Last summer someone recommended that I take a look at the First Bank of Delaware as an investment. I took a look and quickly passed. I saw a bank that was losing money at an increasingly fast rate, and that had experienced some legal issues in their recent past.
The bank was digging itself into a hole that seemed hard to recover from, that was until I found a news release on the bank's website that explained they were looking into the possibility of winding down operations and liquidating. Suddenly I was interested, here was a bank trading for $22m with a book value of $44m. The trade seemed attractive, especially with such a large discount to book value, if the company's book value was anywhere close to reality I had the chance to double my money.
The downside seemed somewhat limited as well, at 50% of book value what could possibly go wrong? What sort of event could destroy this investment? I was initially worried about a bad loan book, but then First Bank of Delaware sold their entire loan book to Bryn Mawr Bank at a 3% discount to book value. My biggest concern had been cleared up, investors were now set to double their money right?
Here are two spreadsheets I put together last summer showing the value of the bank:
At the time of my research the stock was trading at $2.00 per share, the investment value was straight forward.
What went wrong?
What I neglected to mention above is that the bank didn't willingly decide to enter liquidation, they were forced into it by the FDIC. The FDIC issued a consent order that forced them to either submit a plan of reorganization or to voluntarily liquidate. The company missed a few deadlines on submitting a strategic plan of reorganization, and was forced into liquidation. This should have been my first warning sign, that bank's management was unable to submit a plan of action to satisfy the FDIC's request. At the time I didn't think much of this, but in retrospect is speaks volumes to the speed and reactive nature of management.
The First Bank of Delaware's troubled past had finally caught up with them. In their recent history they had been known as a subprime enabler, they were a clearing bank for subprime credit cards. They were also involved in a supposed security incident where the bank processed a large number of fraudulent Visa and Mastercard transactions. The bank was also involved in a check cashing company from California that was accused of lending at usurious rates. And lastly the bank was involved in an online check cashing and payment system that was allegedly used to send fraudulent payments that they bank was aware of.
On the last point the bank was facing action from the US Attorney General regarding the check cashing scheme. Based on some cases and settlements dug up from the internet it seemed that the bank would be able to settle, and even in the worst case scenario I could imagine shareholders would end up with a small positive gain. I had estimated a settlement in the range of $1m-$5m, with a potential worst case scenario at $10m.
Shareholders never received the full story behind the fine, but the bank was slapped with a $15.5m fine for their involvement in the illegal check cashing scheme. My gut tells me that there was more to the story than just what the filings said, but unless a prosecutor's lips become a little loose we will never know.
The $15.5m judgement was 50% higher than my worse case guess, it knocked the value of the bank's equity from $39m to $23.5m. The bank had also incurred close to $5m in liquidation costs at this point as well meaning that their book value was further reduced to $18.5m. My initial investment was in a bank with $40m in equity at the $22m level. With book value reduced to $18.5m my margin of safety quickly vaporized.
When news of the US Attorney General's fine was released the stock sold down sharply, I realized that I had no hope of a gain on the investment and sold for $1.70 a share, locking in a 15% loss. It was shear luck that I was able to limit my loss to 15%, the stock continued to fall and I know a lot of shareholders who experienced a 50% loss on paper before their shares were converted into liquidating trust shares.
The company is still working through the liquidation. According to the latest mailing I received last week they have $1.37 in net assets per share, but it's very likely the company is over-reserving and might have a little bit more to distribute.
Lessons learned
It's always painful to review a losing investment, but I think the pain is necessary to improve our investment processes. There was no way I knew what the government fine would be, but I had enough warning signs that indicated I should beware.
My biggest mistake was ignoring the company's past. I glossed over their involvement in subprime lending, and questionable short term lending practices. Because the bank was liquidating I didn't think any of the past mattered, but it did. The past spoke to the quality of management, and to their character. The type of management who would willingly engage in illegal activities, or would turn the other way when illegal activities are occurring isn't one I want running a company I own. Whatever the bank actually did was egregious enough that the government didn't back down on their fine, they refused to negotiate a lower settlement with the bank.
My second mistake was that I estimated too many variables for this investment. At one level this investment was simple, $40m worth of value being liquidated at $22m. The gap between the two values was what the market was assuming a settlement plus some legal costs would be. I had estimated costs to be less, and while I believed my guess was scientific, it was after all just a guess. The best investments are ones where there are only one or two assumptions that need to happen for the investment to work in the investors favor. With the First Bank of Delaware there were many assumptions that needed to work as planned for me to earn a return.
I firmly believe that each loss in my portfolio has a lesson attached to it. I will never avoid losses entirely, but there is always something to be learned. Even if the lesson is something I can't avoid in the future, there is value in awareness.
Great post!
ReplyDeleteNate,
ReplyDeleteVery interesting story.
I disagree with this statement, however: "I firmly believe that each loss in my portfolio has a lesson attached to it."
Have you ever read "Fooled by Randomness" by Taleb? It's a classic in the investment community, so I assume you've read it, but if you haven't then you definitely should.
I think a lot about this issue of "learning lessons". I believe it's a lot trickier than it seems, and that's because investing is such a probabilistic activity. It's entirely possible, and in fact it happens frequently, that an investor makes a good decision that results in a negative outcome. Now, the frequency of negative outcomes does depend on the types of investments you make. An extreme example would be the repeated purchase of underpriced out-of-the-money calls. Almost every such investment will yield a negative outcome, but if the calls are truly underpriced then the rare winner will more than compensate for the much larger number of losers.
Your type of deep value investing is not at all analagous to the above example of buying cheap calls, so I would expect your percentage of losers to be much lower. However, I do think it's a mistake to believe that "each loss in my portfolio has a lesson attached to it.""
- aagold
aagold,
DeleteI have never read a Taleb book, maybe I'll check it out from the library. I have read some of the book 'Options as a Strategic Investment' so I'm familiar with them.
I say there's a lesson for two reasons:
1) I believe that success is often random and most of the time impossible to replicate. There isn't a lot to be learned by success. But failure is often a repeat of a common pattern. The First Bank of Delaware failed, there was a failure pattern present.
2) In terms of an investment I agree it's tougher to look at, often a bad thesis will result in a gain, or a great thesis can result in a loss. In both cases the thesis might actually turn out true, but the investment fails. There is some insight to be gained from that, although it's like my comment on success, it might not mean much.
I think the better avenue for consideration on a failed investment is to look at what precipitated the failure and ascertain if any of it rested with the investor. Was the purchase price too high? Was there a risk element that was ignored?
So those sorts of things are the lessons. I should also clarify, that while there is a lesson in everything most of the lessons don't have much applicability beyond their scenario. But there is great value in understanding why something happened, and the environment that it took place in. Often things do repeat in the future.
On the calls, this is a weird application to it, but I love to think about option theory in real life. I had a painfully long commute a few years back. It was an hour at least coming home in heavy traffic. I had two routes I could take, one route which didn't have much traffic and was reliably an hour, every single time. There was another route that was shorter and if traffic was light would be 35-40m, but if traffic was heavy it would be an hour plus. I remember driving up to the merge where I had to choose and thinking about the option theory. I could take the shorter route for a week and get lucky with little traffic, but if I hit it bad two days in a row all of the time I saved was wiped away at once. So while the longer route was reliably longer over time it was actually shorter. I tried all sorts of traffic cameras and tricks to figure out if the short way was moving fast. It was just that tricks, I'd get lucky for a few weeks then hit a nightmare week and erase any gains.
Nate
As disasters go 15% is not too bad.
ReplyDeletegreat post. Everyone makes mistakes, but rarely someone share it...
ReplyDeleteI was thinking...do you think that another lesson to be learned is that liquidating a firm usually costs more than we think?
How does one get information on the liquidating trust? You mentioned book value of $1.37 per share, just wondering where/how you get on that distribution.
ReplyDeleteI found an FDIC failed bank website, but FBOD wasn't on there; perhaps because it was structured as a voluntary liquidation???
https://www5.fdic.gov/drrip/bal/
Do the shares still trade?
I'm not sure if shares still trade.
DeleteI received a packet of information in the mail from the company and it had the $1.37 figure in it. FBOD was indeed structured as a voluntary liquidation, you can find a number of the documents regarding it on their own website.
If you want a copy of the trust document sent me an email, I scanned it in.
FBOD was affected by the current political climate in which government regulatory entities are used as a sword against business to raise revenue. The fine was outrageous and much above what one could predict, and I have two law degrees, an MBA and 42 years of legal experience. The lesson to be learned is the treacherous effect of politically affected, anti-business, revenue seeking governmental entities in a regulated industry. This Company agreed to exit the business and sell out to a purer than snow entity and then their shareholders got hammered with an outrageous fine representing a large chuck of their net worth. Unfortunately, it would have cost even more in legal and other fees to fight. This is one reason job creation is so low today----the result of anti-business policy and regulatory overreaching. That was what you missed.
Delete