Category Crypto Economics

There have been a number of recent surveys asking millennials with substantial cash savings — predominantly young professions in tech and creative positions — what kinds of investments are they interested in.  

As if they were disciples of the late great fund manager Peter Lynch, whom they probably never heard of,  they say the are interested in investing in what they use and understand.

Plus, the added benefit of such investments is being able to talk about them to friends who are familiar with the names.  Really, how fun it talking about how great your S&P 500 index fund is doing?

The Peter Lynch approach to investing is wise in some ways, but foolish in other ways as it tends toward undiversified, trendy, high risk investments as opposed to diversified, value-based investments.

At the top of the list of investments of interest to millenials is own home ownership.  Next comes stocks in the big tech companies they use and understand: Apple, Facebook, Apple, Amazon, and Google.  Next comes smaller, consumer-facing tech companies like Tesla, Netflix, and Snapchat.

And within the last two months, cryptocurrencies have captured their interest.

But, with the bust of crypto and the dim prospect of ever saving enough for a down payment on a “starter” home of $1+ Million in tech heavy areas like the San Francisco Bay Area,  there is an opportunity to come up with new investment vehicles  composed of a diversified portfolio of assets that millennials use and understand.

One recent innovation is something called an eREIT  (electronic Real Estate Investment Trust) like Fundrise — a trendy looking online website for investing as little as $1,000 in a professionally managed portfolio of property REITs.  

But there are multiple problems with eREITs.  This includes a double layer of fees charged by the managers of the eREIT on top of the fees charged by  individual REITs.

It also includes evidence that long term rates of returns (ROI) on actively managed real estate REITs are less than ROIs on low fee, passively managed S&P 500 index funds.

As an alternative to eREITs, we would like to propose a new straight-up REIT that both should appeals to millenials and should outperform existing REITs.  Obviously, the increased expected ROI comes with the increase risk as of a concentrated portfolio of properties concentrated in about 8 metropolitan areas.

We call this new millenial investment vehicle an HQ2 REIT.

We identify below 8 metropolitan areas  as most likely to be named a future location of  secondary headquarters — know as HQ2 — of big tech companies.

The includes the already announced intent of Amazon to name one city out of 20 finalists for its HQ2 in 2018 plus Apple’s recent announcement that it has plans for its own smaller HQ2.   

While unannounced,  it is highly likely that Google and Microsoft will also need to plan for an HQ2 in the next 5 years.    Assuming that it is unlikely that the four companies — Amazon, Apple, Google, and Microsoft — will pick the same metropolitan area, this means that 50% of our 8 most likely choices for an HQ2 will actually get an HQ2.

In terms of arriving at this list, we start with Amazon’s recently narrowed down list of 20 metropolitan areas in the running for its HQ2 that is projected to employ ultimately around 50,000 people.    

We next apply a Business Insider assessment of the likelihood (a simple linear ranking 1-20)  of each city being chosen.  We also make an additional division into two group based on median housing prices and proximity to a University with a top 20 Graduate School Computer Science Department in Artificial Intelligence   

Sources:

Business Insider Ranking of Finalists for Amazon’s HQ2

Median Home Prices in Top Metro Areas — 2015

US News Ranking of Graduate AI Departments

Here is the more extended version of list

An Enron moment –– def. when an accounting ploy to offload toxic assets to an unconsolidated LLC backfires.

The Bancorp’s Continuing Problems

The Bancorp (NASDAQ: TBBK) is a publicly-held Philadelphia regional bank with a diversified loan portfolio, but also known for being one of largest issuers of reloadable prepaid debit and gift cards in the country.

We have written a number of papers since early 2015 detailing its “continuing problems with a discontinued commercial loan operation.” There have been two basic points we have tried to make:

The portfolio was not fairly marked initially because “fairly marked assets sell fairly quickly.”

• The Bancorp: Bad Moon Rising (January 2015)
• The Bancorp: Continuing Problems with a Discontinued Operation (March 2015)
• The Bancorp: Why the Continuing Delays in Filing Its 10-K (May 2015)

Once the bank began to take additional markdowns, the hits to equity brought it close to going below the Dodd-Frank standard of a “well-capitalized bank.”

• The Bancorp: Private Placement Needed To Shore Up Status as Well-Capitalized Bank (August 2016)
• The Bancorp: Oversold Says Richard Thaler’s Behavior Finance Fund(September 2016)

 

A Deal Between Friends Gone Bad

Buried in The Bancorp’s 3Q17 10-Q filed with the SEC on November 9, 2017, but not mentioned a week earlier when releasing its financials to the public was

Note 13

“The independent investor in Walnut Street, the securitization into which the Bank sold certain loans when it discontinued its Philadelphia commercial loan operations, has taken actions which may result in litigation.  

Specifically, counsel for the independent investor has requested that the Note Administrator hold monthly distribution payments in escrow until the independent investor’s alternative interpretation of the order of payments, as compared to the interpretation of the Bank and the Note Administrator, is resolved.  

Based on the independent investor’s request, the Note Administrator withheld the September 2017 payment to the independent investor and the Bank and indicated that it would continue to do so until this issue was resolved.”  

Based on names in a copy of the Purchase Agreement between The Bancorp and the LLC,  we believe that the sale was between two friendly parties rather than an arm’s-length transaction.

The so-called “independent investor” in the Walnut Street LLC  was Angelo, Gordon & Co (AG & Co.)  out of New York City.  According to its website, AG & Co. is a large $26 Billion manager of  “alternative investments” including commercial real estate mortgage-backed securities (CDOs).  

Legally speaking, AG & Co. is an unrelated, third party to The Bancorp and its Chairman Daniel G. Cohen.  But, AG & Co. is listed as a “banner investor” of a firm that merged into Cohen’s latest concoction — a “blank check” IPO called Fintech Acquisition Corp, which we have written about in our paper Fintech Acquisition “Blank Check” IPO: Buzzy Name Fuzzy Aim.

The  LLC’s “Directing Holder”  was Jonathan Lieberman, head of AG & Co’s considerable commercial and real estate loan trading operations.

The LLC’s  “Designated Manager”  was Kenneth L. Tepper, head of Kildare Financial Group, an independent contractor that has been used by the FDIC to sort out bankruptcy messes.  The initial address for the LLC was c/o PLANcorp in Gladwyne, PA, another Tepper controlled company.

It turns out Tepper has close ties to The Bancorp. According to a Bloomberg bio, Tepper has served as Managing Director of Financial Institutions Group at Cohen & Co, a firm founded by the family of Chairman Daniel G. Cohen.   In short, Kenneth L. Tepper was a front for The Bancorp when it set up the LLC in 2014.

The LLC’s corporate attorney  — Dechert LLP — has close ties  to The Bancorp as Dechert LLP is listed as one of the Bancorp’s corporate attorneys and defended them in an investor lawsuit.

Finally, we just want to mention that the very name for the LLC — Walnut Street 2014-1 Issuer, LLC. — marks the LLC as part of The Bancorp “family”, not a true partnership.

The Bancorp’s founder, Betsy Z. Cohen, the mother of Bancorp Chairman Daniel G. Cohen, was instrumental  reviving the Walnut Street area of downtown Philadelphia in the 1970s by making risky loans to startup restaurants in the area.  It is ironic that the same Walnut Street name that was associated with a civic-minded banker/mother in the 1970’s is now associated with a rule-bending banker/son now.

In sum, the dispute that The Bancorp quietly buried in Note 13 of its 3Q17 10-Q is about a deal between friends gone bad.  

The Toxicity of the Bancorp’s Unconsolidated LLC

On October 31, 2014, The Bancorp announced that it was discontinuing its $1.2 Billion commercial lending operation.  It set aside this portfolio on its balance sheet,  claimed it was marked-to-market, and that the bank was actively seeking buyers.  Since that announcement,  the bank has had considerable trouble selling off the most troubled segments to third-parties.  

On the next to the last trading day of 2014 when most of us are making New Year’s plans, The Bancorp issued a terse 8-K saying it had made the first sale to a partnership called Walnut Street 2014-1 Issuer, LLC.  

What caught our eye initially in early 2015 was NOT the financing structure.  That came out nine months later.  What caught our eye initially was the stark contrast in markdown between the sale portion to the LLC and the remaining portion of the discontinued loan portfolio.

 

 

In February, 2017, the Bancorp provided an update  (see above) to the loan portfolio held by its unconsolidated LLC in a note accompanying the release of its 4Q16 financials.

 Based on that information we calculated a 40.6% AVERAGE markdown of the LLC portfolio despite 79% of loan principals were classified “performing.”

What a joke! The incongruity of these two statistics confirms the meaninglessness of “performing” as a sign of loan quality when a loan operation engages in “extend and pretend.”

Obviously, a lot of the so-called “performing” loans had been modified to interest only with a balloon payment after a number of years. And the non-performing loans probably involve skipped balloon payments rather than skipped flat payments according to a normal amortization schedule.

We provided more detail about the Bancorp’s commercial loan operations that spawned this toxic loan portfolio in our February 2017 paper The Bancorp: An ‘Extend And Pretend’ Loan Operation That Won’t Go Away.

 

The Convoluted Structure of the Bancorp’s Unconsolidated LLC

Nine months after the Bancorp finally issued its 2014 10-K (another bank debacle detailed by us elsewhere), the bank revealed that it did not consolidate this LLC into its balance sheet despite the fact that the overwhelming proportion of the LLC’s financing came from the sale of notes back to The Bancorp itself.  The table below is our presentation of the variable interests in the LLC as detailed in Note H of the bank’s 10-Ks:

 

In electing not to consolidate, The Bancorp cited almost verbatim in Note H of its 2014 10-K (filed 9 months late), and in its 2015 10-K,  the criteria for consolidation specified in FASB 46R – Statement 167:

“(1) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance; and

(2) through its interests in the VIE, the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE.”

The fact that bank waited until the day before New Year’s to disclose this sale in a terse 8-K plus the fact that the structure of the deal was so convoluted,  giving its partner 51% of the voting stock despite practically no “skin in the game”,  suggested to us right from beginning that The Bancorp was testing the limits of Post-Enron GAAP.

In Note H of its 10-K, the bank had nothing to say about who had the most power to make decisions that affected the performance of the LLC.  It just ended the note abruptly with this conclusion:  “The company is not the primary beneficiary, as it does not have the controlling financial interest in WS 2014 (the LLC)  and therefore does not consolidate.”

We have written an accounting paper, The Bancorp: A Test for Post-Enron GAAP, presenting more evidence in support of our believe that it is The Bancorp that controls the LLC and not it’s so-called independent partner Angelo, Gordon & Co with 51% of the equity.   

In previous papers, we suggested that the bank’s independent auditor, Grant Thornton LLP, take a harder look at the Bank’s election not to consolidate.   We renew that suggestion here.  Oh…wait…

We see that in July 2017, The Bancorp appointed Mr. Armondo Burnette as Chief Audit Executive and Managing director.  The Bancorp’s website says

“He will work with the Audit Committee and Executive Management to assess, direct and maintain The Bancorp’s audit management plan and oversee internal audits, risk assessments and audit finding remediation”.

It also says that

“Most recently, he was Director, National Business Advisory Services, for Grant Thornton LLP”

 

The Bancorp’s “Enron Moment”

An Enron moment –– def. when an accounting ploy to offload toxic assets to an unconsolidated LLC backfires.

Clearly,  the so-called independent partner Angelo, Gordon & Co. (AG&Co) is not happy with the performance of the LLC and wants more cash out now.

AG&Co is a savvy player in the distressed commercial real estate market. They must have had a plan to get enough cash out early to more than cover their $16 Million investment before the flood of defaults inevitably arrives.

The LLC is clearly unprofitable.  Portfolio interest income (cash and accrued) is not enough to offset the $24 Million (non-cash) expense of additional markdowns plus the $6.6 Million in notes payable interest (cash) to The Bancorp and considerable legal expenses (cash).  

Even without precise numbers to calculate profitability, the LLC’s is clearly insolvent (assets – liabilities < 0) with $24 Million in additional markdowns since inception wiping out the $16 Million in initial equity.

The LLC is overall cash flow positive only because of the $24 Million in paydowns.

In our opinion, AG&Co has the edge in this dispute as they have 51% of the voting stock.  Even though there might have been documents created at the LLC’s inception that support the Bancorp’s position as to the distribution of cash to partners, it would seem to us that AG&Co has enough votes to rewrite these instructions in their favor.

The moral of this story is that you cannot both control and not control an unconsolidated LLC with a convoluted ownership structure.  

 

Trumpcare has focused exclusively on eliminating mandates, reducing tax credits, and rolling back Medicaid expansion to the working poor. But, the consequences of this are an estimated 24 Million people dropping coverage and huge increases in premiums for those who wish to remain covered.

Trumpcare is up for a vote in the House of Representatives and its passage very much in doubt despite a 24 vote majority held by Republicans. Even it passes the House, its chances of passage in the Senate are deemed slim seemingly by design.

To appeal to moderates, Trumpcare needs to preserve Obamacare’s affordability, keep the Medicaid expansion, while at the same find a way to reduce overall budget costs in the order of 20%. To appeal to conservatives, Trumpcare must reduce overall costs in the order of 20% plus eliminate mandates which was a source of affordability by providing cross subsidies between health-risk cohorts.

The only way we see out of this conundrum is a move to consumer-directed healthcare espoused by the late economist Milton Friedman.

While Friedman is probably better known for his voucher plan for schools, he had similar ideas espoused in a paper written in 2001 called “How to Cure Healthcare.” A condensed version has been made available online by the conservative think tank The Hoover Institute.

Friedman’s big idea in 2001 was this:

“Two simple observations are key to explaining both the high level of spending on medical care and the dissatisfaction with that spending. The first is that most payments to physicians or hospitals or other caregivers for medical care are made not by the patient but by a third party — an insurance company or employer or governmental body. The second is that nobody spends somebody else’s money as wisely or as frugally as he spends his own.”

Friedman was no knee-jerk conservative. He made it clear that Federal subsidies to the uninsured was a fairness issue and not some handout. This is because of the unfairness of the current system of giving tax exemptions only to employer-provided medical insurance.

When Friedman wrote his healthcare piece in 2001, the estimate of this tax shelter was $100 Billion. Today, The Brookings Institute estimates this selective subsidy at $261 Billion.

When Friedman wrote this piece in 2001, consumer-directed healthcare with payments made from a Health Savings Account (HSA) was a new idea. He envisioned HSAs eventually as centerpiece of both Medicare and Medicaid through a combination of Federal contributions deposited in HSAs to cover normal expenses supplemented by Federal government single payer, high-deductible catastrophic insurance.

There have been three trends since Friedman’s 2001 article that have made consumer-directed health care so much more a viable option today. Trumpcare should take advantage of these trends.

The first trend — a negative one — is the dearth of Federal Trade Commission challenges to anti-competitive mergers among healthcare insurers and pharmacy benefit managers (PBMs). It is ludicrous today to think that insurance companies and PBMs compete for customers today by working hard to hold down healthcare costs and associated premiums. We have written extensively about the bilateral oligopolies in the drug supply chain and the misaligned PBM business model.

The second trend — a positive one — is the extent to which the Internet, payments technology, and mobile phones have lowered transactions costs — price discovery, evaluation of treatment options, patient advocacy, and payments — associated with the purchase of healthcare. This includes the substitution of the costly paperwork that used to plague HSAs with HSA-linked debit and credit cards programmed to pay only for SKUs certified as reimbursable healthcare costs.

Interestingly, it was Friedman’s colleague at the University of Chicago, the late Ronald Coase, that had the big idea that transactions costs could have profound effects on markets and institutions.

Notice, we said nothing about the need for government mandates for healthcare price transparency similar to the recent bipartisan legislation introduced in Congress.

We have no doubt, as would have Friedman, that consumer-directed healthcare would create such an explosion in provider price transparency as to make regulation unnecessary.

Recently, the U.S. House Oversight Committee Chairman Jason Chaffetz admonished people who complained about increased premiums under Trumpcare. He said they should get their priorities straight and cut back on luxuries like iPhones.

If Trumpcare were consumer-directed, this admonishment would be ironic because smartphones would pay for themselves by helping consumers hold down costs. For example, it is a sure thing that there would be app-based patient advocate services you could summon on a moment’s notice upon being admitted to a hospital. All bills would be run through the service. Consultants would be available 24/7 to review proposed treatments.

Indeed, we would argue that under consumer-directed healthcare, a portion of a smartphone’s expense should be a deductible.

The third trend — a positive one — is the exponential growth in venture-capital funded startups focused on healthcare price discovery, cash-only drop-in clinics, lab tests for early detection of cancer, low cost step-therapies, etc. All of these services are in a symbiotic relation with consumer-directed healthcare.

We would like to mention just two of the many healthcare startups out there with services focused on enhancing consumer-directed healthcare. Both would thrive if Trumpcare were based on Milton Friedman’s ideas.

One is a basic healthcare clinic just starting up in San Francisco called Forward. The innovation here is an out-of-pocket only subscription business model of $1,800 a year billed annually. They do not accept insurance. This type of clinic is made-to-order for consumer-directed healthcare.

The other startup we want to mention is the crowd-sourced price discovery website Clear Health Costs. Here is just one screenshot to give you some idea of its value to consumer-directed healthcare.

Again these are just two of the hundreds of healthcare startups that would make consumer-directed healthcare a viable alternative to Trumpcare as initially designed.

We conclude below with a table outlining how Obamacare, Trumpcare, and Trumpcare + Milton Friedman would address major issues:

Trumpcare + Milton Friedman

Advice First — Then Analysis:

Coinciding with a new CEO Damian Kozlowski, The Bancorp (TBBK) has been forthright in taking additional markdowns on it discontinued commercial loan portfolio. But, this has resulted in three successive quarters of unexpected losses followed by double digit percentage declines in its stock.

This article will present the case that these quarterly losses will continue throughout 2017 culminating in the need once again for a private placement to shore up its status as a “well capitalized bank” per Dodd-Frank.

The stock is NOT long term buy.  Nor is it a short at this time as there will be value funds like the bank’s 5th largest shareholder, Fuller & Thaler (of  behavioral finance fame) that will jump in when the stock falls below $4.75 / share.

At best, it is a short term trade with buys made AFTER quarterly announcements of losses and sells one month later as value funds complete their accumulation.

Analysis

Systemic problems with mortgage loan operations — originations and modifications — are flows which are capitalized into a long-dated assets or stocks.  Correcting bad origination practices, or changing the flows, does not change the prior stocks created by the flows.  

There were systemic problems with the origination and securitization of subprime residential mortgages a decade ago.  The process was corrected. But financial institutions, mostly the Federal Reserve Bank, still have a good portion of those troubled assets on their books.  The flawed origination process was stopped years ago, but the troubled loans still produce losses to this day.

Here is the analogy of the subprime debacle a decade ago to The Bancorp’s “continuing problems with a discontinued operation”:

On October 31, 2014, The Bancorp (TBBK) announced that it was discontinuing its commercial lending operations and set aside for sale a loan portfolio with a principal of a $1,124 Million. During the Conference call, the former CEO Betsy Cohen stated that  “…we do anticipate those sales being completed within the next 120 days.”

The flow process ended. But, two years later the bank still has nearly half of its loan portfolio either on its books or off-loaded to a non-consolidated, self-financed LLC.

There have been surprise loses due to markdowns / write-offs for the past three quarters.  During the 3Q16 conference call, the new CEO Damian Kozlowski sought to reassure rattled analysts by claiming  

“We believe this (markdown) is not systemic. We believe this is a one-time item.”

During the 4Q16 conference call, when pressed about another private placement in late 2017, the CFO Paul Frenkiel said,

“So right now we’re fairly comfortable we can work our way to a higher capital base without raising additional capital at this time.

At the end of this unusually long and testy call with analysts (a first!),  CEO Kozlowski wearily pledged,

“I want to wind it down as quickly as possible…”

The purpose of this article is question all of those statements.

Summary of Our Past Work

We have written a number of papers for Seeking Alpha on The Bancorp’s “continuing problems with its discontinued operations.”  There are two basic points we have tried to make:

1. The portfolio was not fairly marked initially because “fairly marked assets sell fairly quickly.”
   1. The Bancorp: Bad Moon Rising (January 2015)  
   2. The Bancorp: Continuing Problems with a Discontinued Operation (March 2015)  
   3. The Bancorp: Why the Continuing Delays in Filing Its 10-K (May 2015)

1. Once the bank began to take additional markdowns, the hits to equity brought it close to going below the Dodd-Frank standard of a “well capitalized bank”.
   1. The Bancorp: Private Placement Needed To Shore Up Status as ‘Well Capitalized Bank (August 2016)
   2. The Bancorp: Oversold Says Richard Thaler’s Behavior Finance Fund (September 2016)

We have also written an accounting paper The Bancorp: A Test for Post-Enron GAAP which challenges the bank’s election not to consolidate the LLC created to off-load the most toxic portion of the loan portfolio.

Systemic Problems With The Bancorp’s Operations

Thankfully, the new CEO Damian Kozlowski has eradicated one systematic problem that plagued the bank in the past: a slowness to book markdowns / write-offs.

But,  we have identified two other systematic problems  related to specific bank operations.

The first systemic problem is the bank’s approach to what it known as  “troubled debt restructurings” — described by the bank in its latest 10-Q  as “loans with terms that have been renegotiated to provide a reduction or deferral of interest or principal because of a weakening in the financial positions of the borrowers.”

It turns out that the bank’s commercial lending operations had a practice of “extend and pretend” or “kicking the can down the road” which can disguise the true quality of a “performing loan.”

The classic example of turning a non-performing loan back into a performing loan is to modify the terms to allow for interest only payments for a number of years followed by a huge balloon payment at the end.  Shades of subprime mortgage debacle of a decade ago?

Evidence of the bank’s practices comes from interviews with former employees found in court documents (p.25-29) connected with a class action suit by investors suffering losses for the class period January 2011 through June 2015.

Here is detail explanation (p.27) of the practice from one former bank employee “CW3”

For instance, CW3 stated, “rather than actually calling the loan or forcing a liquidation or calling it what it is, sometimes the action that was taken was funding new money to pay the existing loan down, that was delinquent.” CW3 stated that another technique Bancorp used to “try to turn nonperforming loans into performing ones” was to “switch up” a loan’s amortization, which changed the cash flow and decreased required payments.

That class action lawsuit was settled out-of-court by fake do good lawyers for a paltry $17.5 Million or 15.5% of the $112.5 in total stock market losses claimed by  the plaintiffs.  Worse, the settlement was covered by The Bancorp’s insurance (see 3Q16 10-Q p.32) and so there was no hit to the bank’s financials.

The second systemic problem was the way the bank has wound down this discontinued loan portfolio.  

The most toxic portion was sold off first to an unconsolidated LLC accompanied a bare-bones 8-K sneakily filed the day before New Year’s Eve 2014. Two years later in 4Q16, The Bancorp finally provided enough detail to support our early 2015 assessment of the toxicity of  this off-balance sheet portfolio. (see spreadsheet below)  

With the most toxic portion removed, the bank has spent the last two years getting rid of the cleanest portions.

About 25% of the principal has been payed off / paid down. The bank touts this as a success. But, this means that the borrowers with the best finances and opportunities to refinance are off the books.  

The corollary is that the remaining borrowers have little ability to pay down and have relatively high loan-to-value (LTV) precluding them from refinancing with another lender at a lower interest rate.  

The remaining portfolio on the bank’s books has been shopped around to every regional bank in the Mid-Atlantic region for the past two years.

In 2Q15, loans totalling $150 Million were “cherry-picked” by the Cape May Bank, NJ ($102M) and another unidentified bank.  In 3Q16, a loan package of $65 Million was “cherry-picked” by the First Priority Bank, Malvern PA.

What is left is stuff no regional bank in the Mid-Atlantic would touch.  It’s like they say —  never shop at the farmer’s market at the end of the day as it’s all been picked over.

A Comparison of the Two Loans Portfolios

Below is a spreadsheet comparing the remaining portion of bank’s two loan portfolios in terms of

• % markdown of remaining principal
• % non-performing
• % of initial principal that has been paid-down / off

And, in a later spreadsheet

• A “reverse engineered” disaggregation of average % markdown overall into average % markdown by performing class  

This data comes from the end of the bank’s announcement of its 4Q16 results.  After two years of providing next to nothing, the bank suddenly discovered financial transparency.  This was likely due to a crescendo of pressure from investors coupled with a new CEO realizing that financial transparency (not the same as GAAP) is best in long run for the bank.

There are three statistics in the spreadsheet below that confirm our suspicions made two years ago that The Bancorp’s strategy was to bundle the most toxic and unsellable loans first and off-load them to an unconsolidated LLC which it obviously had to self-finance as no third-party would partner with them otherwise.

The first piece of confirming data was a 41% AVERAGE markdown of the LLC portfolio despite 77% of loan principals classified “performing.”  What a joke!  The incongruity of these two statistics confirms the meaningless of  “performing” as a sign of loan quality when a loan operation engages in  “extend and pretend.”  

Obviously, a lot of the so-called “performing” loans had been modified to interest only with a balloon payment after a number of years. And the non-performing loans probably involve skipped balloon payments rather than skipped flat payments according to a normal amortization schedule.

With no more “extend and pretend” possibilities, or refinance because the borrower is “underwater” with a current loan-to-value (LTV) > 100%, the endgame here is foreclosure followed by Chapter 7 or Chapter 11 followed by sheriff’s sale.

This sequence is similar to the loans largely responsible for The Bancorp’s losses in 2Q16 (The Schuylkill Mall in Frackville, PA) and 3Q16 (The Fashion Square Mall in Orlando, FL).

A third telling statistic is the difference in % paydowns / offs.  Here 62% of the bank’s original portfolio was paid down / off versus a paltry 6% for the LLCs portfolio.  

A high % means that the bank’s portfolio contained a lot of borrowers with spare cash to pay and/or appreciating assets — low current LTVs– that provided opportunities to refinance at lower interest rates.

A low % means that the LLC portfolio contains a lot of borrowers with interest first loans with no spare cash to paydown and depreciating assets — “underwater” LTVs > 100% — that provides no opportunity to refinance.

An Estimate of Future Losses

The commercial lending operation was discontinued in 3Q14, but it wasn’t until 2Q16, coinciding with a new CEO,  that The Bancorp finally began to account for the deterioration in the loan quality in the two portfolios.

Below is a chart of the FY16 discontinued portfolio markdowns and LLC note write-offs.

The Bancorp uses mark-to-market accounting for the portfolio still on its books, taking account of specific events like the 3Q16 foreclosure and subsequent Chapter 11 filing of The Fashion Square Mall in Orlando, FL.

The accounting is entirely different with the off-balance sheet portfolio in the LLC.

The LLC itself uses mark-to-market accounting internally per GAAP.  But because the LLC is unconsolidated and overwhelming financed by notes taken back by The Bancorp, the bank uses note valuation accounting here.

Note valuation affords the bank discretion in models and interest rate parameters chosen to calculate discounted present value of the notes.   This variability in possible valuations was discussed at length during the  4Q16 conference call.

All of this is evidenced in the difference between 4Q16 LLC write-off of $13.2 Million discussed during a January 31st private call with analysts and $25 Million write-off discussed February 10th during the 4Q16 conference call.

Below is our estimate of addition mark-to-market markdowns for both portfolios.  The caveat is that our estimated markdowns for the LLC portfolio are internal to the LLC.  Whether or not they are reflected in the opaque, discretion-laden note valuation model used by The Bancorp is another matter.

The key to our estimate is a disaggregation of average % markdowns supplied by The Bancorp into markdowns by performance type.  The Bancorp helps us do this for the portfolio still on their books.

They disclosed an average 41% mark for subclasses like shopping malls which are laden with non-performing loans versus a average 5% mark for subclasses laden with performing loans.  

Tellingly, the bank did NOT reveal marks by subclass for the LLC portfolio.  But, simple tie-out math dictates that the components that weight the LLC  41% average be higher than the components that weigh the bank’s 15% Average.

We could see the LLC booking  $30+ Million yearly markdowns for the next 3 years.  Again, there is a caveat that what the LLC books internally according to mark-to-market GAAP  is not the same as what The Bancorp books as changes in discounted present values of notes from an unconsolidated LLC (now insolvent according to my reconstruction of its 4Q16 balance sheet).

In any case, the losses will not end soon and will plague the new CEO Kozlowski for the next three years despite his 4Q16 pledge  “I want to wind it down as quickly as possible…”