bundling qualitative content, quantitative data, and better automation and technology together in the same platform. Instead of piecing together data from fragmented sources, just log into tegu to get expert research company and industry specific metrics and KPIs, SEC filings and more all under the same license costs. You can even take a look at your work offline with an Excel add-in that updates almost any model with the latest financial data, keeping all your custom formatting intact. Tegu is the fastest way to learn about a public or private company and the only platform you’ll need for fundamental research. To try it for free today, visit tegu.com/value. That’s T gs.com/value. Alright, hello and welcome to the yet another value podcast. I’m your host, Andrew Walker, also the founder of yet another value blog.com. If you like this podcast, it would mean a lot. If you could rate subscribe, review it wherever you’re watching or listening to it with me today, I’m happy to have Derek Palecki. Derek is from, well, Derek, are you the CIO Eric Gator or what’s the official title?

Derek Pilecki:

Yeah, I just call myself a portfolio manager.

Andrew Walker:

Portfolio manager at Gator. Well, Derek, thanks for coming on.

Derek Pilecki:

Yep, thanks for having me.

Andrew Walker:

Look, really happy to have you before we get started today, just want to remind everyone quick disclaimer, nothing on this podcast is investing advice. That’s always going to be true, but particularly true today because as I was telling Derek before we started recording, I’ve been following Derek’s letters for probably 10 years at this point and we’re just going to be going through the financial sector space in general. So we’ll be talking about a lot of different companies, a lot of different stocks. Just remember not investing advice, please consult a financial advisor, all of that. So Derek, we are talking today, I believe it’s March 12th is the official day. Tons of stuff happening in the financial space. We can talk about anything. We could talk crypto, we could talk regional banks, we could talk just all sorts of stuff. I’ll just start by asking you, as we sit here March 12th, how are you thinking about the financial sector day? What’s most interesting on your mind these days?

Derek Pilecki:

I mean, I think that the way the sectors from trading in the wake of NYCB news is really the most interesting, right? I mean, we got through most of earning season, the banks were reporting just fine. NYCB was one of the last big of the larger banks to report and just totally changed the narrative for the whole sector. And so a lot of names are down, A lot of names that had really good earnings in Q4 are down a ton. And so I think that’s the most interesting thing right here.

Andrew Walker:

So I guess on the names that are down, I wrote a piece on this, it was so crazy, as you said, every bank had reported NYCB is one of the last to report. They report and they disclose. I don’t think it was unknown, the rent regulated portfolio they had, but I think the degree and the magnitude and everything really shocked people. They report the stocks down 50% in a day, 50% the next day, whatever, but every other bank gets hit. And I did think it was kind of interesting that everybody just kind of went and said, oh, all these banks that reported great credit trends, everything Valley Western Alliance, some banks that don’t even have rent regulated exposure were getting hit five or 10%. And some of them have got it back, some of ’em not. I guess you could take two minds to that. You could say, Hey, the market shot first and ask questions later. Or you could say the market’s looking at these and saying, Hey, lending is complicated and if we missed it at NYCB, maybe we’re not missing it on rent regulated, but maybe we’re missing it on government leasing somewhere else or all this how of stuff. How are you thinking about that?

Derek Pilecki:

Yeah, I think investors in the regional bank space have PSTD to some extent. We just went through March of 2023 and I think the NYCV news was like, oh no, not again, and let’s just cut our risk and move on. I think a couple other currents, one that you mentioned about okay, credit quality, we’re seeing the first signs in NYCB here, NYCB was supposed to have perfect credit. I mean they’ve had perfect credit for years, decades with New York apartment buildings. There’ve been no losses and this is a change. And then the other narrative of them crossing a hundred billion dollars and supposedly the regulators tapping them on the shoulder and saying you have to increase liquidity and increase your loan loss reserves to look more peer. All of a sudden you have these banks that are approaching a hundred billion, okay, what do we have? What do these banks have to do to get to those levels? And so I think there’s several things going on there, but a lot of banks that had just fine earnings that are pretty far away from a hundred billion dollars are down 15%. I think that’s pretty interesting.

Andrew Walker:

A few things I want to follow up. So in March, 2023, let’s just start there. That was deposit risk, especially at Silicon Valley Bank. You had people just, they were pulling their deposits left and and you saw how quickly, I do remember people were comparing WAMU in 2008 where five or 7% of the deposits left in 48 hours because people were still literally going and trying to deposit checks. Whereas Silicon Valley Bank, you just wired out. A lot of people were rethinking deposit risk and I’m of two minds of it. Yes, deposits are scary, but I’ve heard a lot of people throw around deposit risk on the heels of NYCB and I kind of look at and NYCB wasn’t really having flight until the morning before the bail-in or bailout or whatever happened, and I kind of think if deposits were going to leave, they’d already left. So how do you look at deposit risk in these, especially regional banks these days?

Derek Pilecki:

Yeah, I think the big surprise from March of 2023 was the level of uninsured deposits in the banking industry. I saw one, I think it was either Steven, I think Steven’s put out a report that said that the average level of uninsured deposits or the median level of uninsured deposits in the regional banks was 39%. And even being a bank investor, that seemed like a shockly high number to some extent. I understand 250,000 is not a high level for an insured deposit account. I have a retired school teacher who has say, been a diligent thrifty woman all her life and she’s gotten a little over a million bucks, like 250 thousand’s, not a lot of money for somebody who’s been thrifty and in their seventies. And so we need to raise the level of deposit insurance for consumers. It needs to go up and for operating accounts for businesses, it needs to be higher. Silicon Valley was just off the charts mean they had bill.com had a nine figure checking account that’s the government shouldn’t have to insure it or the industry shouldn’t have to insure those accounts.

Andrew Walker:

It circle had 4 billion in uninsured deposits sitting had it. I saw that number and I was kind of like, dude, just let the fricking guys fail 4 billion in uninsured deposits. Are you kidding me?

Derek Pilecki:

I mean, I guess I’m of the view of as a society, we can prevent bank runs by just saying everything’s insured, right? There’s no societal benefit of bank runs. Nobody benefits from them. There’s no discipline imposed on the banks by depositors zero. Silicon Valley had a 16 billion market cap when they went to go raise that capital. There’s no depositor who would look at that market cap and say, oh, my deposit’s at risk. The depositors just don’t enforce discipline on the bank. So the theory that we have this concept of a limit on deposit insurance is questionable. In my mind.

Andrew Walker:

There were people who were long First Republic or Silicon Valley bank stock who get paid professionally to look at this and you go to them and be like, Hey, what do you think about the health to maturity issues? They’ve got negative equity, Justin, and they wouldn’t know what you were talking about. And that is just absolute shame on them. But if a professional investor doesn’t know what they’re talking about now, they’re probably not a financial investor like you if that was the case, but if they couldn’t be expected to pick that up in a 10 K, how can you expect mom and pop who are just going and getting a toaster oven when they open a deposit accounts? Get that? I’m completely with you there.

Derek Pilecki:

I completely agree. And so then question in my mind is why hasn’t it happened already? Why haven’t we raised deposit insurance? And I guess there’s no political capital right now to raise deposit insurance. It makes it look like you’re bailing out rich people by raising deposit insurance where you’re actually making the system safer. So hopefully that’ll change in coming years and more sanity in Washington. But who knows

Andrew Walker:

I, oh, go ahead. Go ahead.

Derek Pilecki:

I guess the other thing is in Dodd-Frank, I think they implemented something where congress has to sign off any increases in deposit assurance rather than the FDIC just making a regulation change. So they’re just going to make it harder to raise deposit insurance.

Andrew Walker:

The two most frequent banks that we got asked about and that I think are probably among the most interesting right now are Valley and Western Alliance. So let’s start with Valley and for people who don’t know Valley is, I believe they’re Jersey based, but they’ve got a lot of New York City lending and people looked at them when NYCB kind of had all their issues. Valley was the first thing they shot, right? Because there’s a lot of similarities there and people are just lobbying in tons of questions. I don’t believe, I know they’re not a top five position for you. I don’t know if you’ve got a position one way or another, but just wanted to ask you, I know you cover all these things. What do you think about Valley these days?

Derek Pilecki:

Yeah, I mean I don’t own a position in Valley. I haven’t owned a position in Valley. It’s on my to-do list of things to work on. I think it’s interesting. I think they have a very conservative credit culture. I guess the obvious scary things of New York City exposure, Manhattan exposure, a lot of fixed rate loans, but I think there’s a potential opportunity there. I just haven’t done enough work to say, Hey, they’re clean. I feel comfortable owning it.

Andrew Walker:

I like that. I like answer. I do think one interesting thing is Valley, from what I remember was very close to taking over the Silicon Valley Bank remains and First Citizens obviously beat them to that, but Valley kind of made it known. They were the backup bidder if I remember correctly. And then NYCB obviously won a lot of the signature leftover assets, and I do just think it’s interesting in March, 2023, there was a lot of stories like, Hey, if you were approved to be a bidder, that was the all clear signal from the Fed. This is a safe bank, these are good and valid. Getting hit now may be right or wrong, but NYCB obviously it was not the all safe. Go ahead. Clear regulators are on your side. Obviously they had issues and regulators were the ones who kind of tapped them and revealed a lot of those issues. I

Derek Pilecki:

Mean, that’s the head scratcher about the story of the regulator tapping NYCB on the shoulder and saying raise liquidity and loan loss reserves because the time to do that was when they gave them the deal in March of 23, instead of taking a bargain purchase gain on the signature deal, have them put all that extra money into the loan loss reserve. Back then it wasn’t. I mean they were crossing a hundred billion. It seems like that with a little bit of foresight on the regulators part, that would’ve been the time to get everything to the level that they wanted.

Andrew Walker:

So NYCB trips over a hundred billion, and what happens is the regulators kind of unexpectedly to N-Y-C-B-I think go to them and say, Hey, we’re going to treat you like a hundred billion bank today. Loan reserves go up today. Capital requirements go up today. Take a harder look at your bank today, dividend coming down today to get the capital reserves. I guess my question there is obviously they bought the Signature Bank, but a lot of the loans that they’re having trouble with in my opinion, are the loans that kind of NYCB had written previously to Signature. I don’t think they bought most of signature’s rent regulated book, which obviously the DS had a lot of trouble selling, but NYCB is having a lot of issues with, I don’t think a lot of the office book came from signature. I guess my question is, if they hadn’t bought signature NYC B’s a 60 to 70 billion bank right now, what’s happening with NYCB? Is it just kind of they’re muddling along? Nobody’s really looking under the hood at this thing because to my mind, a lot of the issues are still there. What’s happening right now with them,

Derek Pilecki:

And I think if they don’t buy signature, they’ve already had problems because their balance sheet was upside down as far as fixed rate loans versus deposits. And so buying signature, they was made them a lot less liability sensitive. I mean, they’ve got a lot of cash in the signature deal and they were able to use that cash to pay off some FHLB borrowings, pay down some broker deposits with that cash, so their balance sheet would’ve been upside down if they hadn’t done the signature deal, so they might’ve already had problems.

Andrew Walker:

Okay, that’s perfect. Let me ask you another one. This is to as of your Q4 letter, I think your fifth largest position, so Western Alliance, and that is a bank that I remember the day, I hadn’t really studied it. I remember the day signature failed or First Republic or one of them. This stock went from like 60 to eight in a day, and I remember looking at be like, oh, I want to buy this, but oh my God, bank runs. What does someone know? And they’ve been clear, their depositors were a little freaked out by it and all this sort of stuff. As you know, I sit today trades for about $60 per share. The returns on equity at this franchise have been great. Their credit especially, they talk about how they’ve got great, great controls for dealing with trouble loans, recovering trouble loans, everything. So it trades for 60 tangible book value is about 46. I just want to ask you, what’s the thesis there because I’ll dive into it more in a second. I want to ask you what your thesis on it is.

Derek Pilecki:

Yeah, so I think Western Alliance is in this category that I consider growth banks. They earn high returns on capital. If you look at the long-term, outperformers and regional banks, they’re the ones who grow tangible book value at the highest rates and usually you need a high ROE to grow tangible book value at a high rate, and you also have to avoid doing dilutive acquisitions. So Western Alliance for the most part, does all organic growth. Occasionally they’ll make an m and a transaction to buy a platform business that they can then grow, but for the most part it’s all organic growth and they earn a very high ROE, so their tangible book value grows over time. They have not been a huge capital returner. They’ve been reinvesting that capital back into loan growth, and so they’ve just been a faster grower than the rest of the industry.

I think the management team’s very good. I knew him when he was the CFO at NBNA, the credit card company 20 years ago, and I was impressed with him then followed his career. I think he is a very pragmatic bank manager. I like him a lot. I’m a little worried about he’s 69 years old, so usually bank CEOs don’t manage far into their seventies, so I hope he continues to run the bank, but we’ll see. I agree with you. I love their credit risk management. They’re very proactive when issues start to arise that way. Loan losses have been low so far, so I think they’ve been tainted with the Silicon Valley brush because they had one business that was venture banking. They had bought a bank in the Bay Area Bridge that had a lot of Silicon Valley clients and they had some deposit outflows, not only from those clients but from tangential businesses because of the headline risk.

Andrew Walker:

This episode is sponsored by tegu, the Future of Investment Research. From the beginning, Tegu has been committed to creating efficiencies in the research process by making it easy to access the content that investors need to get differentiated insights today. They’re taking it one step further by bundling qualitative content, quantitative data, and better automation and technology together in the same platform. Instead of piecing together data from fragmented sources, just log into tegu to get expert research company and industry specific metrics and KPIs, SEC filings and more all under the same license costs. You can even take a look at your work offline with an Excel add-in that updates almost any model with the latest financial data. Keeping all your custom formatting intact. Tegu is the fastest way to learn about a public or private company and the only platform you’ll need for fundamental research to try it for free today, visit tegu.com/value.

That’s tus us.com/value. I guess so I’m no financial experts but financial expert, but the thing I always struggle with is to me, I look at a bank and it’s really hard for me to look at US regional banks and understand these guys were reporting until last year, 20% plus returns on tangible equity every year. I guess the two knocks I had on them was one, I just didn’t understand how a bank could consistently be this good outside of some of the guys who get cash and flows from buying gift cards at the kiosk and they’ve got that and they’ve just got free money there, which has much different types of risks. There’s a different set of risks there, but I wasn’t sure how a regional bank could kind of earn a 20% return on equity consistently. So I’ll just ask you what’s the secret sauce these guys have and then I do have a follow up.

Derek Pilecki:

Yeah, I think some of it’s the efficiency ratios. So banks tend to be very old organization and very bureaucratic systems are very ancient, so there’s a lot of expenses, there’s a lot of people involved. It’s very efficient moving around a lot of paper for some of the newer bank organizations that have been built on more modern architectures, they have less branches, they have less people involved. If you look at Western Alliance, the number of branches they have, they’re not a consumer facing bank. I mean they’re commercial banks, so they don’t have branches on every corner and they also have less people in the bureaucracy. They use technology to automate their processes to some extent. And so I think having that low efficiency ratio and then also just driving those returns through asking for higher yields on loans and being more aggressive in deposit pricing is where you get the higher returns.

Andrew Walker:

Okay. Yeah, I guess the other knock I had on Western lines, and this isn’t a huge one, but after First Republic especially, it’s always go check the fair value of the loans and the held to maturity securities because First Republic wasn’t really held to maturity securities. They had those, but it was a lot of loans to rich guys, 2% 30 years, and any bank that looked at and be like, no, we have to pair value those when interest rates to 7%, it’s not huge for them, but I think they’ve got about 3 billion of fair value marks on their loans. I’m just looking at their 10 K and I think their overall equity was in the 8 billion range, if I’m remembering correctly off the top of my head. So it’s kind of like, oh, it’s 6 billion, 6 billion actually. So it’s kind of like, oh, well you mark to market and you’re paying a little over two times tangible book value and even with a great franchise that will acrete back, but even with a great franchise that mark to market, what do you think about that?

Derek Pilecki:

Yeah, so it’s not quite two times book value. It’s 60 bucks, $46 a share, so it’s like one,

Andrew Walker:

Oh, well, I was taking the 3 billion fair value mark on the loans out of that six, so then that’s kind of how we’re slipping to that.

Derek Pilecki:

Okay. Yeah, I mean they grew their single family book at the wrong time. Yeah, I mean I think the earnings power is there. I mean it’s going to be a little bit of a drag. I think there’s a ton of banks that have group of fixed rate loans that I don’t know, they’re going to just be an anchor around them for a while. I think Western Alliance is in that group, but it can’t have a perfect investment. Everything is, I agree it’s a knock, but it’s not a big deal

Andrew Walker:

And the best way to get rid of that put up 20% ROEs for a few years and all of a sudden that loan book looks a lot smaller. When you were mentioning I didn’t realize how tech enabled Western Alliance was, and when you were mentioning that, I want to talk more about the Discover Capital One merger in a little bit, but just it does strike me the way you were talking about Western Alliance is the way a lot of my friends who are along Capital One talk about Capital One where they say, look, yes, you’re buying them at 1.1 times book or something, and yes, obviously if we go into a recession, credit cards might not be the best place, but what you don’t understand is Capital One is so tech enabled, right? They have redone their, it is the most modern architecture of any of the banks and you’re paying 1.1 book, but as you compound that, it’s just going to result in much better returns, lower expense. I guess my two questions to a, am I thinking about the comparison between Western Alliance and Capital One correctly there obviously two very different banks, but is that kind of the right frame and B, I’d actually love to shift to talking about Capital One.

Derek Pilecki:

I agree. I think Capital One has been forward thinking on their tax spending and they’ve been trying to get to a more modern architecture, so I agree that they’re probably better positioned than the other big banks from a technology. I guess my question with Capital One is, is that technology spending going to lead to a bigger bottom line or are they going to find other ways to spend that money? My issue has been Capital One’s advertising program. When we see their ads all the time, we see the high profile celebrities in those ads. Taylor Swift, how expensive is it to have Taylor Swift in your Capital One ad, Samuel Jackson, Charles Barkley, Jennifer Garner, they’re all over the place. Is the extra profit from the tech spend more efficiency going to drop to the bottom line and it’s going to shareholders or is it going to get reinvested in advertising?

Andrew Walker:

Sue, would your argument, if I’m taking your argument to its conclusion, is your argument like yes, they’re more efficient, but they’re almost spending the old thing where the CEOs used to love to have a branch in Hawaii or something because then they could go to Hawaii on vacation or they love to have a celebrity endorser as you’re saying, because then they get a hobnob with celebrities. I guess the best would be like Amazon making its way into media because then Jeff Bezos gets the hobnob with all the Hollywood celebrities. Is your argument kind of like, yes, they are more efficient, but you’re worried that this marketing spend, it’s not actually return on investment. It’s kind of the CEO’s way and the execs ways of getting to hobnob with important people?

Derek Pilecki:

I don’t know that, I mean, I respect Richard Fairbank a lot that he’s very forward thinking. I just worry that he likes advertising, spending college football bowls or whatever and not sure. I’m not convinced that their return on marketing spend leads to higher returns. Yeah, I think there’s a lot of waste in that spend, and so I’m worried as a potential shareholder that that’s not going to come to me, that it’s going to get burned up in just additional ads.

Andrew Walker:

Another one just high level I’ve thought about is they’ve got the Capital One. It’s not quick slow. They’re going after the high end credit card customers and they’ve been talking about how they’re putting a lot into it and they think the return on investment is measured in seven to eight years. And I’ve always kind of looked at it and been like, I mean Capital One, I don’t know, going after the Chase Sapphire, they’re literally trying to compete with Chase Sapphire reserved and Amex black or gold or whatever it is. And I’ve always kind of looked at and be like, is starting up a de novo high spend credit card where these people are very likely to switch for the best rewards and you’re trying to grab ’em. It just didn’t seem like a great return on investment and I believe they said it would take seven or eight years to capture what they’re grabbing customers out us. That doesn’t seem like a great return for a bank to me.

Derek Pilecki:

I mean, I think Capital One’s been going after that high spend customer for a number of years. I think it’s been a long time. They were subprime at first and then they went to the barbell strategy of subprime and high spenders. So I think it’s a super competitive space. I mean it’s JP Morgan and it’s American Express and everybody’s going after these high spenders, and so I think they’ve been doing it for a long time. I think it’s hard. I think it’s a super, I’m not aware or not up to date of what the returns marginal returns are in that space. With that, do you

Andrew Walker:

Have any thoughts on the discovery merger?

Derek Pilecki:

I think it’s a super interesting strategic move, right? I’m sure Capital One’s been wanting to buy Discover for a number of years, and I also hear that JP Morgan was a bidder or was interested in Discover for a long time. I think one of the most interesting things is moving the debit card spend to the Discover Network by Capital One, but they didn’t move all their credit card spend away from MasterCard to discover. And I think about it in terms of you have different interchange rates. You have Amex at the top, visa and MasterCard in the middle and discover at the bottom and Visa and MasterCard. Their take rate is, although it’s been increasing in recent years, it is not huge. The issuing bank gets most of that discount. And so why Capital One not moving the business away from MasterCard to discover tells me that even with paying MasterCard Capital One’s making more money with issuing MasterCards than if they moved everything to Discover. And so if that’s the case, and this would be the ideal time to move all that business, how do they get the Discover discount rate higher? And I think that’s a hard, that’s going to be a thing for Capital One to work through.

Everybody wants to get to the Amex positioning where Amex says, we have the big spenders. If you accept Amex cards, we’re going to bring you the high spenders and they’ll spend more than any of your other customers. And so all these stores say, okay, I want to have access to that Amex customer. The Discover customer is not the high spender, right? I mean it’s kind of middle America and if you layer on Capital One on top of Discover’s Middle America customer, you kind of get this hodgepodge of Subprime Middle America and then the high spenders that Capital One’s been going after. So is that going to allow Capital One to raise discover’s discount rate to parody with MasterCard, visa or even above it? I don’t know. That’ll be the interesting thing to follow with a story.

Andrew Walker:

The two interesting things that struck me, and again I’m not an expert on it, but I think it’s a really fascinating deal, is number one, the call option on buying Discover taking one of the largest credit card issuers in the United States. And even if initially they’re not pumping all of their spend through Discover, pumping, a lot more spend to try to get more merchants IT maybe keep the rate low to start, but eventually try to close the discount. I think that’s really interesting. I think it’s really interesting. Now they’ve got a hammer with MasterCard and Visa every time they negotiate, Hey, we’re launching Capital One, we’ve got Quick Sliver, now we’ve got Quicker Gold. We’re launching that. Is it going to be on MasterCard or is it going to be on Discover? We’ve got our own network. You guys need to give us a really good rate here or else you’re going to miss out on a hundred billion worth of spend.

I think that’s interesting. And then the third thing that’s interesting is if you think back to what we were talking about with Western Alliance Cap One, I don’t think anybody thought, I mean Discover is selling because they had a lot of regulatory issues. They had a lot of internal controls issues. I don’t know of anyone. I’ve done a few extra calls. I don’t know of anyone who’s out here being Discover. I mean their underwriting system, their tech, my God, those guys are light years ahead of everyone else. But people do say that about Capital One and you think about bringing all of the Discover customer base, all of their marketing spend everything, all their underwriting onto the Capital One platforms, they guided too. I think it was a billion in synergies, but I’ve had some people who’ve been like, look, when you really look under the hood, I would be kind of surprised if maybe it’s not pure cost synergies, but just in terms of better underwriting, better marketing spend, they think they’re going to blow those synergies out the water. So I think all of those are very interesting considerations. I don’t know if you want to add anything to that.

Derek Pilecki:

I mean, I would just say that the cost synergies seemed really low compared to the potential, right? I mean just what you said, getting rid of Discover’s IT system and just moving those customers onto the Capital One’s platform should be a lot bigger savings than what they outlined.

Andrew Walker:

Yeah. Let’s see. So Capital One Discover is actually a nice segue into one of the things you mentioned when we were talking about NYCB regulators. I don’t think there’s an antitrust issue with Discover Capital One. Clearly the market’s worried about it. We don’t have to talk about the antitrust issue here, but regulators and banks is really interesting right now, right? They tapped NYCB on the shoulder and that was a big issue. You just hear a lot of banks are saying, Hey, the banking regulators are being a lot more aggressive with us. Basal three rules are coming in and banking’s a regulated industry. If we took capital requirements up to 25% tomorrow, bank investors would not be very happy. That would be So how are you thinking about just the overall regulatory environment with banks and financials these days?

Derek Pilecki:

Yeah, I think the regulators have been under a lot of pressure recently. There’s the article about the improprieties that came out in the Wall Street Journal about how there’s sexual harassment or an unsafe workplace. I think there’s and SVB ramifications, why weren’t they more on top of that issue? And then they constantly are going to get pressure. Banks are too big, but every time we go through one of these episodes, the big banks just keep getting bigger. I mean, first Republic went to JP Morgan, right? And so it seems like we’re going to continue this wave of a consolidation into the big banks and people hate the big banks, so that just leads to more regulation. I think it’s tough here with we’re heading into what seems like a little higher credit losses. So rates have come up 500 basis points in the past couple of years. A lot of CRE lending seems like it’s going to have to get equity injections to roll over to get extensions. So have the regulators been too lax and now they’re going to certainly come down hard on the banks? Are they going to be start looking through loan files more diligently? Are they going to start questioning bank’s, risk management systems? I think that’s all higher regulation, higher regulatory costs for the banking system.

Andrew Walker:

Do you think about anything when it comes to, obviously we’re in election year, I think people overblow elections a lot of times. How is the election year going to impact Lululemon’s earnings? Not a lot, but with banks it does make a difference. The banks are so regulatory controlled. Do you think at all about the election when it comes to, and this isn’t just banks actually I keep saying banks, but I know you cover, actually we’ll switch to talking about a few other sectors. You cover all financials, just financials in general, do you think at all about the election and outcomes there?

Derek Pilecki:

I think the best benefit for the banks is with mergers will be easier in the Republican administration. So I actually think that Discover Capital One is going to have a trouble if Biden wins the election. I agree based on typical antitrust view, it should get passed, but just I think in this environment, there’s no way they’re going to let it or it’s going to be really difficult to have a big bank merger like that get passed.

Andrew Walker:

It’s so crazy that Discover Capital One is an antitrust cross airs because I remember Sprint T-Mobile when that went through, and I probably disagreed with that going through, but their argument was this is not a four to three. You had Sprint T-Mobile, Verizon at t, they’re like, this is not a four to three, this is a two to three at t and Verizon are so much bigger and so much more competitive. We come in and we form the third competitor and that merger has actually worked, I think in large part because cable was an unexpected entrant more than anything else, but that has worked here. I just really struggled to see what the issue is. Discover they’ve bungled that network for 15 years. It’s not going away. At worst, it’s four to four, but to me this is three to four, right? Because Capital One saying, Hey, we buy them, we’re going to inject all this spend.

We’re actually going to a competitor to the big 2.5 and it’s not like any of the assets are disappearing. I just really struggle to understand the antitrust case and I almost think, I know it goes against Liz Warren, a lot of them and I have no issue with them, but I know it goes a lot against a lot of the thinking to be like big Bank m and a, let’s go. But it actually seems like something that they should be cheering because this is introducing a competitor to the big two and a half in my opinion.

Derek Pilecki:

I guess the tough part is Capital One will be the biggest issue of credit cards. So does forming the giant credit card company like that raise concerns? But I agree with you that it should pass on. If you look at other industries, it’s still going to be a super competitive market.

Andrew Walker:

Let’s go to something completely different. I read your Q4 letter. I’ll include a link in the show notes for anyone who wants to follow along. And your Q4 letter came out and announced a new position in Robinhood and I read it and as soon as I read it, I was like, oh my gosh, this is a beaten down stock, completely overlooked. This is a great thesis, I need to do work on it. I started doing work on it and they announced earnings the next day and the stock was up 30% or so. So I was like, ah, I missed it. But I want to talk about Robinhood as of your Q4 letter, your second largest position. I don’t know where it is today, we don’t have to disclose or anything, but I just want to ask about the overall thesis for Robinhood. And it’s really interesting right now, crypto markets, retail trading coming back in a big way, the stocks had a big run, but just want to ask how you’re thinking about Robinhood these days, overall thesis, all of that.

Derek Pilecki:

So I bought Robinhood after they reported Q3 last year. So Q3, the stock was a little squishy. I think there were two issues I think this month of September. Crypto trading was a little soft and then they might’ve lowered their guidance for an end interest revenue because the yield curve shifted. And so I looked at those are two environmental factors. So it wasn’t like the company failed to produce anything, it was just if you’re going to own a stock for five years, the environment’s going to change, especially a brokerage stock. So Guy I generally don’t buy or sell stocks because the environment at the margin things in the margin, the environment changed, but the stock was down 15% after they recorded earnings on those two issues. So I knew the stock was close to cash, it was about cash value. I think their net tangible assets was about eight bucks a share and the stock was eight bucks.

I had been short the stock when they originally came out of the IPO, I just thought it was overvalued. They had their meme stock issue where they shut off trading GameStop because they were short on capital and I just thought it was overvalued at the time. They were spending a lot of money, it wasn’t profitable. But in the meantime, since the time I was short to Q3 earnings, they’d gotten religion about getting expenses and under control, reigning in stock-based compensation. And then they also had been introducing new products and they had this very clear product roadmap of introducing new things to customers to grow. The customer base was growing, customers were adding new assets. And then I guess to top it off, I remember when I first got in the business in 1999, Ameritrade was a rocket ship that year. It was up 13 times on the internet stock bubble, just new accounts, customer acquisition costs were low.

Lifetime value of a customer was high. Ameritrade just grew like crazy. I was like, okay, Schwab just acquired Ameritrade. And so the industry is in need of another competitor. Schwab. I mean Schwab really, maybe we will get into this in a second, but I think we really need another competitor to Schwab and I thought Robinhood could potentially be that other competitor. So buy-in net cash value. I felt like there was a little downside risk given that there had been profitable to the previous three quarters. And then you also have that upside optionality of if we go another bull market or customers start growing that they could have a lot of upside there. So that was kind of the thesis, like asymmetrical positioning of the stock and I didn’t expect it to double in two months. I mean that’s just luck. I didn’t expect the Bitcoin ETF to launch Robinhood to start going up.

So from here, the stocks at 16 and a half, it’s down a little today. It’s moved a long way in a shorter period of time. The other, but I think that they Q1 numbers are tracking pretty well, right? They’ve spoken to a couple of conferences. They’ve said customer deposits are running above recent quarters. Has the stock moved at this point? It’s kind of like a game of expectations where the people who’ve bided up to 17 bucks, what are they expecting the company to say on customer growth and net new assets versus to what the number that actually prints. So I’m agnostic about the stock here. I still own it, haven’t sold any shares, but it’s gone up so much. Who knows? It’s trying to call the next wiggle.

Andrew Walker:

No, this is why when I read it I was like, oh, this is such a good thesis. I’m kicking myself like, Hey, it’s trading. I had close to net cash liquidation value. Now you would always have the question, I think about something like there was this company context logic, the ticker, there was WISH and they had a billion in cash and they were just incinerated cash so quickly that the billion became 400 million before you knew it. But you do have the worry of, hey, are they going to just, with Robinhood, it would be a, are they just going to keep pouring money into customer acquisition at negative costs just because it’s growth at all costs? I think they had solved that or b, I do remember during the GameStop, what if they have regulatory issues and get hit with fines? But I just love the combination of the downside protection of the assets and the upside of, Hey, I’ve seen this before.

They’re funding customer growth and by the way, if we catch another rocket ship, it’s hard to remember, but October, 2023 was kind of bleak at the time, but if we catch another rocket ship, this thing could skyrocket I guess with Hood, how much of their, because during 2022 when everything kind of crashed on the heels of the manis and everything, it felt like they were talking more about becoming a regular broker, moving away from Hey, we want retailers just like day trading and celebrating memes and how much of their growth now is correlated to crypto going up retail really being interested versus your more traditional, the people, the mid thirties who you would traditionally think are putting $10,000 into an E-Trade account or something,

Derek Pilecki:

Right? So I think they’re starting to get more longer term customers. I still think it’s a lot of brand new investors. They’re very friendly to brand new investors. The average account size is $2,000 means a lot of small accounts. They have the best user interface, but they don’t have a really good desktop app. The user interface is on the phone, and so they just introduced retirement accounts, so you couldn’t get an IRA account until a couple months ago. All those new products are an effort to get bigger accounts. They have this gold subscription where for $5 a month you become a gold subscriber to Robinhood and you get 5% on your excess cash. So I mean compared to Schwab, that’s huge. And so I think that’s incenting people to say, Hey, start using us for your checking account or leave your excess cash in your brokerage account and that’s driving new customer bigger balances and new customers.

Andrew Walker:

Could you imagine if IBKR heard what you just said, $5 a month to get 5% on your cash, we’ll give it to you. Just bring your cash over here. Thomas is going to be having a stroke when hears that.

Derek Pilecki:

I hope not mean, I hope IBKR continues to work on the user interface. I mean to make it easy for new investors, I mean it’s very good for professional investors like us. We can kind of struggle through that and love IBKR, I’ve been a customer for 15 years, but I love it. But for somebody who’s brand new to investing, it’s a little tougher, right?

Andrew Walker:

You open the IB KR account and you’re like, did I just download a nuclear launch codes or something? It’s so crazy. I’m completely with you. Whereas I can’t remember if I did tried Hood, but I’ve tried some hood competitors when they were giving out a lot of freebies in 2021 and it’s literally you just load it and they’re like, press buy here and you have a stock. It’s so intuitive and so simple. You mentioned Hood has a lot of $2,000 customer accounts. Is it even profitable to have a $2,000 customer account just between KYC regulatory servicing the client? Is that even profitable?

Derek Pilecki:

I think it probably is at the margin. I mean $2,000 customer account, they’re probably not subscribing up for the Gold Service. They leave a couple hundred bucks. They don’t pay ’em any interest on the couple hundred bucks cash that’s in the account. So they make 10 bucks revenue a year off that maybe 20, I don’t know. They’re not mailing statements, right? I mean they’re just sending emails. They probably do have to mail a quarterly statement. So what does that cost? A dollar a statement? So the marginal cost is four or $5 a year.

Andrew Walker:

A few years ago you were following the Fannie’s and Freddy’s pretty closely. Are you still involved there at all?

Derek Pilecki:

I’m still involved,

Andrew Walker:

Yeah. Hit me.

Derek Pilecki:

Yeah, I worked at Fannie before business school, right? I worked there for five years and I think eventually it’s going to come out of conservatorship. I mean, I only own the preferreds that own the common. I think the common gets diluted pretty well, pretty hard. I think that there’s the senior preferreds and the junior preferreds and the government owns the senior preferreds, and so the companies have been building their capital, but the government senior preferred state keeps accreting, and so I don’t think that gets forgiven. I think that’s gets converted to common and that, so the common doesn’t really make sense to me, but I think the junior preferreds, they’ll take a haircut, but the haircut’s not going to be anywhere close to the junior preferreds are trading 12 cents on the dollar. I think it could be. Even if they take a 30 or 40% discount, it’s still a lot upside from here.

Andrew Walker:

So just on the fannies, I guess the two things, I mean, look, you’ve pitched it. Bill Ackman’s obviously pitched them before. I guess the two things is it’s been, we’re in 2024, it’s been 15 years since, and I know a lot of people come and say, Hey, the best play on the Trump administration winning is the Fannie Preferreds, and I hear that. I get it. You think you put a conservative administration in, they want to get the government out of things, but Trump was in office four years ago, and I remember four years ago when he came into office, you were like, he’s going to get the preferreds out of conservatorship. And I just wonder, is it in the government’s incentive? Is the Trump admin really going to do it? Is Biden admin really going to do, is any admin really going to do it? Because yes, you’ve got constitutional, people are saying this is unconstitutional. You’ve got hedge fund owners who own the preferreds, but the government’s making a lot of money here and they’ve been able to delay this a long time. Is it really in anyone’s interest? Is this ever going to actually happen?

Derek Pilecki:

I think it’ll happen at the end of an administration. So I don’t think it’s the first thing Trump does. If he comes in, I think it’ll happen towards the end of an administration. There’s possibility Biden loses. They could do something because Biden could use it as a honeypot for housing finance, and so they could use the proceeds from an IPO to fund some pet housing programs that Democrats have. I don’t know from what, when I talk to people in Washington, I don’t know that the Biden administration’s really getting ready for that scenario. So I don’t think that it’s likely to happen this year under Trump. I agree with you. The story was Trump Trump’s going to get them out of conservatorship. I think Secretary Ian who decided not to do it because I think there was some people questioning or saying that, oh, he had good ties to some junior preferred holders, so he’s definitely going to do it. And I don’t think it

Andrew Walker:

Wasn’t good ties. I remember when they got elected and he put ’em in, I was like, oh my God, these are going to convert this. Because

Derek Pilecki:

I don’t think he wanted to ruin his reputation. I mean, I think he had a pretty successful stint as treasury secretary, and I don’t think he wanted any questions about his ethics there. And so I think he put a kibosh on it is my read of it.

Andrew Walker:

I completely agree. I was just going to finish the story. He had ties to a lot of preferred shareholders, and I remember when he got elected, a lot of people were looking to be like, this might be corrupt if it went through. But it does feel like there are a lot of ties here that these are going to get released. Speaking of Secretary Mnuchin, he pumped money in $2 per share, lots of common, lots of warrants into NYCB. The stock is three 40, so his investment is a lot different than what shareholders are looking at these days, but it’s tangible. Book diluted for the warrants is a little over six. I think they’re saying there’s probably going to be a lot of capital reserve building in the next few months, but do you have any thoughts either maybe not on NYCB, but just on his investment into NYCB?

Derek Pilecki:

I think it was a super good investment on his part. I mean, at that entry price, we don’t see how he’s going to lose money. I guess the thing I have a question about is did they raise enough capital, a billion dollars, 1,000,000,006 if they exercised the warrants?

Andrew Walker:

The warrants are cash, the warrants are cashless. So I don’t think that would bring anything in. Okay.

Derek Pilecki:

Yeah. So I guess it’s an open question. Do they know that the CRE issues are small enough that the billion’s going to be fine, but it looks like a good entry price from here?

Andrew Walker:

When I was hearing them talk on the heels of it, I was with you. I was like, Hey, why not just buttoned up? If you’re about to raise capital, you go over so that you kill any concerns. And I was kind of with you, but it seemed to me like I think the regulators, as the regulators tapped NYC on the shoulder, as we talked about earlier, it seemed like they talked to a lot of regulators. And the one thing with the bank, especially with loans that are deteriorating but deteriorating slowly, it seemed to me like the regulars might’ve given them the green light. Hey, put this money in and we’re going to give you the two years to kind of zombie bank accrete your way out of this. Right? And if you can do that, there is, to my understanding, a very good deposit base there. There’s some good franchises if you can do that. And the PNPR is I think about 850 to 900 million per year. So even if you take all of that and put it to reserves, if you’re buying it at $2 and the government’s promised to give you the runway to get to the other side, like buy at $2 with tangible book at six, take two years, put it all towards reserves, that $2 investment looks really, really attractive. Sure. Is kind of how I was thinking about it.

Derek Pilecki:

I mean, I think that’s a fair way to think about it. I don’t know that those discussions take place, but I wouldn’t be surprised.

Andrew Walker:

Yeah. The other funny thing I heard was I think it’s the, obviously NYCB is having the rent regulated issues, and I think the board is nine people, two landlords, two tenants, and then five appointed from the mayor. And they’re like, man, maybe you make that investment and you’ve got a line into the mayor’s office like, Hey, we’re going to fund everything you do, but man, you are appointing five people who are really favorable to the rents going up 4% instead of 3% next year or something.

Derek Pilecki:

I mean, I think it’s super interesting about NY CCBs loan loss reserves because they’re in the asset class that they had literally a hundred thousand dollars of losses over 30 years. And so since they come public in their early to mid nineties, and so they had always run with light loan loss reserves because they always said, look at our history, close to zero losses. And then right when they do the signature deal and get to Q4 and the regulators tap on the shoulder, they also have a couple of loan issues. It’s like, oh, hold on a second. This portfolio is not supposed to have issues. They’ve always had this great history of credit. They ran with lower loan loss reserves because they always had better experience and now do they not have that experience? So I think that whole dynamic makes it a super interesting story. Are these two loan issues that they brought up, are they just the only two or is there a whole bunch of ’em that we don’t see yet? There’s stories about them doing interest only loans. And I think it’s a fascinating situation.

Andrew Walker:

As you’re saying, it blew my mind when their Q4 results came out and they say, Hey, we’ve got this 22 billion loan portfolio or whatever it was, and over the past 10 years, write-offs in it, have rounded to literally zero. And then it just surprised me. Everyone’s freaking out about this. I’m like, what are you guys freaking out about 22 billion of loans and you guys are freaking out. They’ve had no write-offs. This is money good. And then you look at it and say, oh, all of a sudden 13% of these loans are getting criticized. And even there you’re kind of like they were doing it at 60% LTV, but if you had zero losses for 30 years, you would have to think there’s a lot of cushion there. It’s crazy how quickly things flipped. And that margin flipped with obviously it’s all the 2019 law, but as one friend told me, it was like, look, they had a great franchise, but what that franchise was was you were underwriting political risk, whether you knew it or not, you were underwriting political risk. And that chicken came home to roost in 2019 and it just took a couple more years for the problems really to show themselves.

Derek Pilecki:

For sure. Sure.

Andrew Walker:

Hit me.

Derek Pilecki:

I wanted to talk to you about a subject, sorry to drive you off course, but talk. I’ve been having this discussion with a lot of bank managements in its own buybacks, and so my thinking on buybacks has evolved, and I wanted to go through the subject with you. You might have a different view, but

Andrew Walker:

I’m excited.

Derek Pilecki:

I’ve become less enthused with buybacks. And so as a bank investor going through a couple of cycles, I see that the banks who have high capital have an easier time getting through. Also, they get some opportunities at the end of the cycle buying failed banks or more distressed franchises. So I guess I’ve been trying to counsel a lot of my banks that I meet with to don’t be so quick on the buyback trigger. Some of ’em are like, well, our stocks below tangible book value, and a lot of people are telling us the buyback goods of the creative. I’m like when you’re at 90% a tangible book, it’s not that accretive. It’s basically the same as buying it back at tangible book and you have to buy so much. If you’re a Barclays or a Citi group and you’re trading 45% a tangible, you should be buying back your stock at 90%.

I don’t know if it’s that a creative to book value. Also, you should think about capital in the sense of optionality. Just because you don’t buy back stock today doesn’t mean you can’t buy it back in six months or a year. You have optionality by retaining the capital, you retain optionality and so that’s good. As a bank manager, I guess one of the reasons why investors really like buybacks is it prevents management from making dumb acquisitions. So if you’re a shareholder of Coca-Cola, you want them to buy back stocks so that they don’t buy Columbia pictures. I mean that is a dumb value to strain acquisition. You’d rather just own more Coca-Cola, right? And so I totally get that. You don’t want bad acquisitions, but if you’re a bank management team and there aren’t that many hostile bank mergers or there are no hostile bank mergers, you really don’t go outside of the banking industry. Maybe you would overpay for a bank if you had a bunch of capital in your storehouse, but you also have the optionality. If there’s a good growth situation, you can make more organic loans and grow that way. And so I’ve just been changing my view of iax and talking to bank management teams about not being so quick on buybacks and just wanting to get your view or pushback from you.

Andrew Walker:

No, look, I do love, one of the great things about banks is when they trade interchangeable book, if you trust the book, you can create a lot of value quickly, in my opinion by buying. I guess I would ask you two things. So number one, the level you’ve mentioned 90% is not that different than a hundred percent for buying back stock. And I guess how do you think about that level? How do you think about that level changing in terms of with the ROE the bank can produce? Because let’s take Western Alliance, which we talks about and let’s just to make numbers simple, say that we think they can do 20% returns on tangible capital. That means every dollar that they spend buying back their stock is not a dollar. They can invest at 20% returns on tangible capital, but humorously, because a bank that gets 20% returns on tangible capital should be worth a lot more than book value. It’s trading even cheaper when it’s at 90. So how do you weigh those two measures? Where’s the line for you where yes, now’s where I think they should start leaning into the share repurchases.

Derek Pilecki:

I actually think Western Airlines is a great example of a bank management team that aligns with what I’m thinking. They were issuing capital, they had an ATM issuance back when three years ago when the stock was above a hundred and they had loan opportunities. They were hitting the ATM raising capital and making more loans and then when the stock during, maybe it wasn’t during Silicon Valley, it was maybe during covid when the stock was below tangible book, they were buying back shares at 80% of tangible book. I think they’ve shown flexibility of both issuing when it is a high price to tangible book buying back when it’s below tangible book. Now, I wouldn’t say with their high ROE buying it back to tangible book, if they can’t put all that capital work and it’s below tangible book, I was okay with them buying back stock, but as soon as I got above tangible book, they’re like, we’re not buying back any more shares above tangible. We’re not going to dilute tangible book by buying above tangible book.

I guess I think some investors think you need to buy back stock to get your equity account lower to show a higher ROE so that you got a higher valuation. And I think investors are the market smarter than that, right? The market can suss out what’s the natural ROE of the business holding aside whether capital level is correct or not. If a company like First Citizens has excess capital, the market can kind of figure out, okay, their reported ROE is depressed because I know they have excess capital. And so I don’t think you can fool the market by artificially making your equity accounts smaller to show you the best thing

Andrew Walker:

About banks is the first number they report kind of below the income statement is it’s not ROE, it’s return on average assets. So you can kind of just look at the return on average assets and anything in the high approaching one or above one is great, but cool. Your ROE is 20 because you’re running 5% set one and you’re about to get seized by the regulators. Okay, great. Your already looks great, but you’re about to get cs. I’m with you. I think the market does a good job of looking through that individual metric.

Derek Pilecki:

Yeah, I agree.

Andrew Walker:

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That’s TG us.com/value. No, it’s an interesting thought, especially for someone whose largest position is for citizens. People can read the Q4 letter and First Citizens has done a fantastic job of they’ve done these distressed deals, but I think what a lot of people like is they do to the distressed deals and then they take all that excess capital and they buy back stock like crazy. So it’s an interesting thought process. I don’t know. I do worry. You look at something like there are other things, but there are a lot of small regional banks or even smaller than regional that have specific niche focuses, right? And a lot of people worry these trade well below book value. One reason is because people are worried about the concentration risk. If you’re lending all to one niche, then if something goes wrong with that niche, you’re going to have huge problems all at once.

But B, a lot of these guys, you talk to the management teams and they think buying back stock is almost like a sign of failure and they just rather invest in loans and often their ROAS and ROEs are very good, but the market is clearly worried about empire building and refusal to buy back share. So it’s just I’m with you. There can be better uses for share buybacks, but the two things that’s striking me are that gray area and a lot of the market’s going to start saying, oh, these guys are just building capital. And then the other issue is like Valley Valley gets passed over for Silicon Valley by First citizens, and if you’re running with excess capital for three years and you don’t get chosen for that one swing, that’s a big opportunity cost. And does that also start encouraging you to make that one swing a little too aggressively where the one swing, NYCB maybe signature saved them, but it pushes them over a hundred billion? Or Jamie Diamond’s always talked about how you regret some of the bailouts he did in 2008. Maybe you make a swing and you pay too much for it or it’s too much for you to handle and you do that because you’ve sat on your hands for three years.

Derek Pilecki:

I think your point about empire building is really important because I think there are a lot of small banks where the management team does not own a lot of stock. Their biggest assets, they’re W2, and so that prevents from wanting to sell because if they’re the seller, they’re out of a job and they’re not going to another bank. They kind of need to retain their paycheck. And so finding those situations where the bank CEO thinks like an owner, and I find the guys who try to grow tangible book value growth also think like owners. They think of that’s how I’m going to get value out of this bank. And there’s a lot of smaller banks who, you run a small bank, you’re the king, right? I mean people have to come to you for capital. Every small business in your town, your city comes to you for capital, and so there’s not much incentive to leave those jobs, and I think that’s why bank m and a has been nothing this year. Some of it’s the bond marks, but these bankers don’t want to sell or they see selling at not all time highs as a sign of weakness. And so I think that’s that’s keeping bank m and a tempered down.

Andrew Walker:

My favorite thing about banks is you read the proxies, and this is more the community banks that have gone through the Demutualization process, but when you read ’em and they’ve put in the golden parachutes for the management teams and the directors, I’ve never seen golden parachutes for directors before. I really started looking at community banks and two years ago I was like, God, these guys are getting paid for nothing. But now I read it, I’m like, oh my God, thank God. Finally a little alignment in this stupid little three branch bank where the CEO is making 500,000 and the director’s making 50,000, as you said, the kings of town. Finally, they have an incentive to sell. It’s so funny how that incentive and look, there’s no hostile bank m and a, right? You cannot do a hostile bank m and a. You need to look under. And so as a shareholder, your one hope is that in some way, shape or form management is aligned with you to either grow tangible book value to create value that way, or to sell and let somebody else take your deposit basis and grow a tangible book value.

Derek Pilecki:

The other thing, Andrew, I wanted to mention, we’ve talked about banks a lot and I would just want to share, I think banks are below average businesses, right? I mean, I’m an investor in banks. I invest in all types of financials. I think there are some really interesting business models within financials, asset managers, alternative asset managers, some specialty insurance companies. I think there are some good growth banks that will earn above average ROEs for a long period of time with good management teams, but I think the average bank is a below average business. It’s very competitive. Intensities high, high. I think it’s increasing. I think they’re getting chipped away by fintechs. I think the very big banks are great. They haven’t captured the consumer business, so the small banks are left with just commercial business and a lot of commercial businesses just CRE. And so it’s a very volatile asset class.

So I think I would not say, Hey, let’s go invest in the KRE together for the next 20 years. I don’t think that’s a great winning strategy. I think banks are cheap now. They’re cheaper than they are historically. I think that’s going to change if we get a little bit of normalization of the yield curve and maybe credit’s not as bad as the market thinks, but I think, and I think there are some interesting banks that are good growth banks that will compound for years, but the average bank, I think it’s a struggle. And I think that deposit flight last year kind of highlighted that. So I just wanted to mention that

Andrew Walker:

Obviously it’s a deposit flight, but do you think it’s also, it’s well documented, right? JP Morgan, their tech systems, their consumer app, there’s this increasing in the regulatory burden. The tech burden for banks is going up, up, up, up. Do you think part of that is 30 years ago the difference between a community bank and the chase at the time was not that large because you didn’t really need the internet presence, your regulated, so do you think it’s just that return to scale and that issue that so many people talk about, Hey, the us we’ve got this dichotomy between we have 5,000 banks, but we’re regulating and the systematically important banks have this huge advantage where your deposits are safe there. Is that all kind of the issue that makes these below average businesses these days?

Derek Pilecki:

Yeah, I mean, I think the big banks have the scale of the branch networks, although people don’t go into branches as much as they used to. People like to know that there’s a B of a branch or a Chase branch on every corner. I think there’s also scale to advertising, so they feel comfortable with, they see the ads, they feel comfortable that there are banks there. I think for the most part, the consumer banking business has been captured by the large regional and the universal banks. I just think people with means have checking accounts at the big banks or for the most part. And so I just think the consumer is not in play for small banks on average. Yeah, they have some friends and family accounts, and maybe if you have your commercial account there, you also have a checking account there. But the average consumer, the middle market consumer is not going to small banks. They’re going to the big banks.

Andrew Walker:

Well, Derek, I have so much more to ask you about. Genworth was actually what I reached out to you about that I wanted to originally talk to you about. There were lots more questions, regulation, but you’ve been super generous with your time and I have a physical therapy appointment I need to run to. So look, Derek, I’ll include a link to his Q4 letter in the show notes if anybody wants to read it. And look, he’s the best in financial, so you should be following him on Twitter, following his letters and everything. Derek, thanks so much for coming on and looking forward to having you on Again,

Derek Pilecki:

Andrew, thanks for inviting me. Great to talk to you.

Andrew Walker:

A quick disclaimer, nothing on this podcast should be considered investment advice. Guests or the hosts may have positions in any of the stocks mentioned during this podcast. Please do your own work and consult a financial advisor. Thanks.

 

Financials Pilecki Reprint

 

One of the top contributors to the Fund in Q4 was a newly purchased position in Robinhood Markets. We understand this may surprise some of our partners as a money losing, VC-funded financial technology company appears to conflict with our investment history of preferring highly profitable companies with low valuations. We had followed Robinhood for several years before purchasing shares. In fact, we shorted the stock from December 2021 to April 2022. We continued to follow the stock and have admired Robinhood’s innovation of the mobile app, engagement with its customer base, and its introduction of zero-commission stock trading.

 

After reporting earnings in early November 2023, Robinhood’s stock declined 15% due to a slight adjustment in guidance as a result of changes in market interest rates as well as a seasonal slowdown in customer trading activity during September. We did not think either of these issues justified the stock declining 15%. We also believed the valuation was attractive and started to buy shares.

 

Here was our investment thesis when we purchased Robinhood in November 2023:

 

  1. Robinhood was trading at $8.07, and its tangible book value was $7.92. This valued Robinhood at just above 1.0x book value. We felt this valuation provided a good amount of downside protection. In fact, Robinhood has been buying back its shares in recent quarters because of the low price. Robinhood is marginally profitable, and we do not see book value declining except in severe market scenarios.
  2. Robinhood is growing accounts and consistently attracting new net assets from customers onto its platform on a monthly basis. Robinhood adds about 30,000 new accounts per month and attracts over $1.0 billion of customer inflows per month. At this rate of customer inflows, Robinhood is growing at an 18% per year rate without considering market appreciation from their customers’ investments.
  3. Robinhood has better positioning as a customer advocate than industry leader Schwab. Although Schwab has a great franchise and large market share, we think the company has wrecked its business model in the name of imitating Robinhood. When Robinhood was launched, the company’s innovation was free stock trading. Schwab copied Robinhood’s free stock trading model. Schwab’s move caused Ameritrade’s management to panic and agree to an acquisition by Schwab. Schwab’s management team thought they could make up for the lack of stock commission revenue by forcing their customers into holding their excess cash in Schwab’s affiliated bank and paying an unreasonably low interest rate on this excess cash. The table below shows the interest rates major brokerages pay their customers on excess cash.

 

Broker Interest Rate on Default Option for Residual Cash Default Option
Schwab 1.35% Schwab Bank
Fidelity 4.98% SPAXX
Vanguard 5.29% VMRXX
Interactive Brokers 4.83% Broker interest
Robinhood 5.00% Broker interest (Gold subscription)

 

Schwab is clearly on the wrong side of customer advocacy on this issue.

  1. Robinhood is introducing new products at an impressive pace. They have already introduced Gold Subscription Accounts, retirement accounts, UK accounts, and credit cards. In addition, Robinhood has several new exciting products that they’ve announced but not launched, such as futures and advisory accounts. They can also introduce other products in the future, such as trust accounts, corporate accounts, advisor accounts, and mortgage lending. We believe these new products will help Robinhood take market share and grow faster than the industry.
  2. Robinhood appears to be getting its expenses under control. Robinhood has been reducing its expenses, including stock-based compensation. In Q3 2023, Robinhood beat analysts’ estimates for EBITDA by $30 million due entirely to lower expenses than previously forecasted. We think Robinhood’s management is realistic about reducing the company’s expenses while still investing in new products.
  3. There is historical precedent for stock market investors to place high valuations on discount brokerage firms during periods of high growth. In late 1998 and early 1999, Ameritrade’s stock price climbed 17x in six months as individual investors opened new brokerage accounts to trade stocks at the beginning stages of the Internet bubble.
  4. Robinhood’s business is still small, but this allows Robinhood plenty of room to grow. We think this potential growth will create substantial shareholder value.

 

There are risks to Robinhood:

 

  1. Low-end customer base – Robinhood’s average account value is only $4,000. It has millions of very small accounts. Most of these accounts will never amount to anything. There is also the risk that existing customers will look to “graduate” from Robinhood when they start saving and investing more substantial amounts of money.
  2. Potentially damaged reputation from meme stock operations – When GameStop’s stock went parabolic in early 2021, Robinhood’s customer base traded the stock like crazy. Robinhood’s systems had trouble keeping up with the order flow, and Robinhood had trouble meeting its skyrocketing net capital requirements from the increase in customer trading. Robinhood paused the trading of certain stocks during very volatile days, and customers could not transact. There were many stories of customers not able to trade out of losing positions. The damage to Robinhood’s reputation continues. But, we believe the damage is dissipating as Robinhood continues to show growth in customer accounts and customer assets.
  3. Robinhood has had consistent insider selling. Several executives have programs in place to sell shares regularly. We don’t have a satisfactory answer for this selling given what we believe is a low stock price.

 

Although Robinhood’s price is above where we purchased shares, we think Robinhood is still attractive because the downside is limited to tangible book value. The upside could be multiples of the current stock price depending on customer acquisition and market share gains. We are excited about management’s efforts to grow the business by introducing new products to attract additional customers. Management also recognizes the opportunity to gain wallet share with existing customers. We believe the industry needs additional competition after Schwab’s purchase of Ameritrade. We think Robinhood has the potential to produce good returns as they step into the opportunity left open by the Schwab-Ameritrade merger.

Garrett Brooks:

Good afternoon everybody, and thank you for joining us. My name is Garrett Brooks with Slingshot Financial. We are a Colorado registered investment advisor and your institutional representative for Gator Capital Management. With me this afternoon, happy to have the man, the myth, the legend himself, Derek Pilecki, Managing Member of Gator Capital Management and Portfolio Manager of Gator Long Short. Gator Long Short …

Derek Pilecki:

Hey Garrett.

Garrett Brooks:

… if you remember – oh, hey Derek. How are you doing?

Derek Pilecki:

Thanks for having me on.

Garrett Brooks:

Thanks for joining. How are things in your world?

Derek Pilecki:

Things are good. We’re just wrapping up earning season. We’re coming, the end of Q3 earnings so, it’s been good. Conference season’s starting. I went to the [inaudible 00:00:52] conference last week and headed to the Piper Sandler conference next week, so getting to meet with a lot of current holdings and prospective holdings, so it’s been good.

Garrett Brooks:

Fantastic. And for those joining and just becoming familiar with Gator Capital and the Long Short strategy here, which we’ll get into deeper in a second, Derek is a financial sector specialist, has been his entire career and so we spoke on a call like this back in April/May, I think it was, and you had said to me you were squarely focused in your sector, what you knew and you felt that the market was serving you up a big fat pitch at that time. And clearly the volatility in the sector, still a lot of uncertainty there and I know that you are just finding a ton of opportunity both for the long and the short book in your portfolio, but was hoping that you said, just came out of earning season, you could share with us your thoughts, first on the economy and the broader equity markets in general and then how that’s translating into the financial sector where you are squarely focused and finding that opportunity.

Derek Pilecki:

Sure. I guess to start with the economy, I would say we’ve been in a while here coming out of the pandemic where things have been super confusing and there’s been a lot of crosscurrents and I think most people would’ve expected the economy to have weakened by the stamp by this point, but the consumer continues to show strength and the economy seems to hum along. I would say we still have yet to see the full effect of interest rate increases. A lot of people have fixed rate mortgages, so they’re not seeing their payments go up from the higher rates, but there’s some loans that are going to repriced higher or any new business is slowing down because they have to take out new loans. So we could still see a weaker economy going forward. I would say that there’s been a lot of dynamic changes in the economy due to COVID.

First it was a product cycle where people just sat at home and order products and then as we got to move back out around, services really took off and now people have to go back to work. So it seems like consumption’s going to go down, but people are going to work more. So just a lot of different things, unusual for … some things that we haven’t seen for 50 years with inflation ramping up and then ramping back down. So I think the economy’s in pretty good shape. I’m worried about certain sectors of the economy, especially the big ticket items like housing and cars, just where people would have to take out a loan to make those purchases. I’m also worried about the construction trades. I think a lot of construction projects that are in process are going to completion and construction trades are working on those, but then the new projects that should be getting started in 2024, late 2024, 2025, they’re not really penciling out from an economic return standpoint for developers.

So I’m worried about the construction segments of the economy, not new homes, more just commercial like office buildings or new hotels. There’s just not new commercial billings that are getting started, so I’m worried about that and I’m worried about the knock-on effects of that. We’re starting to see some indications of slowness like FedEx telling their pilots that they have to want them to go work for a regional airline because Christmas is not going to be as strong as they had thought.

And so we’re starting to see some little incidental evidence that the economy is going to slow, but so far I think whatever happens will be relatively shallow. I think we’ve gotten some good news out of the Fed that they’re done raising rates. I know they don’t exactly say they’re done raising rates, but I think if you read the tea leaves, they’re not going to raise rates. I don’t think inflation’s going to re-accelerate from here. I think financial conditions are tight enough that there’s no way inflation can accelerate, but that’s my general economic view.

From a market standpoint, we’ve had a relatively strong market this year, but it’s been concentrated in a few stocks. I think there’s a lot of stocks that are inexpensive here. I think valuations are pretty interesting. Normally stocks discount a recession and they’ll bottom before we actually see the recession. So I’m not saying I think that the economy’s going to be weak, so we should [inaudible 00:05:40] out of stocks. I’m saying more I think the recession is here, but it’s going to be shallow and stocks might be bottoming now and getting ready for a run. So that’s my near term market view.

Garrett Brooks:

Great. And then how about in the financials, specifically in the sector that you follow very closely. I guess, what sorts of things are you seeing? Obviously there’s still a lot of chatter, a lot of commentary. I think I like to consider them more narratives surrounding the sector. I know that there’s, in talking with you closely, there are certainly some misconceptions and what can you share with us from your seat and looking very closely at the individual names in the sector?

Derek Pilecki:

So looking at financials, I mean I look at all different types of financials. Obviously banks, but also insurance and capital markets and asset managers and REITs. Banks are pretty topical because we had a regional bank crisis earlier this year. I think there’s a couple issues with the banks that bank valuations are as cheap as they’ve been, so it seems like the whole sector trades at seven times next year’s earnings, so that’s full expense.com. It’s expectations getting worse next year. It seems like almost every bank trades for seven times earnings. Which is cheap relative to where they usually trade. They usually trade nine and a half to 12 and a half times earnings.

I think the market’s discounting two things, net interest margins are getting squeezed. I think that’s close to coming to an end as deposit costs have risen to become more competitive money market rates and then some fixed rate loans are finally starting to reprice and we’ll move higher. So margins should start to expand going forward. I think the other big bogyman for banks is credit; is if the economy weakens, are we going to have credit issues? So far I think the office building sector is really the only source of concern within credit and a lot of banks have three to 5% of their loan portfolio in offices. A lot of those offices are suburban or focus on the medical community where people have to use their office to see patients.

I think a lot of banks have some pretty big reserves against the office portion of their loan book. We’re not seeing other sectors show weakness yet, but there’s one or two banks that have one or two issues and maybe this is just the start of a credit issue. So we’ll see. I think that other sectors of financials, insurance pricing is headed higher and the insurance stocks are doing phenomenal. Capital markets is kind of hit or miss. There’s not really been a strong IPO market or a big M and A market, so big investment banks aren’t really hitting all cylinders as far as the fees, but there’s pretty good trading.

Asset managers have been okay. We still have some pretty secular shifts from active to passive, and so the average asset manager trades pretty inexpensively. I think there’s some opportunities there. I think there’s a couple asset managers that trade at six times EBITDA and have diversified businesses. They’re not in large cap value, which is easily replaced by an index. Like they’re in either small cap stocks or fixed income products. They don’t necessarily have good passive products to follow along. So I think there are select opportunities there, especially finance, there’s constantly opportunities in that sector. And then in the REITs, I’ve really been short office REITs. I think the office sector is a problem. I’m surprised the office REIT sector has held up as well as it has given that they’re facing negative occupancy growth and negative lease rates. And so I think that’s a prime area for some shorts in the REITs.

Garrett Brooks:

Sounds like lots of opportunity. Sounds like there lots of value to be had there.

Derek Pilecki:

I would even add to it, within banks, with everybody trading at seven times earnings, it’s almost like the sector is not differentiating between banks that are well positioned for higher rates and banks that are not positioned for higher rates. It’s almost like people just trade in and out of the KRE, the ETF and they’re not differentiating between, hey, these banks are the best positioned for higher rates and these banks are really messed up with a lot of low coupon loans and that they’re going to be eating those low coupon loans for years. And so I think it’s a pretty interesting sector from both longs and shorts right now. I would say predominantly I’m net long the banks, but I also have plenty of shorts amongst the banks that have fixed rate loans.

Garrett Brooks:

And to that point, I know for a fact that there are a number of people who are simply trading the ETFs to try and get they’re either trying to bottom fish or trying to short, but doing the sector broadly, and that’s one of the key points I know that we’ve talked about before, you’ve seen through your career that generally a lot of your peers who were financial sector specialists following the financial crisis in 08/09, kind of became more generalists or lost interest with focusing on the sector. And so that’s leading to less competition for you and others like you, but for you and finding those gems, the hidden opportunities in the sector because so many people are simply placing trades with the ETFs broadly.

Derek Pilecki:

So generally there’s about two dozen financial sector funds, whereas there’s almost 200 technology sector funds. I just think that there’s less people looking at the sector and so that leads to some opportunities, especially in the small mid-cap stocks. There’s less liquidity. The multi-strat funds can’t really participate in the lower, the smaller market cap companies, so I just think there’s less people looking at them. And there’s tons of small cap financials to look at.

Garrett Brooks:

We talked a little bit about some of the different sub-sectors, the industries that are in the portfolio. In terms of themes, what would you say is really driving some of the performance that you’re seeing and we’re enjoying as shareholders?

Derek Pilecki:

If I look at the third quarter, the top three performers during the quarter were Genworth Financial, Jackson National Life Insurance, and First Citizens Bank. Starting with First Citizens there, they were the acquirers of Silicon Valley from the FDIC, so they bought the remnants of Silicon Valley Bank and they got a fantastic deal. So in Q1 and Q2, the stock was very strong and then it continued in Q3 where a lot of the banks pulled back during August and September where Citizens kind of just held its own and the market’s starting to figure out that Citizens is undervalued. I think Citizens, it trades for about $1,400 a share, book value is like $12.50, $12.70. I think book value is going to accrete over the next three years to like $1,800 and I think it can trade at one and a half times book, so it could get up to $2,700 in a three-year timeframe, and so you could have almost a double on the stock in a three-year time. And I think that’s pretty interesting.

Genworth’s been a stock we’ve owned for about 18 months. It has two main businesses, a mortgage insurance business and a life insurance business. They IPOd 20% of their mortgage insurance business two years ago. It’s Enact Mortgage Holdings and Genworth continues to own 80%. If you do some of the parts on Genworth, they have some debt outstanding. So if you take their value of Enact minus their debt, Genworth still trades at a discount to its publicly holdings of the mortgage insurance subsidiary and that totally assigns a zero to the $5 billion life insurance company. The life insurance company might be a zero because they were in the long-term care policy business and long-term care policies have just been mispriced and there has been a big black hole. But Genworth’s done a good job of repricing those policies over the past 10 years and they’ve, just to give you an example of how big the problem was, they’ve raised prices $22 billion on those policies and the market’s still assigning a zero value to the life insurance company.

So they’ve massively repriced those policies. Now those people are just getting to their mid-eighties where they’re making claims on those policies, so their claims are going to increase over the next 10 to 15 to 20 years, but I’m thinking that there could be some value in that life insurance company subsidiary, but it might not be realized for several years. So Genworth has held up this quarter and some of that discounts closed. And then Jackson National is a variable annuity writer. They were spun off from the Prudential UK a couple years ago. It was a very small percentage of your Prudential holdings, so say you’re based in London, you own Prudential UK, and then say you owned $10,000 Prudential UK, you got a $500 spinoff listed in the US in Jackson National. And so those investors all just sold off their shares and the stocks traded very inexpensively.

Variable Annuity’s are very tough, opaque business, so it should trade at some discount. I just argue that discount’s too steep and so the company’s done a good job of returning capital to shareholders. And so those three examples of things that have worked during the quarter, those aren’t Wells Fargo, Bank of America, Berkshire Hathaway, Travelers or JP Morgan. I mean it’s not the XLF/ETF. It’s small mid-cap companies with differentiated stories, unique stories that you don’t normally hear about, and I think there’s dozens if not hundreds of those companies within the financial sector for me to pick and choose from.

Garrett Brooks:

And right there, that hits the nail on the head. How can you explain such really impressive performance amidst a lackluster year to down year really in the process there, bottom up portfolio deeply, deeply researched, concentrated on small to mid-cap financials and businesses that Derek knows very well and oftentimes sees some sort of a catalyst in insight for either multiple expansion or some sort of a deterioration in the stock price. So that’s fantastic. In terms of the near term, I know that we’ve talked and talked with some advisors and you are very optimistic for the portfolio in the near term for the foreseeable future. What are you seeing in terms of opportunities and maybe some risk that we should be aware of?

Derek Pilecki:

So, I think in the near term, I think we’re in a good seasonality part of the year that the fourth quarter tends to be good. We started to see a little bit of a rally last week. I would expect positive market events over the next couple months. I think of this time as very similar to 1994/1995, where the Fed raised rates substantially in 1994 and then when they paused at the beginning of 1995. I think they did one last rate hike in March of ’95, but the market just ripped higher, especially financials. And so if the Fed’s pausing here, and that’s right, and the valuation of financials, I think there can be a substantial re-rating higher.

That being said, the recession is lurking out there and what is it going to look like? There has to be a lot of treasury issuance. The Central Bank, Chinese and Japanese investors and commercial banks are not buyers of treasuries right now, and they historically have been big buyers, so you’re going to have to have money managers buy all these treasuries, The Treasury’s going to issue, so that could be a risk. Then also if there’s surprise credit problems, more than what I think, and I outlined my concern about office buildings and loans on office buildings, but if there’s other segments of the economy that we can, I think they could some credit problems that would be a potential risk.

I do also want to just mention, obviously not all our picks work out great. We had the three biggest detractors in Q3 were Vornado Realty Trust, Axos Financial and Arlington Investment. So Arlington investment was a mortgage rate that was getting acquired, that was announced in Q2 and then the acquirer went down a little bit in Q3, so Arlington went down in sympathy.

Axos is a online bank based in San Diego. They have a super entrepreneurial CEO. It has been a short seller report around their involvement in crypto. I think it’s not an issue. I think the bank’s addressed the issue, but it underperformed slightly in Q3 and Vornado is an office REIT that had a terrible first part of the year and they bounced in Q3. I think it probably got oversold in May and just bounced a little bit on us in Q3. So I just want to be balanced about presenting stocks that work that don’t work in our portfolio.

Garrett Brooks:

Of course. So you’re saying not every single pitch is a home run, right?

Derek Pilecki:

Not every single one, right. Yes. I don’t bat a thousand.

Garrett Brooks:

Fair enough, fair enough. We would have serious questions, I think, if somebody sat here and said that everything that they’ve ever touched turned to gold. But with that being said, if anybody online here has questions, go ahead and pop them into the chat and we’ll address them as in the order that they come through. While we open that up and give people the chance to do that, I did have a question somebody asked me to ask of you, I should say, yesterday. And you touched on it a little bit earlier on, in terms of valuations, what’s being priced in and what’s not. This individual seemed to think that that long short financials would have a tough time and be seeing headwinds over the next three to four quarters, and I’d love to just get your initial reaction to that statement because I know it’s a fair sentiment and would love to hear what your thoughts are on that.

Derek Pilecki:

I think there are headwinds facing the sector, right? I think margins compressing and I think credit, and I think we got a little bit of an answer with the Fed pausing rates. I think the margins can bottom, if not this quarter, Q4 or Q1. And I think when margins bottom, that that’ll be taken off the table. And then credit, it’s always out there, right? And it seems like it’s closer than it’s been, but we are not seeing terrible credit quality amongst the banks. We just had the all time best credit quality over the past four quarters. Things are starting to tick a little bit higher. How bad will it get? It’s going to be a long process.

I think the banks are well run. I think the regulators are on top of the banks. I think from a credit quality perspective, we could argue that they weren’t on top of things from an interest rate risk perspective with Silicon Valley, but I think on credit quality, they’re reviewing loan files and I think credit’s pretty good. We will see where office loans go and we’ll see if there’s any other hot button credit issues going forward. So I agree that there’s some headwinds. I think the valuation, we’re way below the normal range for banks as far as valuations, and I think it’s way too cheap.

And I think from the long short perspective I touched on a little bit. All the banks are trading in seven times earnings, whether they have underwater bond portfolios or they’re perfectly positioned for this interest rate environment. And so I think that’s where the opportunity is of you don’t necessarily have to be long banks here. You can be long the ones that are well positioned and short the ones that are not.

Garrett Brooks:

Everything’s priced the same.

Derek Pilecki:

Yep.

Garrett Brooks:

Okay. Actually a few questions in here, a few good ones here. First one is, and actually this is going to kind of dovetail with the second one, I think here, but how do you position defensively and what does that look like currently?

Derek Pilecki:

I think I’m relatively defensive, so I’m about 90% gross long and I’m about 50% growth shorts. The net’s 40. I think that’s at the low end of the range. Historically, I’ve been above 50% that long, but I do see some, I’m pretty bullish about the calendar in the valuations, but I think there’s some things that are expensive and there’s also some banks that are not well positioned for the environment, so we’re short those. So I feel like we’re relatively defensive here compared to where we are normally, despite my bullishness.

Garrett Brooks:

Right. Great. I had a feeling that’s what you would say. The second question was actually what is long versus short positioning? You just touched on that, so we’ll jump into the next one. This has to do with real estate and it’s, do you think the banks will take larger losses on real estate portfolios?

Derek Pilecki:

I do think that there’s going to be a lot of work around real estate issues. I think to the extent that loans that, if a loan had a five-year term and it was written in 2019 and they have to refi it in 2024, I think that there might be some refis that sponsors need to contribute cash to pay down the loan a little bit to make the numbers work. I think the real problem is 2021/22 vintage, so as we get to 26/27, the valuations from 21/22 are not going to fly in 26/27, so we have a few years to go before that happens, but I think that’s the real vintage of loans that own commercial real estate that people are going to keep an eye on and how does that get refied. So luckily we have two or three years before we get there.

Garrett Brooks:

Interesting. Very interesting. Okay, one more question here, easy one. Do you take interest rate bets?

Derek Pilecki:

I think it’s hard not to take interest rate bets within the sector. I think there’s a lot of interest rate risk amongst the different companies. I would say, right now, that I’m relatively well positioned for higher, for longer. I think if the economy weakens substantially and there’s massive rate cuts, I’m going to have to make some changes to the portfolio, especially on the short side. I think some of my shorts would respond pretty favorably to aggressive rate cuts. I don’t think, my view of the Federal Reserve is they don’t want to be the ones that let inflation get out of control, and so I think they’re going to err on not cutting very fast. I think we’re in a higher for longer type scenario, and so, there is interest rate risk within the portfolio, but that’s how I’m positioned.

Garrett Brooks:

Fair enough. I would agree with you, higher for longer. It’s all about Jay Powell’s legacy from here on out.

We actually, that is all of the questions in the queue here, so it looks like we addressed everybody’s question. Derek, thank you so much again for your time. Love these chats. I know that the people in the field, the wealth of managers, the portfolio managers, the research analysts that I talk with, also love hearing from you, specifically on the sector, and congratulations on a phenomenal year and keep it up. Like I’ve said full disclosure, I am a shareholder and so I’m loving this and I know that the people who join us and who are listening and there are probably a number of shareholders who are also quite pleased with what you’ve done.

Derek Pilecki:

Thanks for having me on again, Garrett. Enjoy these chats.

Garrett Brooks:

Great, great. All right. Thank you everyone. Thanks for joining and obviously if you have any questions, feel free to pop them into the chat. You can always contact me and look forward to seeing you next time. Take care.

The Fund’s largest position is First Citizens Bancshares (“First Citizens” or “FCNCA”). We acquired our stake over the past three years. Initially, we owned and traded around a small position in CIT Group Inc. (“CIT”) during the summer of 2020. We felt CIT was undervalued and management was making progress in reducing risk during the Covid-19 pandemic. In late 2020, CIT agreed to be acquired by First Citizens. We added to our CIT stake the morning of the acquisition announcement because we thought the acquisition was so financially attractive that First Citizens’ shares would rally and pull CIT’s shares higher. Our CIT shares were exchanged for First Citizens shares when the merger completed. We held onto our First Citizens shares because we admired the management team, we felt the bank was undervalued, and we projected the bank would benefit from higher interest rates. Then, earlier this year, First Citizens was the winning bidder in the FDIC’s auction of the failed Silicon Valley Bank (“SVB”). We added significantly to the Fund’s First Citizens position on the following Monday morning because the deal was unbelievably favorable for First Citizens.

First Citizens’s stock price rose more than 50% that day and has risen another 40% in the months since the SVB acquisition. We have not sold any shares. We believe the stock still has the potential to double over the next three years. Despite this attractive upside, we think the downside is minimal. Our downside scenario is an unchanged stock price in three years.

Here is our detailed investment thesis for First Citizens:

FCNCA trades at a discount to other large regional banks on a Price-to-Tangible Book value (“P/TBV”) basis. It also trades at a slight discount on a Price-to-Earnings (“P/E”) basis looking at sell-side 2024 earnings estimates (see chart below).

Usually when a bank trades at a discount to peers on a P/TBV basis, it is because it has lower returns than peers. At first glance this appears to be the case with First Citizens. It is projected to earn a 14% Return on Equity (“ROE”) in 2024 where its peers are projected to earn higher ROEs. However, when we adjust for the excess capital that First Citizens is holding, we believe it has a ROE similar to its peers and does not deserve to trade at a discount.

We believe there are other possible reasons why First Citizens trades at a discount to its peers. The main reason is it is not a member of the S&P 500 Index, so it does not have the demand from passive index investors. Other minor reasons for First Citizens’ valuation discount are a lack of familiarity within the investment community due to limited but growing sell-side coverage, not hosting quarterly earnings conferences calls until recently, not attending brokerage investment conferences, high nominal stock price and limited trading volume, and a low dividend compared to peers.

One additional unusual reason for the valuation discount is the dual-class share structure of First Citizens Bank. The Holding family controls the Class B voting shares. This dual-class structure may discourage some investors from owning the stock. We disagree with this thinking. First, the Holding family has demonstrated an extraordinary commitment to shareholder returns. First Citizens is the best performing stock of its peer group over the last 30 years. We view the Holding family as owner-operators. We note that many of the best performing stocks have had owner-operators: Berkshire, Microsoft, Amazon, etc. There is data that proves companies with owner-operators outperform because management is able to focus on long-term value creation. We think this applies to the Holding family controlling First Citizens.

Another criticism of the dual-class share structure is the difficulty in applying outside pressure to gain voting control and/or board seats. I believe this is a non-issue for banks. The difficulty of a hostile takeover in banking is high. There hasn’t been a successful hostile takeover of a bank since Bank of New York acquired Irving Trust in 1988. Plus, the regulators limit ownership levels of banks before an investor has to register as a Financial Holding Company. Overall, we see the First Citizens dual-class share structure as a non-issue.

First Citizens’ stock outperformance in 2023 may be distracting some investors from the potential returns still offered by the stock. First Citizens’ stock has returned 78% this year. Its peers have had negative returns between 20% and 35% this year. We know it is natural for investors to say, “We missed it,” when a stock has performed like First Citizens’ stock has. The last thing these investors want is to buy First Citizens after the run and have it underperform once they buy it. In other words, they don’t want to be wrong twice on the stock. As we will discuss below, we believe there is significant downside protection in First Citizens because of the defensive nature of its balance sheet.

First Citizens has a very liquid balance sheet, which is perfect for the current environment. For example, First Citizens has 17.6% of its assets in cash compared to Truist at 5.6%. This liquid balance sheet gives First Citizens plenty of opportunity to take advantage of the wider loan spreads available in the current environment. The extra liquidity also reduces pressure to pay up for deposits. The high cash balance is the best indication that shareholders have a measure of protection from First Citizens’ balance sheet.

First Citizens’ balance sheet is defensive and well-positioned for growth.  The bank has almost no borrowings beyond the $35 billion FDIC note that has a five year term. First Citizens’ management did not invest in long-dated fixed rate securities, so unlike many other banks, it is not carrying a portfolio of underwater bonds. Also, First Citizens loan book is balanced between floating-rate and fixed-rate loans. This balance was created through the strategic acquisitions of CIT and SVB. The CIT franchise produced excess loans and the legacy SVB franchise produced excess deposits. We believe First Citizens is positioned well for the current consensus outlook for rates of “Higher for Longer”.

Investors are not assuming any growth at First Citizens based on its stock price trading just above tangible book value. Based on sell-side models, expectations are for minimal growth in First Citizens’s legacy banking operations and that SVB will shrink going forward.  We think this is wrong because we think prospects for the former SVB operations are strong. Certainly, the SVB franchise is diminished as several business development personnel have been poached by competitors. We think multiple competitors are targeting the venture capital community.

The current environment in the venture capital community is not ideal, but SVB was a powerful growth franchise. To offset these concerns, we note that the current deposit balances at SVB are already down close to 80% from year-end levels. So, we believe customers who want to leave SVB have already left. Also, we believe there is substantial goodwill within the venture capital community for SVB. SVB is intertwined with the venture community and continues to have strong relationships with the community. Lastly, we believe venture capital as an industry will grow faster than the overall economy. We think there is a good chance that SVB will continue to grow under First Citizens ownership. At the current valuation, we view this growth potential as a free option.

Regional banks as a group may re-rate higher. In addition to First Citizens trading at a discount to peer large regional banks, we believe regional banks trade at the low end of their historical valuations. Large regional banks trade for about 7.4x 2024 EPS estimates, we believe the normal valuation for this group is between 10x and 14x. We understand that at this point in the cycle banks should trade cheap, but time marches on and cycles can change quickly. We expect the group multiple to re-rate higher as the industry works through higher interest rates and the credit cycle peaks.

We do see some risks to our First Citizens investment thesis:

Aggressive rate cuts by the Fed.  First Citizens is among the most asset-sensitive of the large regional banks. If the Federal Reserve were to aggressively cut short-term interest rates in response to weak economic conditions, this would hurt First Citizens’s earnings. We think this scenario is unlikely given the recent bout of inflation that the Federal Reserve has been battling and the Fed’s “Higher For Longer” mantra.

Continued calls for increase capital requirements for banks. Bank regulators continue to make statements that banks need higher capital requirements. While we disagree with this sentiment, we acknowledge the potential reduction in returns for bank investors with higher capital requirements. We do believe First Citizens is well-positioned to comply with higher capital requirements due its excess capital position. We would expect First Citizens’ management to operate the bank with a significant capital cushion.

First Citizens may be over-earning in the near-term. First Citizens is experiencing two temporary benefits to earnings. One, as part of the SVB acquisition, First Citizens issued a 5-year note to the FDIC for a below market interest rate of 3.5%. Two, First Citizens marked-to-market the SVB loan portfolio at a discount to account for credit risk. As the old SVB loans payoff, First Citizens recognizes the discount into income. Both of these factors are causing First Citizens to over-earn in the near-term.

First Citizens is facing significant integration risks with the SVB deal. The SVB acquisition was a large deal. SVB was a complex bank in a new business line. Multiple competitors are poaching SVB personnel. The SVB customer base went through a traumatic event in March as it was uncertainwhether they would lose their deposits in the SVB failure. We worry about the integration risks that First Citizens faces with SVB. But, we are reassured that First Citizens has significant experience integrating complex and geographically disperse acquisitions.

Future M&A deals are unlikely to create as much value for First Citizens as the SVB deal did. Going forward the opportunity for value creating acquisitions is less likely now that the bank is much bigger than it was 15 years ago or even earlier this year. First Citizens has a successful M&A track record that includes a number of FDIC deals as well as the heavily discounted acquisition of CIT Group. The SVB acquisition was a monster deal that doubled First Citizens’ capital. While the opportunity for future FDIC deals is diminished, we believe the FDIC is happy to have another bidder besides JP Morgan Chase for large deals. We have been surprised about the lack of outcry over the extraordinary deal First Citizens got in buying SVB. We think the SVB deal clearly shows the FDIC executives are comfortable with First Citizens management team.

 Quantitative Tightening effect on banking industry deposit balances. Even though Federal Reserve’s Federal Open Market Committee seems close to the end of this interest rate tightening cycle, they continue to implement Quantitative Tightening by allowing the Fed’s portfolio of securities holdings to mature with limited reinvestment. Just as Quantitative Easing by the Fed accelerated deposit growth in the banking system, Quantitative Tightening is a strong headwind for deposit growth. SVB had some of the strongest deposit growth during Quantitative Easing, so we expect it will have deposit pressures with continued Quantitative Tightening. Of course, there are other factors that will influence legacy SVB’s deposit base such as: the strength of the venture capital cycle, competitive intensity from other banks attacking SVB’s old franchise, and SVB’s customer’s willingness to return to SVB under First Citizens’ ownership.

Legacy SVB’s business is dependent on the venture capital cycle and it does not look great in the short-term. Venture capital goes through cycles and it seems like late-2021 represented the peak of the latest cycle. The amount of venture capital raised in 2022 and 2023 is down significantly. There are many start-ups who have had to cut expenses and conserve capital. Venture capital exits are few and far between. Given the strength of the stock market in 2023, we are surprised the IPO market has not recovered. There is potential upside from excitement about artificial intelligence.

We think First Citizens is still an attractive holding despite its outperformance to date in 2023. We estimate First Citizens’ tangible book value will be $1,800 at the end of 2026. We think FCNCA can trade at 1.5x tangible book value at the end of 2026 or $2,700, which is double the current share price.

Garrett Brooks:

Good morning everyone. Thanks for joining us on this summer Friday morning. My name’s Garrett Brooks with Slingshot Financial. Slingshot is a Colorado registered investment advisor and we serve as an institutional representative for specialized investment managers, including Gator Capital Management. Excited this morning to have Derek Pilecki. Derek is the managing member at Gator Capital Management, the firm that he founded back in 2008. He’s the portfolio manager for Gator Long/Short, which is the flagship portfolio there offered in a few different formats, including the original hedge fund, a mutual fund, as well as individual accounts. Derek, joining us here fresh out of earning season, so I’m sure it’s been a really busy time for you, but thanks for taking the time, Derek, and glad to have you with us.

Derek Pilecki:

Hey, good to be with you, Garrett.

Garrett Brooks:

Yeah, absolutely. So as we have done, this is our quarterly update, finding long and short opportunities in the financial sector. Derek is a financial specialist, has been for over 20 years. Like I said, founded Gator back in 2008. Before that was with Goldman Sachs Asset Management and a few other buy-side firms before that, but always focused on the financial sector. So we are certainly glad to hear what he has to say. Financials did a little bit better than expected coming out of earnings and would love to hear your key takeaways from this year or this quarter’s earnings season, Derek.

Derek Pilecki:

Hey Garrett. So I would say the story about this season was a relief rally in the banking sector. So regional banks, of course, had the bank crisis in March kicked off by Silicon Valley’s failure, and the regional bank index was down about 30% through mid-May. As we got through the end of the second quarter and the bank started reporting second quarter earnings in mid-July, the bank stocks really rallied. I wouldn’t say that the earnings reports were off the charts. I mean, they were pretty ugly earnings reports. I mean, deposits were down, net interest margins were crimped, but things just were not as bad as what investors were expecting. So there was some stability. I would say for the most part, deposit costs went higher, but maybe not as high as some of the most bearish expectations. Really, the regional banking sector was too cheap coming into earning season and investors did back up. So there was a nice rally in the regional banking sector during the earning season.

Garrett Brooks:

Yeah, we saw that coming out. The regional banking ETFs has actually been really on a run here coming out of earnings. To that end, what would you say overall is the health of the banks? It seems like a distant memory now, the banking crisis. Do you think this is something that’s largely in the rearview for us or something that could reemerge down the road, which was the fear I think at the time?

Derek Pilecki:

So I don’t think there’ll be additional failures. I think there was one transaction where Bank of California agreed to acquire a merge with PacWest, and I think that was done without any government assistance. So I think that really signals the end of the crisis. I mean, people were worried about PacWest. They had lost a bunch of deposits during the crisis. I think that’s really a signal that, okay, now we’re moving forward, if banks get into trouble, there’ll be deals done without government interference. I guess, another takeaway from this earning season was credit quality seems to be holding up just fine. The expectations were a recession coming, credit’s going to get worse, just a matter of time, higher rates. I think some of those things could still play out, like higher rates are definitely going to slow the economy. But I think it’s pushed out a few quarters and so investors are like, well, there wasn’t a necessarily a huge uptick in non-performing assets this quarter that people are expecting that those turn into charge offs in Q3 or and Q4.

So I think just pushing out the risk of credit losses a few quarters is another bullish sign for regional banks. Then I would say that there’s still a wide variety of interest rate positioning amongst the banks. So there’s a lot of banks with floating rate loans and pretty low cost transaction balance deposits. Then there’s other banks that have a lot of fixed rate loans and are funded with very hot money or high cost deposits. Those are the two ends of the spectrum on interest rate positioning. Not all banks are positioned the same. So to the extent that we have the long end of the yield curve go up and rates stay higher for longer, I think there could still be some banks that stumble through the next couple of years.

Garrett Brooks:

Yeah, that’s a great point. I’m curious, I know when we spoke back in May, I was really surprised to hear you say that you’re still finding some banks out there that haven’t done much in the way of interest rate hedging. I would’ve assumed at that point that everybody would’ve gotten their ducks in a row and gotten that taken care of. Is that something that you’re still seeing, you still have some banks out there that aren’t necessarily hedged out properly?

Derek Pilecki:

That’s definitely the case. It seems like they’re just taking the view of these low coupon residential mortgages that they own can’t extend further in duration, which may or may not be the case, but it seems like short-term rates are going to… The Fed’s not going to cut rates this fall, at least that’s what Chairman Powell said last week. So their costs of funds as they roll over are going to squeeze them. So yeah, there’s definitely banks that are exposed here with a lot of low coupon mortgages on their books.

Garrett Brooks:

Which is again, a good… It bodes well for you with the flexibility to both be both long and short, when you see those situations pop up, you’re able to seize those as well. One of the other things I think that we were talking about back in May, and then I’ve heard you talk about a few times since that leading up to this past few weeks, we’re looking for not only what the actual performance of particularly the bank’s would be, but also the market’s response to that. So thinking if we get some bad news and the market continues to push through, have we seen the lows? I’m wondering now, with having seen some of this play out and the market’s response, what are you thinking looking forward?

Derek Pilecki:

Yeah, in the absence of new information or new crisis points, I think that the mid-May lows in the regional bank index are the lows for the cycle. I think that unless there’s a big turn in credit quality or the economy drastically slows from some exogenous event that we’ve seen the lows.

Garrett Brooks:

Yeah, that’s good to hear. The other thing that I was curious about because you had mentioned it a few times leading up to this as well, was keeping a close look on loan volumes within the banks and keeping an eye for do we see a tightening credit that could possibly exacerbate any type of economic downturn that we see? I’m curious, most recently, what are the banks seeing in terms of credit and loan volumes?

Derek Pilecki:

Yeah, you’re right. So I was worried after the regional bank crisis started that we’d see a credit crunch where the banks would just be so worried about their own liquidity that they’d stop making loans and that would slow the economy. I guess, we’ve gotten some new data points on that front that evolved my thinking a little bit. First, it seems like that has happened to some extent, that loan growth has slowed considerably from last year. But it’s not clear that it’s all supply side, meaning it’s not all the banks restricting making new loans. Some of it is demand side. So to the extent that rates are… The prime rate is 8.5%, borrowers just don’t want to borrow money 8.5%. So you’re not seeing as much loan demand. So loan growth slowed, but it’s not all the banks restricting supply, it’s some loan demand constraints.

Then we have seen, not every bank has been deposit constrained. There have been bankers who have been well positioned for this cycle and they’re able to continue lending money. So it’s not like the whole industry’s just cut off the spigot, not making loans. There are banks that are making loans. They’re asking for better terms on the loans, which is natural in a cycle. They want wider spreads and better terms. They might ask for the personal guarantee more insistently this time around, but there are banks still making loans. Then we’ve also have the private credit funds out there that are chomping at the bid to dis-intermediate the banks. So they want to make loans, good loans, that the banks are constrained from making. So it doesn’t look like we’re going to have the worst case scenario where credit crunch causes economic recession.

We are having a slowdown, a natural slowdown, because of loan demands down and the banks are fixing their balance sheets. But it seems like the banks are pretty much through most of the right sizing on liquidity and deposits. So they’re still making loans to the extent that borrowers want them. They’re asking for higher spreads and better terms. Then you also, if the banks are held in check by these private credit funds, being willing to provide credit at the right price. So I don’t see the scenario where we get a bank credit induced recession, which is good news for all of us.

When you think through the recessions that we’ve had in the last 35 years, 1991 and 2008 were really bank credit recessions that were pretty deep recessions, whereas the recession from 01, 02 is more like capital markets, internet bubble, isolated recession. It wasn’t a economy wide where Main Street wasn’t getting funding. The Main Street economy got funded through 01, 02, whereas 90, 91 or 08, 09 Main Street had trouble getting funding. So it doesn’t look like we’re going to have one of those deep recession scenarios.

Garrett Brooks:

The Fed, have they nailed the soft landing, so to speak?

Derek Pilecki:

Yeah, we’ll see. There’s a lag effect to higher rates, and so we haven’t gotten the full lag effect, but it seems like the economy’s pretty strong still in spite of it, in spite of all the rate increases. We’ll see what the next six to 12 months bring. There’s isolated pockets that are really, really struggling. I mean, the office sector is tough. There’s not going to be new offices built, construction of new offices. Those construction crews are going to have to go to other property types. There’s going to be a lot of office buildings that are going to be owned by the bond holders or the mortgage holders instead of equity holders. So that will go through a cycle. But other than that, there’s not really an obvious thing that’s going to contract in the economy right now. Maybe the venture capital field, there’s not as much venture capital funding, but really that’s not a huge, huge part of the economy.

Garrett Brooks:

Yeah, that’s great news. I asked the question almost a little tongue in cheek because I think sometimes when things start to take on the grand narrative of the soft landing that it’s almost we lose sight of the real data points coming in and more focus on the story. So everything you’re saying certainly is encouraging, and this is real actual data that we can point to and give an indicator of what the economy is doing. It seems like things are working out, so let’s hope that we stay on that path. One other quick question for you, because it was so timely, what are your thoughts on the Fitch downgrading US credit rating?

Derek Pilecki:

Yeah, I mean, I am in the Jamie Dimon camp of the US is the strongest superpower in the world. We’re not going to default. I would say we’re running pretty big deficits. The demographics have gotten marginally worse with the lack of immigration over the last few years. So we have a lot of baby boomers retiring and Medicare costs are going to go up and social security costs. So I would say the finances that are driving that downgrade are worse at the margin, but I still think that we’re AAA, or the country’s a AAA credit. I do think that it doesn’t take into account the ability to print money and inflate our way out of our debts. So I think it’s a lot of noise and you shouldn’t change your investment perspective because of that.

Garrett Brooks:

Yeah, I’m glad you mentioned Jamie Dimon. I absolutely love it. I love that he says it doesn’t matter while he’s on his bus tour through the US, it was very like USA, USA.

Derek Pilecki:

I mean, he’s right about that. I mean, he’s a big fan and he’s right on a lot of those points. A lot of times we just get so focused on the pessimism and what’s going to happen bad from here. He’s pretty good about making us feel good about all the good stuff that’s going on. The economy’s pretty strong. We all are living, most everyone’s living better lives than they were 30 years ago. So he’s right about to be optimistic on a lot of those things. He’s in a good position to see it too. I mean, he runs the best bank in the country, the biggest bank in the country, so he sees a lot of the good stuff that’s going on.

Garrett Brooks:

Yeah, absolutely. So shifting gears a little bit here from the sector itself, I have to point out your performance has been stellar year to date. I mean, looking at, easiest I guess to point to is mutual fund performance. I mean, you are hanging right in there with the broad market. Impressive, considering we have big tech, a few big tech names driving that rally and the financials been somewhat of a laggard. To that end, you’re absolutely clobbering the long only financials index year to date and then looking on longer time periods as well. So I’m curious, with that in mind, where are you seeing opportunities now? How are you positioning yourself going forward?

Derek Pilecki:

Yeah, so I think within financials, it’s going back to our discussion earlier about interest rate positioning. So I think to the extent that I’m finding banks that are still benefiting from higher rates and then I’m shorting against them, the banks that have a lot of fixed rate loans on their books and weaker deposit franchises. So to pull out two examples, there’s a bank in suburban Chicago called Old Second Bancorp, and it’s in the far west Chicago suburbs. A couple of years ago they bought a bank called West Suburban, which is sitting between downtown and Old Second’s branch network. West Suburban was a franchise that had a lot of property locations that this previous CEO had bought in the fifties and sixties. These are just in good neighborhoods, middle-class neighborhoods. People used the branches for transactional banking. They weren’t rich people. They were just like middle-class people who had checking accounts and had a few thousand dollars in their checking accounts and aren’t rate sensitive. So it was a great acquisition by Old Second.

So they’ve also kept most of their balance sheet and floating rate loans. So during this rate cycle, they haven’t had to pay out for deposits. They’ve raised their rates a little bit, but really they’ve benefited from the repricing the loan book. So their net interest margins expanded and their ROE is above 20% now. So I think price to book value, it’s rallied recently, but it’s still under two times book. I think that’s a pretty interesting position from the long side. You contrast it to a bank like Hingham Institution for Savings, which is on the south shore in Boston. This is a traditional thrift. They make a lot of apartment loans. They have a very fixed rate loan book, heavy balance sheet, and it’s funded with a lot of high cost deposits.

There’s a lot of CD funding. Their loan to deposit ratio is well above 100%. Usually a commercial bank will run with an 85% or 90% loan to deposit ratio, but Hingham has a huge, huge loan to deposit ratio. So that means they have to fund a good portion of their balance sheet with wholesale borrowings. So their interest rate spread has just collapsed during this rate cycle. So it’s getting to the point where I don’t think the Fed’s going to keep raising rates. They might raise one more time. Maybe they’re done. But if they were to raise rates again or two more times, Hingham’s close to earning negative spread on their balance sheet. This stock still trades well above book value, so it trades for 1.25 times book value. So I just think given that they’re going to earn sub par ROE for the foreseeable future, this should trade below book value.

So those are the opportunities there. I think the opportunities persist in banks because a lot of people are expressing the view of banks through the ETFs. There’s a lot of banks out there and collectively there’s a lot of banks and a lot of market cap, but each individual bank’s relatively small, so it’s hard to get positions. The big investors use the KRE to express their view on banks, but the KRE buys or sells the entire system across all banks, where they’re not selecting individual banks of, I want to buy these ten banks that are asset sensitive and I want to short these banks that are liability sensitive. You just buy them all or short them all.

So, I think there’s nice opportunity for people like me who do the work on the individual banks and say, “Okay, this bank’s well positioned for this rate scenario and this bank’s not.” So that’s where I’m seeing the opportunities going forward. I think they’re still upside to the banking sector. I think valuations are still cheap, but I also like the opportunities within differentiating between the banks within the sector and that’s one of the benefits of having the flexibility of the long short fund.

Garrett Brooks:

Yeah, absolutely, that’s a great point. To that end, a lot of the people that we work with are even broader, more asset allocation oriented. So you take the very selective nature, your ability to be both long and short, and then you combine that with a much broader diversified portfolio and you have a really, really interesting and nice differentiated return stream in the portfolio. I know that current clients have really enjoyed that. Going back to my point earlier in terms of when you look at the broad market, just a few concentrated names pushing that, when you’re able to maintain the same type of returns but they’re much less correlation, it’s a really nice fit for an overall diversified portfolio.

Derek Pilecki:

Yes, definitely.

Garrett Brooks:

That is great news. How about outside of banks, what are you generally seeing or what are your thoughts?

Derek Pilecki:

Yeah, so I think that investors are recalibrating to a deferred recession. So we are really thinking about with inflation coming down and the Fed potentially being at the end of its rate height cycle, but maintaining rates at this level for a while, what does that mean for companies and the market? Generally it’s been pretty bullish for some of the higher beta names. So to the extent that people are deferring the pricing and the recession, that’s helped the sector. So I think some of the interesting names in the sector. There’s some asset managers that are trading for low valuations. There’s ongoing fair thesis in asset managers that we have the shift from active management to passive management. So the ETFs are taking share. So the active managers have had negative flows and the stock prices have gotten very inexpensive. So there’s some active managers that have neutral positive flows that are trading for five or six times EBITDA. So I think that’s an interesting play there.

Then there’s some, especially finance, especially insurance companies that are interesting. So the mortgage insurers have been doing well. We own Genworth, which owns a mortgage insurer called Enact. So that’s been a good area. I mean mortgage insurance is doing great because the housing market’s staying strong here, even in spite of higher interest rates. People just aren’t for sellers of their homes. They’re able to make the payments. They have 3% mortgages. Volumes are way down. If somebody does have to default on a home mortgage, insurers aren’t taking losses now because all the business they wrote in 2020 and 2021, there’s embedded gains there. So mortgage insurance is another good area. So between asset managers and especially insurance, those are the other areas that we like in the portfolio.

Garrett Brooks:

That’s great spots to be, makes a lot of sense. One other question that I had for you, I was actually talking with a investment officer at a wealth management firm, and within the context of Gator and a few other types of specialty funds, he was curious. He views the world very much within the smart beta, the factor type of analysis and uses that in constructing portfolios. Now I have heard you, in the past, talk a little bit about your views on how you incorporate and think about factors in managing your fund. But I thought it would be helpful for people on the call here today and anyone who joins later on to hear what your thoughts are on factors and constructing the portfolio around factors.

Derek Pilecki:

So I mean, I guess, I look at factors to make sure that we’re not taking the same bet on both sides of the portfolio. This goes back to a learning from 2014. I had the view that banks were cheap and REITs were expensive, and so I was long a lot of banks and short a lot of REITs. Then the embedded factor risk there was if rates went up both sides of the portfolio worked or if rates didn’t go up… It was an interest rate bet on both sides of the portfolio. So banks benefit from higher rates, REITs get hurt by higher rates. So in 2014 rates didn’t go up and so the banks muddled along and the REITs did great. So I had the same bet on both sides of the portfolio. So pay attention to the different factor models. We use Bloomberg. We load the portfolio into Bloomberg, look at what the factors our portfolio is expressing and make sure that we’re not out of bounds on having the same factor bet on both sides of the portfolio.

Garrett Brooks:

My factor friends will be excited to hear that. Well I think that those are all the questions that I had immediately. I’m going to go ahead and open up here for Q&A. So anybody on the call that would like to ask a question, go ahead and pop that into the chat. I will answer them as they come in. Well Derek will answer them. I will address them and Derek will answer them as they come in. Give it just a second.

Derek Pilecki:

Feel free to answer them, Garrett, that’s fine.

Garrett Brooks:

Looks like just one in the queue here and this is a slam dunk for you. What is the net long positioning of the portfolio? So I guess what is long versus short positioning?

Derek Pilecki:

Yeah, so right now the portfolio is 90% gross long and it’s 40% gross shorts, the nets plus 50. That’s a pretty comfortable spot for us. Usually the nets somewhere between 30 and 75 or 80, and so 50 is middle of the fairway. Part of that reflects, we’ve had a nice run up in July, so a couple of our positions hit their price targets and we reduced. So we don’t necessarily take the net and say, okay, we have to be at one point or another. It really flows from names we’re finding and we’re still finding a lot more longs than we are shorts and so we’re comfortable at plus 50.

Garrett Brooks:

Yeah, we always get that question, so thanks for asking. It looks like that’s it. It’s a quiet bunch. I wonder if people are taking the call from the beach, lakeside, whatever it might be here today, hopefully. Hopefully everybody’s enjoying their summer. I know you’re now sharing your time between Tampa and New York City, which is of interest, I know to some of the people I’m sure who are on the call here.

Derek Pilecki:

Yeah, so I mean I rent an apartment in New York in March. A couple drivers to that. A little bit more corporate access, so it seems like every financials conferences in New York and there’s a lot more companies coming through New York on a regular basis. So just meeting with more management teams while I’m up there. Then there’s getting access to more investors and so we’re meeting with more prospective investors by spending more time in New York. So those are the two benefits. Our families, were rapidly approaching empty nest stage, so my wife and I have spent 20 years in Florida and we’re just looking for the next adventure. So we’re starting to spend a little bit of time in New York and getting some business benefits out of it.

Garrett Brooks:

That’s awesome. That’s awesome. I know you’re also off on a huge golf trip coming up here.

Derek Pilecki:

Yeah, next week I’m going to Scotland for a few days with some buddies. So I’ve never been over there and I’m a big golfer and just love the game. So we’re going to eastern part of Scotland around St. Andrew’s, Muirfield and playing. I told the tour operator, I don’t want to play any modern courses over there. I want to play all the old Scottish courses. So looking forward to that and getting a few rounds in.

Garrett Brooks:

Yeah, enjoy. I am not really much of a golfer myself, but I know certainly a lot of people in the business are. I don’t want to speak for you, but is it fair to say you’re up for a round? Anybody in the New York area or certainly Tampa area, you want to get out on the course?

Derek Pilecki:

I’m always happy to play. This fall or winter, if somebody’s down in Florida and want to play, please send me an email or give me a call or get in touch with me through Garrett and we will get out in the links.

Garrett Brooks:

That sounds great. Well, we’re right up on time here. Appreciate it, Derek. Any final words from you?

Derek Pilecki:

Yeah, I think super interesting year as far as what’s been happening with the banks. So we’re in recovery mode here. Worst case scenario is not happening in regional banks. I think markets had a pretty good run, financials have lagged. I think there’s some catch up left within the financial sector, still some catch up left in the banks. I think the economy’s looking pretty good here, so I think I’m pretty constructive. We don’t have to chase the high valuation stocks within the financial sector. There’s a lot of cheap stocks, still reasonable valuations, and I think there’s pretty good fairway in front of us.

Garrett Brooks:

That’s great to hear. Like you said when we spoke earlier this year, with the bank and crisis, all eyes right there in your sector. I mean, if the economy, if the market, keeps tossing you those fat pitches, I know you’re just going to keep smacking them right out of the park. So keep it up.

Derek Pilecki:

Sounds good. Thanks a lot, Garrett.

Garrett Brooks:

Great, thanks Derek. Thank you everybody. Obviously any follow-up questions or requests for information, you can go ahead and pop that into the chat now. As always, feel free to reach out directly to me and we’ll make sure to get all of your questions and requests addressed. But with that, I hope everybody has a great afternoon, a great weekend, and enjoys the rest of this summer. Thank you.

Bill:

Ladies and gentlemen, thrilled to be joined by Derek Pilecki of Gator Capital. If you don’t know who he is, you will shortly. And Derek, thank you very much for making the time.

Derek Pilecki:

Thanks for having me on, Bill.

Bill:

I think it only took me about three years of reading your letters and then listening to a podcast where I think I understand the name Gator now. And correct me if I’m wrong, but it symbolizes waiting for an opportunity and then pouncing when you see it. Is that fair?

Derek Pilecki:

I think so. I think that that’s fair. I think Gators are aggressive animals and that’s how I think about my investing style.

Bill:

Is something that’s interesting to me as someone who’s followed you for a while is, as a financial specialist, I wouldn’t perceive it to be the sexiest choice in the world, but your reputation speaks for itself. And I’m curious, if you don’t mind giving some background on how you got into it and why you think it’s the right place for you to be, I guess would be the way to say it.

Derek Pilecki:

So I got interested in investing during college. I went to Duke, but in the fall of my freshman year I was waitlisted at Duke and I was granted January admission, so I had that semester off. And so I grew up in Northern Virginia and I took some classes at American University and my classes were spaced out during the day, so I just sat in the library and read books, and I read investing books that fall. So I really got interested in all different stock types of investing in, it just started my path to becoming an investor.

As I went through my twenties, I got a job at Fannie Mae working in their asset liability strategy. And Fannie Mae used to be one of the aspired companies in America, but it’s a different company nowadays and went through a tough time 15 years ago. But when I worked there in the mid-nineties, it was a great, an admired company and I worked for some great people and I learned all about the fixed income markets. One thing that we didn’t do was stock investing, when we just invested mortgage backed securities and we funded those with agency debt. And so, I continued to do reading at night and just kept reading about stocks and investing and read Lowenstein’s Buffet biography, The Making of American Capitalist, and that really propelled me to… I want to run a portfolio one day. And so just, you knew that it was going to be a long path to becoming a hedge fund manager.

And since I had worked inside Fannie Mae, inside a big financial institution, it made it easy to follow financial institutions or banks when I came out of business school. They said, ‘What sector you want to cover?” And I was like, “Well, I know financials,” so that’s where I’ve added the most value. And I was a financials analyst the whole time I worked on the buy side for other people. And so then when I went to go start my own fund, wanted to stick with what I knew, I didn’t think people would pay me to pick healthcare stocks. Had the specialized knowledge that… and when I started my fund really in 2008, kind of like today, financials were a distressed area. And so there was a lot of opportunity there. I was surprised that they weren’t done to going down yet.

I started in July 1st of ’08 and financials still had a long way to go down from there. It seemed like they were undervalued when I launched. But there’s always just been a lot of opportunity within the sector. I even think till today there’s a lot of people who were portfolio managers during the financial crisis that have shunned financial stocks. And so I continue to see ongoing opportunity within the sector, just for specialists to pull value out of the sector because there’s a lot of companies and a lot of different business models that takes a lot of specialized knowledge to follow the sector.

Bill:

Do you want to describe what your definition of a financial is so that people understand the things that you’re looking at?

Derek Pilecki:

Classically, it’s the banks and insurance companies, but I also include in anything in the financial index and including real estate investment trusts, because when I started, REITs were part of the financial sector. So I’ve kept those within the financial sector. From time to time, I’ll include companies that have significant financial operations. So when eBay owned PayPal 12 years ago, I included eBay in my definition of a financial.

So GE is a classic example of industrial company, big financial operation, anything that has something like that. But there aren’t too many of those these days. A lot of those companies have separated financial firms out. I guess Harley Davidson’s still out there, CarMax is still out there.

Bill:

But something like Caterpillar maybe. But-

Derek Pilecki:

Yeah, John Deere has a big financing operation.

Bill:

That makes sense. Well, when I said it wasn’t necessarily the sexiest, I think there’s so much attention on tech and growth or I think there still is, but I remember once upon a time I was sitting at a table with Bruce Greenwald and I told him that my background was in agriculture, and he said, “That’s a fantastic industry.” And its taken me a while to understand why he said that, but I think it’s similar to financials in that there’s cycles that you go through and there’s opportunities within the sectors.

And as I’ve watched your writing and read what you’ve had to write over the years, it’s been really interesting to see the opportunities pop up. And I guess the most prominent and recent example that I can think of, if you don’t mind talking about maybe the last five years of evolution, but with Silicon Valley Bank and what you saw that made you change your mind, if I can say that in the right way, because I know you admired their franchise for a while and then at some point you said this might get a little bit dangerous here. So I’d just love to hear you riff on that and how quickly things might be able to turn in financials.

Derek Pilecki:

So I was long Silicon Valley back 2018, 2019. So I even owned it back when I worked for GSAM back in 2007. So I followed the company for a long time. I thought they had a very good franchise. They really had a hammerlock of, I think they banked 60% of all venture funded companies and an equivalent market share amongst venture capital firms. And so, you just had this great network effect within the valley of they connected people and got business because of that. And these venture firms left their deposits in the bank for very low interest rates because they got other value from the bank. And I just thought it was a great franchise. And they also grew with venture funding and venture funding was booming.

So I thought that in the late ’18, ’19 timeframe, I thought that the stock was undervalued. It was trading for around 10 times earnings. They were levered to higher interest rates, and I thought rates would go higher. I thought that people overly discounted the Warren income. And so I thought it was cheap and they were growing. People were calling for the top of the venture cycle in ’18, and I didn’t have a strong view on that. It just didn’t feel like it was the end right then. So I owned the stock, got into COVID and fed cut rates and Silicon Valley went down and there was a lot to do. And so it became a source of capital for me in 2020. And admittedly, I sold it way too early. It went on a huge run with the venture cycle. So, there were other things to do. There was a lot of distress in banks and I just didn’t think, I thought there was other higher, better uses of the capital.

But I continued to follow the company, regretted selling it still followed it, thought I’d get an opportunity one day. During 2022, the stock was selling off and the bubble was, the SPAC venture bubble was imploding. And in 2022, the stock was off, and so I started taking a more serious look at it, especially with rates going up. And I was surprised by their securities portfolio, they had all this excess cash and you could see in their financial statements, they had large marked to market losses on their securities portfolio. And quickly did a little bit of digging and it was clear that they had just bought mortgage backed securities. And as those prepaid, they continued to reinvest in mortgage backed securities. So whereas they might have started out with 4% coupon mortgages, they ended up with one and half percent coupon mortgages. And so as the rates started going up, they had these huge losses and it was frustrating.

I didn’t own the stock, but it was frustrated because I admired the company and admired the franchise and that they had just dug themselves this huge hole. So after the third quarter earnings release last year, I looked at it and I was like, “Oh, they’re insolvent.” Their securities losses are big enough that they’re technically insolvent for regulatory capital purposes. Regulators ignore the mark to market losses on held and maturity securities. So they didn’t show a gap negative value, but if you did the math with their $14 billion loss on the held and maturity securities, they had a negative $4 billion equity account.

And so, I actually tweeted that back in November, “Is today the day the market realize the Silicon Valley’s insolvent?” And the stock didn’t move. It just actually rallied. It rallied in January from 200 to 300. And I was like, “Okay, I guess the market’s just going to ignore this loss.” And I was really frustrated with the management team. And then everything happened in March and just finally, when they tried to raise capital and the depositors got scared and pulled money, and of course it imploded, but I admired the franchise. I’m really sad what happened to the bank.

Bill:

Is there a logical reason that regulators would not count mark to market? I understand how silly it sounds in retrospect, but maybe other than fighting the last war, what might have they been thinking as to why mark to market shouldn’t matter for regulatory capital purposes?

Derek Pilecki:

I think it goes back to the financial crisis. There’s a scenario where there’s a lack of liquidity in the market. When all the subprime mortgages, mortgage backed securities went down in value and people were saying, “Hey, the prices of these securities are way below what the ultimate cash flows are going to be. So we should ignore that the market price because the cash flows are going to be higher.” I think that’s where it came from, and that was because a lack of liquidity. And just no institutions had enough liquidity to pay fair value for those securities. And that turned out to be the case. Anybody who bought subprime mortgage securities post, I don’t know, October of ’08 realized a lot more cash flow than they actually paid for price.

And so I think what ignoring mark to market does, it allows banks to take more risks than they really should. So like Silicon Valley had a deposit base where it was all on demand checking accounts, and so people could pull their money out. As we saw, 40 billion the first day and a hundred billion was lined up for the second day of withdrawals. They shouldn’t have been in 30 year mortgage backed securities. They should have been in short term treasuries. Maybe they should have gone out one or two years on treasury securities because the market for the treasuries, short term treasuries doesn’t really move that much. But I think that it goes back to the financial crisis of why people were saying, we need to ignore mark to market because of the way the market price subprime securities back in ’08.

Bill:

Something that I’ve realized through watching this is there’s an assumption on the duration of your deposits. So it seems to me that some management teams will potentially try to barbell the approach. And that’s nice on a computer model until the depositors start to flee and then it becomes a real problem if they do. And you’ve written about, and I think anybody that’s looked at it, Bank of America, Schwab, it’s interesting to see some of these portfolios, but it appears as though maybe the deposit assumption is a little more sound.

Derek Pilecki:

I think there’s been a real change in what the duration of deposits is. During ’08, when WAMU had its initial stages of its run before it was sold to Chase, I think over a 10-day period, $17 billion came out of the bank versus Silicon Valley, $40 billion came out in one day. So I think with technology and everybody having smartphones and apps, it’s really easy to move money nowadays. And I think those assumptions about what the duration of checking accounts is, has to change. It has to be massively shorter. And I would extend this to say that I’m an advocate for increasing deposit insurance. I think clearly 250,000 is way too low. It hasn’t been adjusted for 15 years, hasn’t been adjusted for inflation.

We have these reciprocal deposits like IntraFi or Cedars where you can get FDIC insurance through your original bank because they put the deposits out to other banks. I think that’s just getting around the rules. We should just increase the deposit insurance amount for companies and individuals that should go to a million or $2 million. And for operating accounts for corporations, you can make it unlimited. And so that way we really would eliminate bank runs. If you think about who benefits from a bank run, nobody does. It’s just a negative thing for society. Why should we have bank runs?

And I don’t think you can expect depositors to evaluate the risk management practices of a bank. So look at Silicon Valley, at a $260 stock price, $20 billion market cap, two days before it failed. What depositor’s going to look at that market cap and say, “Oh, my deposit’s at risk,” or, “I don’t like their bond portfolio.”? That’s just not a good use of society’s resources to have depositors worry about that. That’s why we have regulators. The regulators should be in there saying the bank has too much risk. You should reduce risk. It shouldn’t be up to depositors. So, I think we should have more deposit insurance to eliminate bank runs.

Going back to your question about duration of checking account deposits, it has to be, banks just have to assume it’s shorter, with rates going up so much, everybody’s repricing, are you moving excess cash to higher yielding accounts? I think I totally agree with your premise.

Bill:

The one argument that I’ve heard against moving deposit insurance to something unlimited is like, does that take away from some of the smaller banks. Said differently, do some of the smaller banks benefit from the incentive to spread deposits out to different banks and is that a good or a bad thing? How do you think about that?

Derek Pilecki:

I actually think deposit insurance would benefit small banks because then you can leave your money… Bigger… Depositors wouldn’t be worried about a small bank. They’d say, “The FDIC and the regulators are looking at the small bank. I’m totally protected if I leave $2 million here, I don’t need to have an account at a big bank.” So actually, I think it would help small banks to have unlimited deposit insurance or higher, much higher limits.

Bill:

I think the flight to the large banks would probably support your hypothesis. Because it seems as though that deposits just went to the CFIs once the run happened. It seemed like everybody was looking for the big banks to put their money in.

Derek Pilecki:

I think the argument against higher deposit insurance is banks might risk loving banks or risk loving management teams, would take, raise deposits and invest in very risky projects. So during the financial crisis, there was a bank in Chicago called Chorus that was the number one funder of condo developments. And they had a huge portfolio of condo developments both in Chicago and Miami. And so if they had unlimited deposit insurance, would they be able to fund just more and more condo developments? And my argument there is, well, it’s up to the regulators to limit the amount of money they have in any one asset class or to evaluate the risk management practices. So like deposit insurance, unlimited deposit insurance could allow a bank to grow too fast. But I would say the regulators should be there to stop that.

Bill:

So speaking about the regional bank or commercial real estate and condos generally, I can’t help but have a conversation about banks and financials without asking you about what’s going on with, specifically office, but how big of a deal do you think this upcoming refi wave is going to be and how are you taking a step back and thinking about things from first principles?

Derek Pilecki:

I think it’s in a big issue. Rates have moved a long way. So I think there’s a lot. And we also have the banks less willing to refi people out of other people’s loans. They’ll extend existing loans in their own portfolio, but they’re not going to take other people’s loans off their books. So I think it’s going to be a difficult wave we’re going to go through here, especially with leases burning off and occupancy going down, [inaudible 00:19:47] going up. I think it’s going to be very tough. I think it totally depends on who holds the note. If a bank holds the note, they can work with the borrower, they can be flexible, they can extend the note.

If the note’s sitting in a commercial mortgage backed security, there’s not that much flexibility. The special servicer has to try to get maximize proceeds for the underlying bond holders. I think they are just handcuffed of how much they can do to extend the note and to work with the borrower. And so a lot of times they’ll just take it to auction, they’ll just foreclose and an auction off the property. And so I think that’s going to be tough. I think there’s going to be a lot of big… And you think about the central business districts, Chicago, New York, San Francisco, those big towers in those central business districts, those notes tend to be in commercial mortgage backed securities. There’s not a lot of banks who can make loans that size.

Bill:

Your hold size would be huge.

Derek Pilecki:

They’re just huge loans. And the big banks are pretty low risk-takers as far as… I don’t see JP Morgan or Bank of America are holding Office Tower notes in their portfolios. I think that they just let those go into to commercial mortgage backed security. So I think it’ll be a big issue for the commercial mortgage backed security market. And I think there’ll be a lot of foreclosures and a lot of auctions. I think it’s going to be tough. Just in the news last three weeks in San Francisco, Park Hotels turned back the keys of to two big hotels in San Francisco. There’s a mall that just got turned back. I think we’re going to continue to see more of that.

Bill:

And what does that look like practically speaking? And then the person that wins the auction comes in and they are likely financed by bank debt? Or is it private credit? Who steps into some of these transactions, do you think?

Derek Pilecki:

I think it’ll be a lot of private credit. They could have some bank debt, but I think it’ll be a lot of vulture funds that’ll come in and buy those properties. And they’ll generally use private credit. They might use a little bit of bank debt, but the LTVs on bank debt are so low that it’s probably not the most attractive financing for those vulture funds.

Bill:

Well that’s one of the things when I’ve been looking at, I like to look at M&T, I don’t own it. I don’t know anything about financials for real, but I know that they have a very positive reputation. And the LTVs appear, they’re only as good as the assumption of the value. But it seems as though there’s some equity cushion even in some of the regional bank’s portfolios that I think people are maybe a little bit overly scared. I’m not sure whether or not that’s true, but I know that you’ve identified some opportunity in regionals.

Derek Pilecki:

So, I think the banks, the regional banks have done a good job with disclosure around CRE. The amount of disclosure in Q1 earnings versus Q4 earnings just multiplied. So almost every bank put out a slide of here’s our CRE exposure, here’s our office exposure, here’s our essential business district exposure. And so you can really compare and contrast different banks. It seems like office exposure tends to be 3% to 5% of the portfolios. You have to subtract out owner occupied office from investor owned office, you have to subtract out medical office, which the vacancy on medical office properties is a lot lower than typical office properties.

So there’s a lot of mitigating factors, and I think that banks have improved their disclosure around that subject. So I think that’s one of the things I like about banks. So I don’t feel like there’s a lot of scams being run by regional bankers. They tend to be in their jobs for a long time. They’re regulated entities. They all expense stock options. They’re all, I feel like the disclosure is pretty good within the sector. They’re all regulated entities. They all have published call reports that has even more information than what’s in their SCC filings. So I think, to the extent that there’s other distress in the real estate sector, I expect the banks to disclose that.

Bill:

If somebody was interested. Where do you find stuff like the published call reports and some of the public filings that are not like the 10K or whatever? [inaudible 00:24:44].

Derek Pilecki:

I use CapIQ, write minutes. I don’t know if their bank regulatory modules enabled for everybody else, but it’s enabled in my subscription and that’s what I use. But the fdic.gov is where all the call reports are available. You can do searches and find it.

Bill:

I think a writeup that you put out a while ago that I liked because it shows how many assumptions there are in any given number in financials, and I think about what you’re saying right now, but I believe it was the Ambac liquidation. Just to watch your adjustments through that, it was really interesting. And I don’t know how that turned out for you, but your perception of the market, value of the stock versus where it was trading and the amount of assumptions, financials is fascinating because it’s a black box in a way, but I see you cut through a lot of the darkness.

Derek Pilecki:

Unfortunately, Ambac didn’t work out as well, and I don’t think it was because of those adjustments or the sum of the parts didn’t work. There was a legal case, a related legal case that had an opinion that Bank of America was able to use against Ambac to keep the settlement to a lower number than I had hoped for. But I think that’s one of the things I love about financials. You can go through the numbers and sometimes there’s value just sitting there. One of my early hits when I first started the fund back in 2010 was commercial mortgage reits had issued a bunch of CLOs or CDOs and you could go through. And some of the debt, all the senior debt was non-recourse to the equity.

So I remember this one had 10 securitizations outstanding. You’d go through each one and say, “Okay, for these six, the equity’s worthless. But on these last four, I think they’re going to recover some value for the equity.” And it had to report a negative book value because of the marks on the senior debt of the first six securitizations. But since they were non-recourse, you could eliminate that and you could get… the stock was trading for 80 cents. You could get six bucks on the book value if you would limit… but the reported book value was -15. So you could do the math and say, “Hey, as soon as everybody realizes this is non-recourse debt, the stock should be much higher.” And so occasionally, you get those types of opportunities within financials.

Bill:

I have seen you write or talk about, and I’ve talked to my friends about some of the mortgage reit preferreds right now, which is interesting in a similar way. Do you want to talk about those at all?

Derek Pilecki:

So mortgage reit preferreds, they issue these fixed to floating rate preferreds and mortgage reits had a really tough 2022 with mortgage spreads widening. The book values declined. And then there was a little hiccup in August and September last year where spreads just blew out. And when when spreads blew out, the preferreds always trade down like they’re distressed because if the equity goes to zero, then the preferreds get the next hit.

And so, when the equity all took 15% to 20% hits the book value during Q3 last year, the preferreds never took any losses. So they traded down. And then they traded down again in December on tax loss selling, and then they traded it down on Silicon Valley again. So this is a third bite of the apple, these mortgage reit preferreds. They’re on fixed to floating rate periods, and the fixed rate periods coming to an end and they’re going to reset to three month LIBOR plus a spread. And a lot of the spreads are 5% or 6%. So with the preferred trading at 75 cents on the dollar, they’re going to reset to 10% yields. And that works out to a current yield of 14% or 15%.

And so, I think as they reset to the floating rate periods in a year or two years from now, they’ll trade closer to par. And so there’s a couple that you can get 75% return or 45% returns over the next year as they trade closer to par during the reset period.

Bill:

Why would they not trade at par?

Derek Pilecki:

I think it’s just a small market. There’s small issues. I think mortgage REITs are, they’re not squirrelly companies, but they’re not operating companies. It’s just a few guys on a Bloomberg. So it’s just like an investment fund. It’s not like a bank. They trade well outside where bank preferreds trade, even with the distress in banks. And so, I think that’s pretty interesting because mortgage reits aren’t really distressed right now. They’re earning money, yes, spreads are wide, but it’s not like people are worried about liquidity in the repo market right now. So I think it’s an interesting opportunity.

Bill:

It seems to me like the consumer’s in good shape, the duration is extended, because rates have already gone up. So I don’t know, a lot of the risk that you take when rates are lower I think is e-risked. Now, of course it can always go higher, but it’s an interesting concept, especially when it’s trading at a discount to where it should go when the security starts to flip to a floating rate.

Derek Pilecki:

I would even say that with mortgage, the debt spreads this wide. There’s only really one way that could you go, is tighter. And so that would be good for the equity. So I don’t think the next news on mortgage reits is going to be necessarily negative. I think it could be positive with tighter spreads as we get into a better liquidity environment.

Bill:

How much of your job is focusing on stuff like consumer, the strength of the consumer and macro forces versus… I guess what I’m saying is the bottom up and the macro seem to be connected when you’re talking about financials. Is that fair?

Derek Pilecki:

Yeah, but the macro doesn’t change for me often. So consumer credit goes on long trends where it’s not like it’s going to turn on a dime of if the Fed raises 25 bps, my view of the consumer’s changed. My view of the consumer has been pretty steady for the past 10 years. I’ve long thought that we are going to have a long economic expansion. We’ve had a couple hiccups. We had the hiccup around COVID, which was unexpected. But absent that, since the financial crisis, we really haven’t had a recession. And I think it’s going to be a while before we have a recession. I think credit quality is pretty good. I’ve been worried about a recession more in the last three months than I have in the last 15 years because I worry that bank lending getting shut off could cause a recession.

When you think about recessions, ’90, ’91 and ’08, ’09, were pretty deep recessions. And both those times banks cut off lending. In ’01, ’02, it was a pretty mild recession. It was more a capital markets, CLEC debt, telecom debt implosion that caused the recession, not so much bank lendings stopping. So to the extent that banks stop lending because of liquidity right now, I’m more worried about a recession now than I have been. It doesn’t seem like… The stock market’s gone straight up. So the market’s not worried about a recession. And it seems like there’s enough banks still lending that the big banks can still lend. It doesn’t seem like we’re having a credit crunch right now, although I’m wary about that. Because I hear a lot of banks slowing down their lending and they need to raise capital or just their capital ratios grow, so they’re just going to stop lending. But I agree with you that macro and bottom up financials analysis is very similar in my sector.

Bill:

And when you talk about the liquidity, your concern about lending due to liquidity, is that because of these held the maturity or the mark to market losses, creating a scenario where they need to build capital buffers for the short term in case there’s another run on deposits or something like that?

Derek Pilecki:

Yeah. So, I think bank runs scare bankers. And so, that’s death for a banker. And so, I think the banking industry, everybody’s like, “I need more liquidity. I need to retain capital.” So I think a lot of banks have slowed down lending, they’re not doing anything in the edges, everything. I’ll take care of my core customer, but that’s about it. I’m not going to do anything to try to really grow aggressively here. So I think that’s the slowdown. It’s just self-preservation amongst bankers.

Bill:

One of the things that I was shocked by, and perhaps I shouldn’t have been, but I was , because I’ve had people on this podcast that I’ve talked about how good First Republic’s franchise was and qualitatively, I talked to customers and they’d say how much they love them. But that first weekend I was eating lunch at my grandma’s community and there were two gentlemen next to me and they were looking at their accounts and they said, “Why do we have this many deposits sitting there earning nothing and incurring risk when we could be moving it to risk-free treasuries earning a lot more?”

And I think one of the things that I learned was whether, I guess deposit diversity is so much more important than maybe, I mean, maybe this is banking 101, but I just didn’t realize that having a customer base of really wealthy people could actually become an Achilles heel if they are technologically savvy and all reading the same paper. What I thought was actually its greatest asset, I think maybe in a way became what brought it down. And that was an interesting learning.

Derek Pilecki:

I think it’s also the overlap of customer bases between Silicon Valley and First Republic. They’re both were headquartered in the Bay Area. I think they banked the same people to the extent that people got scared because of Silicon Valley and they also had big accounts at First Republic. It’s the same people. So I think you bring up an important point about diversity of customer bases. Because I met with a few banks in May, and these were banks in the middle of the country, Illinois, Louisiana, Tennessee.

And they were talking about to their customers after Silicon Valley, and their customers were like, “Why are you calling me?” And as the news came out there, the customers eventually were like, “Oh, I’m glad you did call me, since I got scared, but you had already called me and I felt better.” But there’s a lot of, middle America, this was not a Middle America event. This was a Bay Area, a venture community event. This was not… But certainly there’s large depositors in every community that got scared about their bank for a minute and they don’t seem to have left their bank. They seem to have asked their bank for higher rates or asked, “Can we do something to increase my deposit insurance?” But for the most part, depositors have not left their banks.

Bill:

Well it turns out middle America is not sitting on Twitter getting, people scaring them, which is something that I took issue with while it was going on, but that’s neither here nor there.

To what extent do you think of the increase? Because you mentioned the banks may have to pay depositors more now. How much do you think of that as credit tightening? Because I would think that if they’re going to pay depositors more, they’re going to have to ask for a higher rate on their loan, otherwise their NIM goes away. So that almost by definition decreases the amount of credit that they can extend, I would think.

Derek Pilecki:

It’s also going to limit the amount of demand that the borrowers have if they have to… instead of paying six and a half percent, they have to pay eight and a half. There’s a lot of projects that don’t pencil at eight and a half. So I think there’s also, it’s both sides. The bankers don’t want to lend and the borrowers don’t want to borrow at the higher rates. So, I think the banks are going to have a tough quarter this quarter on deposit costs. I think we saw some of it in Q1, but it was really just a one-month effect of Silicon Valley happened in March. You get three months in this quarter of deposit pressures. I think it’s going to be a tough quarter for profitability for the banks. Just deposit costs are higher. I think the whole, having the media say, “Bank crisis, bank crisis, bank crisis” and talk about rates. Rates have moved a ton, 5% on T-bills. People are asking for higher rates. And so I think that it’s going to be a tough quarter.

I think we’re going to get to, either as Q2 or Q3 is going to be the bottom, it’s going to get better from there, but this quarter’s going to be ugly. I guess the one thing that we’re was interesting, and Morgan Stanley had a conference a couple weeks ago, and a lot of banks gave negative outlooks for NIM in Q2 and not all the stocks went down. So when stocks stopped going down on bad news, is that a bottom? Banks have had a nice little rally since Mid-May. Are they a little ahead of themselves or is that just correcting, overshooting? It’s not really clear to me yet, but I think it’s interesting on some of those negative mid-quarter updates, the stocks didn’t necessarily go down.

Bill:

That is interesting. When you’re building a long-short portfolio and you have a bank, and it may not be as black and white as the question that I asked, so I apologize if there’s not enough nuance. But say you like one bank, do you try to pick a bank to short against it, or will you say banks generally are relatively undervalued relative to asset managers or something like that? How do you think about constructing a long-short portfolio when you’re constrained a sector?

Derek Pilecki:

I don’t pair off sub sectors within the portfolio. I’m sure plenty of banks. I think this opportunity right now is interesting because there’s great banks that have gone down. Banks are down 30% year to date. So there’s great banks that have gone down that don’t have interest rate problems. They might have some pressure on the deposit side, but it’s not life altering.

And so, I think that’s the opportunity alongside these high quality banks. But on the short side, there’s a lot of banks that are still shorts. There’s still a lot of banks that have fixed rate loans, that have big securities portfolios that are under capitalized. So, I’m not sitting here thinking regional banks are the opportunity, I’m not going to short any regional banks. I’m still shorting plenty of regional banks that have mismanaged interest rate risk and the stock should be lower. And so, that’s what’s so unique about this opportunity, is there’s opportunities on both sides, long and short.

Bill:

I think it’s interesting. And it’s interesting to think about, I’ve talked to somebody who said, he was actually a financial specialist, and he said a couple PMs wanted to go short NASDAQ because they wanted to do a value play. And he’s like, “I don’t want to do inter sector shorts and longs. If I’m a financials guy, I want to be…” So I was curious how you think about pairing up your longs and your shorts.

Derek Pilecki:

I try. I guess one thing that you can get caught in from time to time is, I short a lot of companies that are high, that trade at high multiples that I think that are just average businesses or that are okay businesses. And so, you can get caught up into high quality risk factor. If you think about it, risk factors, quality is a factor and value is a factor. And sometimes you can get caught up of you have too much of one factor versus another, and you might have the same trade on implicitly on both sides of the book. So I don’t want to be long on value and all quality. I want to make sure that I match better than that.

Bill:

Because being long mostly value would imply that the value, quality gap is too wide. So then if you were shorting quality, you would be doubling down on the same bet, right?

Derek Pilecki:

Correct. And sometimes that works. From mid-May to mid-June, long value, short quality worked within financials. If you look at the insurance brokers or Visa, MasterCard or S&P and Moody’s, they all lag the regional banks for four weeks. Now, does that continue? Probably not. Those are great companies. There can be episodes where it happens.

Bill:

Do you mind talking about Genworth? Because I think it is a really great example of how long… Actually Genworth is why I thought of you as the gator that waits. So I’d be curious if you’d talk a little bit about how long you followed it before you saw the opportunity.

Derek Pilecki:

So, I owned Genworth from 2012 to 2014, and then it went off into the wilderness and was trying to get acquired by a Chinese insurance company. And I just followed the company. It bounced between three and four bucks from ’14 to 2020. And then I was listening to earnings call and they were talking about buying back stock. The deal had fallen through finally, and they had IPO’ed, enact their mortgage insurance subsidiary. So I started listening to the calls more closely and just doing the sum of the parts. Genworth, the holding company, was trading at a discount to its publicly traded subsidiary enact. And so I waited eight years to buy the stock back. Genworth talked about in, I think it was January 2020, they said, or maybe it was March 2022, they said they’re going to buy back stock later that year. And that was the catalyst for closing the discount to the sum of the parts.

Genworth has two businesses, the mortgage insurance and then life insurance. And life insurance is dominated by their long-term care insurance business, which is terrible, a terrible business. It’s selling insurance policies to 60 year olds when they might go into a nursing home at 85. So it’s like a 25 plus year insurance policy. And everybody underestimated the cost, the percentage of people who would go into nursing homes and what the cost would be. And so they just lost oodles and oodles of money on those policies. They’ve stopped selling them and they’ve raised rates. So been able to reprice a lot of those policies. And I think the cumulative amount of their repricing is $23 billion. And there’s still a question of whether that life insurance subsidiary is solvent, even though they’ve raised prices $23 billion.

And so, there’s 6 billion of equity capital in the life insurance subsidiary. So in some of the parts, I value that at zero. I don’t know that it’s zero. I think that’s the upside in Genworth, is have they salvaged some value out of that life insurance subsidiary, so they’ll continue to raise prices on that book of business? Those people, some of the older policies, people are finally dying and the policies are going away. Some of their biggest cohorts of policies, people are just approaching the years where they’re going to make claims. So the next couple of years will have a better view of what the policy costs are on their bigger cohorts.

If they can salvage some value out of that life insurance subsidiary, there’s some real value there of the life insurance. So to give you an idea, they have about a half billion shares outstanding. And so the book value of the life insurance subsidiary is about $10 or $12 a share. The stock trades for $5 a share. So at $5, it’s just what the value of the mortgage insurance subsidiary is. So there’s some real upside, but it’s going to take a long time before we get any cash flow out of the life insurance subsidiary, if we get any at all.

Bill:

Is life insurance generally, I know that I got sold term. I was pitched on whole or whatever, but is it possible that life insurance has repriced enough or that the market will reprice enough? First of all, is it still marketed? And second of all, my question is, is it possible that it’s actually going to be a good business at some point, but it’s been so bad for so long that no one wants to touch it?

Derek Pilecki:

They’re trying to make it an asset-like business. So it’s different from just life insurance, is long-term care insurance business. I don’t think the way they used to write the policies is a good business at all. It’s a terrible business. So they’re trying to reuse, they have a claims infrastructure that could potentially be valuable. So if they can make long-term care insurance business priced like health insurance, and where it gets repriced every year, it could potentially be a decent business. UnitedHealthcare has been one of the best stocks in our lifetimes. So if they can get that same model, it could be pretty interesting. But I don’t know. We’ll see if the regulators will go for that. It’s going to take multiple years before they can try to implement that on a wide scale.

Bill:

It’s tough, man. I watched my grandma go through it. Getting old is not cheap and it doesn’t appear to be getting any cheaper. And the labor is very, very difficult to find. So competent people, you’ve got to pay them. And it’s a real kink in the system. So I don’t know. We’re going to have more and more people that need facilities like that, and it seems like we just don’t have a sufficient amount of nurses around.

So, it’s going to be interesting to watch. I’m sure capitalism will solve it. Prices will go up. But it’s interesting.

Derek Pilecki:

It’s tough. I think immigration’s a real issue in the country, number of new residents coming to the country that wouldn’t normally help out in industries like that is making it harder.

Bill:

It’s not a particularly glamorous job to help people die.

Derek Pilecki:

It’s a hard job.

Bill:

And emotionally taxing too. It’s a lot of getting connected to people to then just watch them leave. So I don’t know, it’s interesting.

Derek Pilecki:

It’s hard. It’s hard. Hard business.

Bill:

Huh. One idea that I heard you talk about that really, it really reframed the way that I think when I heard you talk about it was the Puerto Rican banks. And when you talked about them versus Hawaii and the regional oligopolies. And I thought it was so interesting because so much of what I read about Puerto Rico is not positive, that I’m curious how you’ve seen opportunity and what seems to be a lot of negative headlines, for lack of a better term

Derek Pilecki:

So Puerto Rico is an interesting place. It’s a US territory. It’s not a state, but the banks there are regulated by the FDIC. So they’re effectively US banks and all of them have operations in the mainland. And the island’s just been in this 15 year recession. And since the tax laws changed where the pharmaceutical companies didn’t get tax breaks for manufacturing the island, the island’s just been in recession. And so populations left. They’ve gone to Florida and New York. And I think there’s a lot of people, there’s a lot of Puerto Ricans who live on the mainland who would love to go back home if they could work. They’re here because they need jobs, but they prefer to be on the island.

And so I think there’s this opportunity for Puerto Rico to really turn around if jobs went back to the island. And so, we’ve gotten a little bit of a start on that. The reconstruction from the hurricanes has lit a little spark in the construction industry there. There’s potential for reshoring healthcare facilities. So there’s 25 manufacturing facilities on the island, to the extent that we reshore pharmaceutical medical devices from China back to the US. Puerto Rico and Indiana are the two big territories or states that will benefit from that.

So that’s another potential spark to Puerto Rico. And then there’s a lot of, the government being too indebted and going through this bankruptcy is limited growth. And to the extent that they’re coming out of that and improving their infrastructure, that’s another avenue for growth. So I think those are all positive things. And in the meantime, you’ve had this consolidation of the banking sector. They’ve gone from 11 or 12 banks down to three on the island. And just, like you mentioned, the oligopoly is just creating this pricing umbrella that makes banking much more profitable. Banking was unprofitable or marginally profitable for a long time in Puerto Rico. There’s just too much competition and now there’s a lack of competition or just the banks just don’t need to fight with each other, to the extent that there’s only three of them.

Bill:

It reminds me a little bit of Buffett’s airline bet in a different way, which maybe arguably didn’t work, but I think it’s a little too early to see whether or not his bet worked. But that consolidation to an oligopoly structure in a local market, I thought it was very insightful. So thank you for sharing that.

Derek Pilecki:

Thank you. So hopefully it works out like Buffett’s railroad bet.

Bill:

That’s right. That’s right. Indeed.

One time, and we don’t have to talk about it, but when we were talking, you had mentioned that your firm, you went through a period where managing the portfolio, managing the business created an interesting tension in your life. And I wanted to talk to you about that because I think there’s a lot of listeners that are trying to manage that. And if you don’t mind sharing some of your learnings and what you went through, that’d be great.

Derek Pilecki:

So when I started Gator, I had this vision of I’m going to start this portfolio and I’m going to start raising money, and then I’m going to reinvest the cash flow to grow the business. And that was my vision of, I want to grow a business. I don’t want to milk it. I want to reinvest and just grow it. So I thought that we could have four or five PMs and we’d all be managing a couple billion dollars and it would be a great business to have. And so we started going down that path, and I started growing and hired a former colleague from GSAM to start a fund for him.

And there was a couple of things going on. I had very good performance the first five years of the fund, and then I started growing. And so just growing my own product took demands of my time of new investors. People wanted to talk to me with performance. And then at the same time, I hired this other person and was trying to grow the firm. We hired a few additional employees, and then you have to keep raising money to pay off those investments. And so at the time, I would’ve said, I can handle it all. I can. I got the investing down, I’m expanding the firm. These other investments don’t take a lot of my time. Right about that time, my performance, my fund turned down, there was 18 months where I underperformed the sector in the market. And in hindsight, I think those stresses of raising money for my own product and then also trying to expand the firm and managing this other PM created a lot of stress that affected my performance.

I can’t look at anything specifically and said, “Oh, I made that mistake,” but there was a series of investment decisions that didn’t work in a row. And I have to think that I was, that pressure affected my investment performance. And so, I got to, after about a year and a half, I realized I wasn’t going to be able to raise money for the second pm. And so I closed his fund down, had to let him go, which was stressful as a friend. And-

Bill:

Yeah, that’s tough.

Derek Pilecki:

I had spent a lot of money trying to do it, trying to hire him and raise money for him. And then closing his fund was like, it’s like the stunk cost. All that money’s out the door. I’m never going to recover it. I think I spent about $800,000. And so I look back at it, I live in Tampa and the beach is about 45 minutes away, and I don’t own a beach condo because I tried to start this other fund.

And so, I think about it in those terms of like, “Oh, I tried to open this fund for my buddy instead of buying a beach condo.” And buying the beach condo wouldn’t have aligned with my values at the time. I was very much of, I want to reinvest the cash flow into the firm. And so that’s what I wanted to do, and it didn’t work. And so, since then I’ve narrowed the scope, my vision of Gator, just my fund. It’s financials only. We’re not going to be anything else. We’re not going to have other products. I’m just going to be focused on putting up the best numbers I can for my fund. And so it was a humbling experience, it was lost of money, didn’t give my investors good performance during those 18 months. So all that is just a learning experience that has kept me focused in the years since.

Bill:

Well, I appreciate how honest you were. I went back and looked, and I would argue that your investors are still probably okay, but it’s tough. There’s demands. I’ve noticed it with some of my friends that are out raising and I’ve got one friend that might be close to closing his fund. And I’m hopeful for him because I think it allows you to get back to the drawing board of what is just the investing side of it rather than the business side, which can be taxing.

Derek Pilecki:

The investing side’s what we all love, and that’s what produces the value. So you need to stay focused on that because the whole thing unwinds if the investment side doesn’t work.

Bill:

So I do have to ask, what is going on with the mutual fund that you run? What was the purpose of taking that over?

Derek Pilecki:

So I had started a mutual fund in 2013 as part of the business expansion. And so when we got to 2017, I got this opportunity to take over this other mutual fund. So it’s the Caldwell & Orkin fund. It’s the oldest long-short mutual fund. So it started in 1992, and Michael Orkin ran it and Michael was going to retire. And so I won the bake off to the board, just selected me to take over the fund. And the idea was I already had a mutual fund. I have the hedge fund, long-short investing, I was the best position to run a long-short mutual fund. And I thought it could add to my firm, because I talked to advisors who want to put their clients into the hedge fund, but then they’ll have some clients that don’t qualify for the hedge fund. Not everybody has 2 million liquid to go in the hedge fund or kids accounts or whatever.

So the mutual fund serves a purpose of, an advisor can keep their clients in the same type of investment. The qualified investors can go into the hedge fund, and then the smaller clients can go in the mutual fund. And so that’s the idea behind the mutual fund. The overlap between the portfolios is significant. It’s not exactly identical, the hedge fund uses a little bit of leverage. And the hedge fund invest, because the hedge fund only has monthly liquidity. It can invest in some smaller cap companies. So those are the two big differences between the two products, the mutual funds out there and trying to build the performance and grow that fund. But I think of it as, it’s not distracting from managing money, it’s just two vehicles. We also manage some separate accounts for some clients. So just, it’s all investing.

Bill:

It’s symbiotic. It had to be rewarding to win the bake off. That’s a cool fun to take over. And that’s neat. I would think that it would be, I don’t know. That would be somewhat validating. I don’t know if you need it. I need validation in my life. I like to win and sometimes hear nice things about myself.

Derek Pilecki:

It’s interesting. I think the mutual fund business is dying. I’ve been involved in it for about 10 years now, running my own mutual fund for 10 years and the ETF structure is such a better tax structure that, I don’t know, mutual fund won’t die because people have unrealized gains. They won’t liquidate. They’ll just leave them out there. But I don’t think, it makes sense to start new mutual funds from here. I would not advise anybody to open a mutual fund. It’s just, they’re trying to raise money and the way the platforms make it hard to get on their platform, the cost or having to have advisors sponsor you to get on the platforms and then have to pay the platform’s money makes it very difficult, I think.

Bill:

Distribution is a hard part of this business. I would think that you would have plenty of distribution, but I don’t think that’s reality. It’s not as easy as my returns are X, put me on your platform. It’s a lot harder than that.

Derek Pilecki:

I think the mutual fund is five stars and nobody’s calling up and saying, “Hey, we need your five star fund on our platform.” They’re like, “Pay me $25,000 and we’ll think about putting you on our platform.”

Bill:

That’s wild. I was going through, I’ve gotten an annuity, which is the bane of my existence, but it’s a nice thing to, you inherit something. It’s not the end of the world, but I was looking through and it’s like the same managers are all of the options. And I just got to thinking to myself, I wonder what these guys are all paying to be the choice. It doesn’t take a whole lot of digging to see the backroom dealing or whatever that goes on with being carried. It’s crazy.

Derek Pilecki:

It is crazy.

Bill:

But the nice thing is, I think with platforms like this or podcasts, education is widespread, I think people are starting to wake up to some of it. It’ll never go away. And you’ve got to have business to business relationships. But I don’t know, some of the paying for placement rubs me the wrong way in the financial industry. It should be more pure than that.

Derek Pilecki:

[inaudible 01:01:53]. I guess the brokers get away because they’re not technically fiduciaries, but it’s serving their own interests rather than their client’s interests.

Bill:

And it’s upsetting because I talk about her sometimes. I’m not trying to throw her under the bus, but my mom, she’s like, “Oh, well this is carried by this person. They must be good.” And it’s like, “No, that’s not at all what’s going on. And also, look at the fees that they’re charging and these…” But there’s a… what is it? It’s almost like an authority bias when somebody recommends somebody else’s. It’s like, “Well, they came vetted through this person, so they must know what they’re talking about.” It’s like, “No, it’s just, a lot of it’s a grift, ma. I don’t know what to tell you.”

Derek Pilecki:

But I think, you use your mom as an example. I’m hopeful that the younger generation sees through that more. I think there’s a little more cynicism or more, “Tell me for real why this is happening.” So I’m hopeful that younger generations just see through that.

Bill:

I am somewhat too, the only thing that I am not particularly optimistic on is it requires reading the documents. And I don’t know that people love to read the docs. I don’t know, maybe ChatGPT and Bard can read the docs for people and tell people what’s really going on.

Derek Pilecki:

Yes.

Bill:

That may be a really good thing to come out of AI. Who knows? One question, I got it from a buddy, that I wanted to ask you. What is your view or how should I think about, in your opinion, some of these rent a bank type structures? Where does finance…? Is this a new phenomenon? Is this an old phenomenon happening again? What’s going on with that?

Derek Pilecki:

So rent a bank, mean banking as a service?

Bill:

Yeah.

Derek Pilecki:

People like these FinTechs using banks.

Bill:

Right. Like Chime has a bank that it uses in another state. And I’m not trying to pick on them, it’s just a structure that I see a lot of places.

Derek Pilecki:

Well, I think a lot of banks have gotten into that, thinking the whole, with 0% interest rates, they’re like, “Oh, look at all these deposits we’re going to pick up.” And I talked to a bank just last week, I talked to a bank that’s heavily into the banking as a service, and I think they have 12 programs. Three are onboarded and they’re constantly talking to new fintechs to… And they’re like, the cost of these deposits is super high.

Because the FinTechs have these contracts and they’re renegotiating the banks against each other that it’s going to turn out that these banking as a service, all these banks that are getting into it are going to not be happy with the cost of the deposits. So I think there’s a lot of growth or there’s a lot of interest amongst banks to rent out their balance sheets, but at the rates they’re going to have to pay for these deposits, it’s not going to be interesting. So I don’t know if that makes banks less interested in them, but I think the winners there will either be the consumers or the FinTechs, will capture that surplus and the banks will not be winners.

Bill:

Because it’s got to result in spread compression. Or I guess if you don’t want your spread to compress, you take more credit risk or duration risk. You got to get paid for something, right?

Derek Pilecki:

Right. Yes. I think it’s interesting. I think, it’s because the FinTechs will own the customer relationship, so they get the value. The banks, it’s a wholesale relationship for the banks, so they’re not customer facing. They’re not going to get the value. I think that’s one of, if you go, you know how we have Apple Pay now and all the banks let you put your credit card on Apple Pay and then you can use your phone to… I think that was bad on the bank’s part to just allow to sign up and say, “Hey, we want to be on Apple Pay, put your credit card on Apple Pay.”

Because I think it takes a lot of the… allows Apple to have the customer facing relationship with the customer. And so I think Apple is going to extract a lot of value away from the credit card banks on that relationship. So I think the banks just, they haven’t given away the store, but I think that they gave up too much in that scenario. And I think the same thing with these FinTech banking as a service things, the fintechs are going to capture the value.

Bill:

Well, there is no greater fox to let into the henhouse than Apple. And I hear what you’re saying. People say, “Oh, Apple Pay is so easy.” They don’t say, “Paying with Bank of America via Apple is very easy.” No one is thinking of it in that way. They’re just thinking, oh, “Apple Pay is the best.” So then if Apple gets a certain transaction volume, then they go to Bank of America and say, “Well, everybody’s using my format, so I don’t care that it’s your customer. It’s really my customer.”

Derek Pilecki:

And so Apple’s going to go to the banks and say, we want a bigger cut of the interchange fee, and the banks live on the interchange fee. So, there is a limit to that because the consumers get a lot of the interchange fee in the form of rewards or airline miles or whatever, but it makes interchange fees a lot less profitable for the banks to have Apple involved.

Bill:

And those are pretty high margin fees. That’s not like the kind of fees that you want going away, I wouldn’t think.

Derek Pilecki:

Correct. Yes

Bill:

Interesting. Well, I don’t know. What do you think, just generally, ALT managers had such a good run. What do you think that higher rates and the ability for people to find yield does to some of the, I guess, private equity and alt managers, if anything? The answer may be nothing, but just curious for your thoughts on that.

Derek Pilecki:

That’s interesting question. I think alts have this mind share amongst institutional investor where they’re like, “We can provide returns for you that are higher and with no market to market. So there’s new volatility, higher returns with less volatility.” And we know that it’s actually a more volatile asset. It’s just not marked to market. But I think there’s some consternation amongst institutional investors right now of, that they’re over exposed to alts. They’re not liquid. They gave VCs too much money. The returns on the 2020, 2021 vintage VCs are going to be severely negative.

And I think the institutional investors are going to eat that. Are they going to continue to be… I looked at some of the fundraising numbers in the last year or two for the big private equity firms, and they don’t seem to be lights out. It seems like they raise funds, they’re not upsizing funds. Maybe a few funds didn’t quite meet their fundraising targets. I do think that the private equity firms generate good returns overall, and I think that we’re just in part of the cycle where the returns, the forward returns don’t look ideal because rates have moved up so much. But I think some institutions will retain some liquidity. They’ll probably increase the allocations, the fixed income and liquid fixed income to meet their return targets and improve their liquidity. So I think there might be a little bit of air pocket for alt fundraising here, but…

Bill:

That would make sense. Almost like a short term cyclical dip in a potentially secular long. Look, if I was an allocator, I would like to get wined and dined by private equity firms. So I don’t… And it’s nice to not have to mark your book to market, as we’ve learned in the last year or two.

Derek Pilecki:

So I would say the number of IPOs and number of small companies are way down from the mid-nineties. We’re down to 3,000 or so publicly traded companies down from 5,000. A lot of that stems from the Spitzer investigations. You can’t pay research analysts for investment banking deals. So there’s not that hamper conquest or the Montgomery Securities out there, Alex Brown’s or whatever, bringing small growth companies to market. They’re just going into private equity firms or private equity funds because it’s more efficient to raise capital through private equity than it is the public markets.

And so that’s going to continue. You can’t pay for research through stock trading commissions. That business model’s gone. So firms aren’t bringing small firm… investment banks aren’t bringing small growth companies to market like they used to. And so that’s a bull case for private equity, but they’re just a more efficient capital vehicle.

Bill:

Eventually, you would think that you got to flip it to the public market once it gets to the biggest firm, I guess. You got to have some liquidity events sometime, but it seems as though they’ve been able to flip the assets to each other or extend and refi out. I don’t know. But it’s been interesting to watch. And one of those things that I’ve heard forever is going to come to a halt, but I just continues to go on, which I’m learning more and more things just tend to go on for a lot longer than people say they can.

Derek Pilecki:

For sure. For sure.

Bill:

So, look, I want to say thank you to you so much for coming on the program. It’s an honor to do a program that deserves a guest like you. And I have followed you for such a long time and I just appreciate you coming on. So thank you.

Derek Pilecki:

Thanks for having me, Bill. Really enjoyed our conversation.

Bill:

Indeed. We’ll be in touch and should you ever want to come on again, just let me know.

Derek Pilecki:

Sounds great.

Bill:

All right.

A second but higher risk opportunity is in select regional banks. Coming into March, regional banks were already at the low end of their long-term valuation range. In March, the regional bank index declined 29%, and many well-run regional banks declined more than the index. We admit there are many new negatives for regional banks in the aftermath of the Bank Crisis. Still, we think they have become too cheap and have the potential to outperform as we get clarity on the going forward business model.

 

We see four new negatives for regional banks: 1) uninsured deposits will decline unless deposit insurance limits are increased, 2) banks will operate with higher liquidity going forward, 3) deposit repricing is accelerating, and 4) regulatory uncertainty is high.

 

One of the largest surprises from the Bank Crisis of 2023 was the high level of uninsured deposits that all banks held. We believe that the concern regarding deposit haircuts at SIVB has caused anxiety among depositors across the country. Unless deposit insurance limits are raised, which looks doubtful at the moment, we think the banks will operate with lower deposit levels as uninsured depositors find more comfortable places for their cash.

 

We think the FDIC should raise the limit on deposit insurance to $1 million for consumer accounts and $5 million for commercial accounts. The $250k deposit insurance limit, put in place in 2008, has not been adjusted and is now too low. For any small to medium-sized companies, there is variability in their cash flow that prevents them from keeping bank account balances below $250k.

 

The main argument we’ve heard against raising the deposit limit is “moral hazard.” We think this is an unsound argument. Commentators use moral hazard to scare people into believing that if depositors don’t monitor a bank’s counterparty risk, then bank management will run amok and take too much risk. However, in our career, we have never heard a bank management team say, “We dialed down risk because we couldn’t get this big depositor to keep his money in the bank.” The people who scream moral hazard are putting forth the argument that depositors should be responsible for monitoring their bank’s risk management. This is the job of bank regulators. As we saw with SIVB, these bank regulators did a poor job of supervising the bank. The bank’s equity and debt holders should therefore serve as another line of defense in risk management after the regulators. We would argue that the equity holders at SIVB also did an inadequate job of forcing the bank to take less risk. We do not believe depositors should act as the risk managers for banks, and as such we are in favor of higher deposit insurance.

 

We think higher levels of deposit insurance will help regional banks retain deposits. The U.S. economy needs regional banks because they play an important role in creating credit for the economy, specifically for small and middle-sized businesses. If deposit insurance limits are not increased, then regional banks will likely have to shrink, which will reduce the availability of credit. Less credit means the economy will grow more slowly or even possibly shrink.

 

Banks are going to run with a higher level of liquidity. For a banker, there is nothing more terrifying than a liquidity scare. We will have a period of lower loan growth while bankers transition to more liquid balance sheets. Once bank balance sheets reflect higher liquidity, banks will generate lower profits due to the decline in loans as a percentage of deposits. Bank securities portfolios will be shorter in duration and more liquid and will yield less, but the banks and the banking system will be safer.

 

Deposit costs are accelerating for banks. The media focus on the Bank Crisis of March 2023 has caused bank customers to search for higher yields on their excess cash. As you know, banks were slow to raise the interest rates they paid on deposits. During the low interest rate environment of the last 15 years, bank customers had gotten used to holding excess cash in their checking accounts because searching for  higher yields was not worth their time. With money market rates approaching 5%, depositors had started to change their behavior and were looking for higher yielding places to keep their cash. The bank failures in March accelerated this phenomenon and deposit costs across the banking industry increased.

 

Our fourth headwind is the uncertainty of new capital and liquidity regulations targeted at regional banks. In the current environment we believe buybacks are off the table for the industry. With the need for capital across the Financial sector, we believe it is unlikely that bankers are going to buy back much stock in this environment even given the low equity prices. However, we have identified a few banks that are down more than 20% that have small securities portfolios, meaning they don’t have any of the mark-to-market issues that SIVB had. These select regional banks have been strong performers historically.

 

Despite these four new negative issues for banks, we believe regional bank stock prices have overshot to the downside. We estimate these four issues will cause a 10% decline in earnings, which is not bad compared to a 30% decline in stock prices. We believe the banks will be able to overcome some of these negatives with wider spreads on loans going forward. We believe we must focus on the best management teams that have shown the ability to grow while maintaining discipline on expenses.

 

Some banks we have identified include Axos Financial, United Missouri Bank, Webster Financial, and Pinnacle Financial. These banks are strong performers and don’t have the same problems that SIVB and others had with their bond portfolios. These banks have strong deposit franchises and have posted strong loan growth for many years. We believe they will be able to balance the demands of the new banking environment and post strong results.

 

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