EVE-Economic Value Of Equity: Our Weekly Musings Explains This Concept & Why The FDIC Cares So Much About It.

Musings 9.30.13 EVE-Economic Value of Equity & Mortgage Stocks

A few months ago, the FDIC released a presentation and video for Bank Directors to educate on the agency’s emphasis towards interest rate risk at community banks.  We found this to be an excellent primer on this important topic and worth review by any investor affiliated with the industry.  The #1 point made by the FDIC is to set risk limits on their earnings and Economic Value of Equity or “EVE”.  The concept of EVE and fair value has been mentioned in public banks’ SEC filings for many years and caught our eye being featured in the FDIC’s educational series.

The EVE definition is the Fair Market Value (FMV) of Assets less the Fair Market Value (FMV) of Liabilities.  Sounds simple, right?  The problem immediately discovered in our review of Banks between $3 Billion and $15 Billion in Assets is that disclosures are NOT alike and the FDIC’s own call report filings contain very little on Fair Value of financial statements except for Available For Sale Securities.  This creates a real quandary for investors and analysts like us who read the FDIC’s communications and desire to pay closer attention to EVE and how it changes with interest rate changes (i.e., especially when the yield curve has steepened so much in the past 4 months).  In fact, we pulled the 10-Q filings for 55 public companies and found that FMV of Assets was at least 85% or better of actual Total Assets at June 30, 2013 for each of these companies.  However, when the FMV of Liabilities was subtracted, the residual EVE (per the definition above) exceeded 80% of TCE-Tangible Common Equity in only one-third of these banks (i.e., 17 stocks).

Musing 9-30-13 Chart-A

Does this mean that TCE is overstated at these community banks with $3 to $15 Billion in Assets?  We are absolutely not reaching that conclusion because in nearly all of the cases, the 10-Q disclosures miss the proper balance sheet items on Fair Values.  This leads to a lack of confidence in how useful EVE can truly be when the data is suspect.  For example, RNST-Renasant Corporation (MS) has combined Fair Value of Assets that represents 88% of Total Assets reported at 6-30-13 yet the EVE calculation after removing the disclosed FMV of Liabilities is a mere $20 Million!  RNST has over $310 Million in TCE and a sustained price-to-tangible book valuation above 150% for several years (i.e., we don’t think the market is mistaken on the RNST story).  Thus, with RNST the FDIC’s required EVE analysis simply does not work.  We can make an identical assertion with HOMB-Home  Bancshares which enjoys an even stronger stock valuation yet has very little in EVE from its 10-Q filing.  The reason we conducted this study was to verify whether the promotion of EVE by the FDIC’s Director Training video was sufficient enough to be used and scrutinized by investors.  However, there is a massive difference in so many cases between reported TCE and the EVE calculation that we cannot understand how the FDIC can assert that EVE be such an important component of Interest Rate Risk management.  Perhaps companies have far greater information internally on FMV of Assets and FMV of Liabilities than is shared in these company’s 10-Qs … but we doubt this is true.  We conclude that the regulatory agency is imposing an academic concept on Banks which is not yet ready for prime time.  This makes the application of EVE very suspect as the basis of governing changes in interest rate risk, in our view.

In the tables in today’s Weekly Musings industry report, we share the disclosures from the companies which we studied to explore whether EVE and Fair Market Value (FMV) disclosures could be used in analyzing interest rate risk in the manner suggested by the FDIC’s director education series (see the link to the video and slides above.  We pulled 10-Q and 10-K data from December 2012, March 2013, and June 2013.  This was interesting data, but as we state above, we have difficulty putting it into real use.

What do you think?  We welcome your feedback on this issue and our bank disclosure examples.  We would like to apply the FDIC’s standards on EVE-Economic Value of Equity to better track the impact of interest rate risk … but until FMV measurement improves (or perhaps disclosure becomes stronger), this concept is not useful.  Maybe the FDIC can take a leadership role here and have Bank Call Report filings include the necessary line items to have a uniform EVE calculation each quarter.  If we were a Bank Director, this is precisely the request that we would make.