Some Daredevil Distressed Bank Picks

 | Jan 20, 2012 | 3:00 PM EST
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Today, as we close our bank week discussions, I want to talk about one of my favorite long-term banks investment approaches.

But I want to offer two huge caveats. This approach is NOT for everyone. It is risky, very volatile and many of these stocks may simply go to zero over time. When I practice this approach I have every intention of holding them for a decade if necessary. That is not a slogan or a metaphor. I mean 10 full years of holding these stocks. Ten years, high risk and very volatile, OK?

Back in 2009 it was thought, if not hoped, that private equity firms would flock into the banking industry to rescue many of the failed financial institutions. Although the FDIC relaxed the rules a bit, they remained strict enough as far as capital levels and holding periods that the flood never developed. But some private equity investors have moved into the financial area buying troubled banks.

This is distressed investing and most of these banks are a mess with huge loan losses. There lies the opportunity. If the economy recovers and management manages to pull off a successful turnaround, these stocks could soar over the next decade.

Flagstar Bancorp (FBC) is the poster child for troubled banks. It seems like if there was bad loan to make, the Michigan-based bank managed to make it. The bank has struggled to get the loan portfolio under control and has had to raise capital several times in the past few years. Distressed firm Matlin Patterson had to triple down on its original investment and to-date has lost almost $1 billion in shares of Flagstar. Although things are better, they are still not great. The bank has non-performing assets that have fallen, but are still more than 17% of the total. The one potential bright spot is that according to the FDIC website, $1.3 billion of the $1.7 billion of non-current loans has at least a partial guarantee by the U.S. government. Flagstar has exited unprofitable markets by selling branches and has been disposing of nonperforming mortgage portfolios.

"This is a long term turnaround and not for the faint of heart," CEO Joseph Campanelli told Forbes.

I am down in this stock and, like Matlin Patterson, have averaged down a few times. If the turnaround succeeds I will sell these shares for many times my cost. If it doesn't work, I am going to lose a few dollars. Either way, it is not for those with a weak stomach.

United Community Banks (UCBI) saw its stock price take a hit earlier this year when they had to restate its 2010 and year to date 2011 financial statements as a result of changes in its deferred tax assets and income tax expenses. The Georgia bank has seen its stock price fall by about half in the past year as its markets have struggled to recover from the housing crisis.

But things are getting better for the bank as nonperforming assets have fallen form 4.96% of assets to just 2.64% over the past year. Corsair Capital, one of the few private equity firms focusing specifically on financial services, owns the legal maximum of the bank, having invested $380 million at about $9.50 a share. UCBI also sold a portfolio of nonperforming loans and foreclosed properties as they continue to move to clean up and strengthen the balance sheet.

Hampton Roads Bancshares (HMPR) troubled bank that can serve as an excellent example of the volatility of this investment approach. Since private equity in the form of Carlisle Group, Anchorage Capital and others rode to the banks rescue, the stock has gone (adjusted for splits) from roughly $10 to almost $25 and now trades for less than $3 a share. I have taken the whole ride and still hold my shares in the troubled bank. Like other troubled banks, management is slowly selling or trying to work out troubled assets but non-performing assets are still almost 10% of the banks total assets. In addition to the private equity ownership, Davidson Kempner and Fir Tree both own almost 10% of the bank, so there is some smart money betting on a turnaround. If it happens the stock will eventually sell for many times the current depressed price.

There are some smaller banks also being acquired or having private equity firms make large investments in their shares. I own several of these and expect those that work to more than compensate me for those that do not. I expect that the economy and real estate markets will recover over the next decade and I will have far more hero stocks than zeroes in my distressed bank portfolio.

Now, please go back and read the second paragraph again.

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