Northeast Bank Goes All-In
With roots tracing back to 1872, Northeast Bank, a Maine state-chartered bank with $1.7 billion of assets and $252 million of equity as of September 30th, was originally organized to serve communities in western Maine as a run-of-the-mill mutual savings bank. It is anything but that today. Over the past decade, Northeast Bank has transformed itself under the leadership of its current CEO, Rick Wayne. Wayne led an investor group in a friendly takeover of Northeast Bank in 2010 with a plan to implement a fundamentally new strategy. He deemphasized Northeast Bank’s traditional community banking lending in favor of purchasing and originating “scratch and dent” and other unconventional commercial real estate loans nationwide. It is roughly the same strategy Wayne executed for nearly two decades as CEO of Capital Crossing Bank, a bank he founded with a partner in 1988, took public in 1996 and then sold to Lehman Brothers in 2007 for nearly ten times its IPO price. Wayne’s strategy for Northeast Bank has led to a step function increase in the return on equity and long-term growth the Bank should be able to achieve. It has been steadily making progress over the past decade toward realizing that potential.
Figure 1: Financial Snapshot of Northeast Bank’s Transformation
In his book, Playing Poker Like the Pros, Phil Hellmuth, winner of a record sixteen World Series of Poker bracelets, famously categorized poker players into one of five animal types, the jackal, the elephant, the mouse, the lion and the eagle. The best poker players are eagles. They have the rare combination of conservatism at most times and a willingness to be stunningly aggressive at the right moments. When an eagle goes all-in, you can rest assured without even seeing any cards that he is going to take down the pot. In the world of commercial real estate lending, Northeast Bank is an eagle, and it just shoved all its chips into the pot.
On its earnings call at the beginning of November, Northeast Bank announced that it had purchased loans with a total unpaid principal balance of $303.6 million in the month of October. That amount exceeded what Northeast Bank had bought in any year since it began its loan purchasing strategy in 2011. For Northeast Bank’s fiscal year 2022, which ended in June, the bank purchased total loans with just under $200 million of UPB. In other words, Northeast Bank’s loan purchase volume in just the month of October was about 50% more than what it purchased for the entire preceding fiscal year. It was a truly impressive volume of loan purchases for a single month by any measure.
Yet just 38 days later, Northeast Bank made it look quaint. On December 8th, Northeast Bank issued a press release announcing “significant loan purchase volume.” Over the course of November and the first week of December, Northeast Bank had purchased additional loans with a total UPB of nearly $860 million – more than twice the volume it purchased in October – bringing its total loan purchase volume for the final calendar quarter of 2022 to an eye-watering $1.16 billion at the time. That is nearly six times the volume that Northeast Bank had purchased in any previous year. In total, the recent purchases should almost double the size of the Bank’s balance sheet.
Figure 2: Northeast Bank Historical Loan Purchase Volume
Saying Northeast Bank went all-in with these loan purchases is not just a metaphor. Northeast Bank appears to have pushed its capital ratios right up to their limits. The Bank ended September with just under $260 million of both tier 1 and total capital. At that time, its tier 1 leverage and total capital ratios stood at 15.6% and 17.8%, respectively, both well above Northeast Bank’s corresponding policy standards, 9% for its tier 1 leverage ratio and 12% for its total capital ratio. Assuming Northeast Bank paid around $1 billion for the $1.16 billion of UPB, the loan purchases would grow total assets by 57% and risk-weighted assets by 69%. Holding the rest of the balance sheet constant and taking into account capital generation during the quarter, Northeast Bank’s tier 1 leverage ratio would fall to around 9.6%, just above its policy limit, and its total capital ratio would fall to roughly 11%, somewhat below its policy limit. In reality, the Bank likely remained complaint with its capital ratio policies through other changes in its balance sheet, such as normal course repayment of loans and shutting off originations. Northeast Bank literally used every last cent of its existing capital to fund the recently announced loan purchases.
Now it is rifling through the cushions for spare change to buy even more. Four days after announcing its gargantuan loan purchase volumes for October and November, the Bank announced plans to raise equity capital. Specifically, the Bank hired Piper Sandler to run an on-going, at-the-market offering to raise up to $50 million. An additional $50 million of equity capital should give the bank capacity to purchase additional loans with $500 million or more in unpaid principal balance.
“We’re seeing more volume now than I think we’ve ever seen.”
The fallout from the historically steep increase in benchmark interest rates since early 2022 is the driving factor behind the opportunities Northeast Bank is currently seeing. The spike in interest rates has shocked the commercial real estate asset market. Property values are falling and there is uncertainty among investors and lenders about where those values will ultimately settle out. Borrowers with floating rate debt are facing steeply higher payments and a corresponding deterioration in their debt service coverage ratios. Lenders with fixed-rate commercial real estate loans may experience net interest margin compression. Banks have been tightening credit standards for commercial real estate lending in a variety of ways in response to falling property values, deteriorating debt service coverage ratios, increased regulatory scrutiny, and broad-based deposit outflows. For all these reasons, the supply of performing CRE loans for sale is up, returns required by buyers have surged, and the number of buyers with access to financing has shrunk, leading to sharply lower prices for performing CRE loans on the secondary market.
In its market snapshot for the fourth quarter of 2022, DebtX, an online platform for secondary market loan sales, made the following comments about market conditions:
Figure 3: Excerpt from DebtX 4Q22 Market Snapshot
Although the prices for performing commercial real estate loans have been falling sharply on the secondary market, it does not automatically follow that buying those loans will deliver exceptional – or even good – returns. Funding costs are up, collateral values are falling, borrowers may struggle to refinance loans at maturity in light of tighter credit standards, certain property types face secular challenges, and the Fed seems intent on pummeling the economy into submission. Northeast Bank has yet to disclose sufficient details about its recent loan purchases for analyst and investors to evaluate the merits of those transactions for themselves. However, the track record of Northeast Bank’s management is so strong that it is hard to imagine them pursuing these purchases as aggressively as they have unless the prospective returns were truly exceptional and the risks limited.
Figure 4: Northeast Bank Historical Net Charge-Off & Capital Ratios
Over the past decade, Northeast Bank’s management team has proven itself to be extremely conservative. The Bank has patiently held substantial excess capital since the current management team took over in late 2010. Wayne could have easily put that capital to work and boosted near-term growth and earnings by compromising his investment standards, but he didn’t…for more than a decade. The Bank’s track record of charge-offs on purchase loans tells the same story. From June 2012 through June 2022, Northeast Bank purchased loans with a cumulative total UPB of $1.4 billion. Charge-offs on those purchased loans have amounted to a total of just $1.7 million so far, or less than 0.12% of UPB. Northeast Bank’s excellent loss ratios – especially considering the high yields its loans have achieved – are the result of disciplined underwriting, which is most evident in the low LTV ratios in Northeast Bank’s loan portfolio. The weighted average loan-to-value for Northeast Bank’s entire national lending portfolio was just 49% at September 30th. While much of what Northeast Bank’s management team does is unconventional, the team has proven itself to be as conservative as they come in terms of managing risk.
Figure 5: National Lending Portfolio Statistics as of September 30, 2022
At the same time, on the few occasions in the past when Northeast Bank’s management has acted with stunning decisiveness, the results have always ultimately been spectacular for shareholders. After having not repurchased a share in almost four years despite holding substantial excess capital, Northeast Bank repurchased $11.5 million worth of stock – nearly 10% of the outstanding shares – in the four months following the onset of the COVID-19 pandemic. The average price paid for those shares just over two years ago, $13.45, is hardly more than one-third of the Bank’s current tangible book value per share. Similarly, Northeast Bank did an incredible job of capitalizing on its opportunity to participate in the pandemic-era Payroll Protection Program. Over the course of the PPP, Northeast Bank originated $3.3 billion of loans and funded $11.2 billion of loans purchased by a third party originator, huge sums for a bank with $1 billion in assets and less than $400 million of annual origination volume prior to the pandemic. Northeast Bank earned substantial, low-risk fee income and meaningfully grew its tangible book value in the process. When Northeast Bank’s management gets aggressive, good things are in store for shareholders.
Figure 6: Northeat Bank Historical Share Repurchase Activity
Even using conservative assumptions, recent loan purchases should be enormously accretive to earnings per share over the intermediate term and book value per share ultimately. Since fiscal 2013, Northeast Bank’s purchased loans have delivered an average annual net interest spread of 10.43%, with a high of 17.05% in 2013 in the wake of the Global Financial Crisis and a low of just over 8% more recently. Even assuming the net interest spread on the recently announced loan purchases is in-line with the low end of that range, Northeast Bank’s likely investment in recent loan purchases of around $1 billion should deliver incremental annual net interest income of around $80 million. Northeast Bank’s efficiency ratio came in at just under 50% for its most recently reported quarter. Taking into account incentive compensation, loan servicing expenses and FDIC insurance premiums, the Bank’s incremental efficiency ratio with respect to the announced loan purchases should be no more than 20%. As a result, recent loan purchases should add at least $64 million to pre-tax income and $45 million to net income assuming a 30% tax rate. That amounts to more than $6.00 of incremental annual earnings per share from the recently announced loan purchases. If the loans persist for four years on average, the loan purchases will ultimately add an incremental $24.00 to Northeast Bank’s book value per share over time. Keep in mind, those figures assume a net interest spread on the loan purchases at the low-end of Northeast Bank’s historical range for purchased loans. More optimistic assumptions would put the incremental benefit to annual earnings per share and ultimate book value per share at more than $10.00 and $40.00 per share, respectively.
Any additional loans purchased using funds raised through the Bank’s $50 million at-the-money equity offering would only add to those accretion figures, although to a somewhat lesser extent due to dilution from newly issued shares.
On a normalized basis, Northeast Bank earned about $1.00 per share in its most recently reported quarter, or about $4.00 per share at an annual run-rate. Its balance sheet is slightly asset sensitive with 76.8% of its loans having variable interest rates. Even the most conservative assumptions for the impact of recently announced loan purchases, which point to $6.00 per share of incremental annual EPS, suggest that the Bank’s total annual earnings per share is headed north of $10.00 in the near-term. That is well above the current consensus estimate for the fiscal year ending June 2024 of $7.28. Tangible book value per share should correspondingly increase from $33.57 at September 30, 2022 to more than $70 per share over the next four years.
At a current market price of $43.17, Northeast Bank voting common stock (NASDAQ: NBN) looks exceedingly cheap in light of the outlook for the Bank’s earnings and book value. NBN’s current market price could prove to be less than 4x the EPS the Bank achieves for the 2023 calendar year and roughly half the book value per share it hits by the end of 2026. Northeast Bank’s differentiated and proven investment strategy should allow it to deliver return on equity in excess of 20% on a normalized basis while steadily growing its originations and balance sheet. A bank with those characteristics would need to trade at more than twice tangible book value to be fairly valued. If Northeast Bank grows its tangible book value to more than $70 per share by the end of 2026 and achieves a valuation of at least 2x tangible book value, NBN would soar to more than $140. That would represent more than a triple from the current share price and an annualized return in excess of 35%.
When a world-class poker player – a true eagle – goes all-in, all you can typically do is watch from the sidelines. In this case, Northeast Bank shareholders should ultimately be the ones who rake in the chips.
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