As a casual observer in the 1990’s and 2000’s, I noticed that banks always seem to buy smaller banks in order to grow. Bank of America was the most notable example; before the NationsBank/Bank of America merger, there were dozens of other smaller mergers that grew the bank’s deposits and branch footprint. Interstate banking had made it difficult for banks to operate beyond one state, and as barriers came down, hundreds of mergers followed. Even legendary baseball player Nolan Ryan started a couple of de novo banks, including Express Bank of Texas in Round Rock, which he started in 2003, and sold in 2006 to publicly-traded Texas United Bancshares. From July 2004 to January 2007, the FDIC did not have to close a single bank nationwide. Banks were succeeding and the exit strategy of selling out to a larger bank seemed readily available.
Small Banks Appeal to My Sensibilities
Growing up the son of a small businessman and real estate broker, I also noticed that many of the successful people I knew either were doctors, lawyers, or they owned their own private businesses; generally these were businesses that they started themselves. Back then, I had little exposure to anyone who had made an abnormal amount of money buying and selling public companies. Most of the dot com IPO’s appeared to be unsustainable businesses, and even people that had a substantially above market return by investing in local Atlanta companies like Coca-Cola and The Home Depot seemed to be more or less lucky. Trying to out-pick the stock-pickers seemed like a crap shoot to me. Investing in a business that had not yet gone public intrinsically appealed to me. The stock is not yet liquid and not everyone knows about it.
Finding Opportunities to Invest
Around 2005-2006, I came across an opportunity that seemed to tap into my interest in bank stocks and small business ownership. There were a few websites, most of which no longer exist, that promoted their consulting services as advisors to “de novo” banks (startup banks that are just being organized and are seeking regulatory approval in order to open for business). Some of these sites including the offering memorandum, offering you the chance to invest. I found some other de novo bank investment opportunities by Google searching banks that had “In Organization” after their name. At that time, regulators were looking for de novo banks to have a minimum of $10,000,000-$20,000,000 in capital, with some banks raising substantially more than that. For an investment as small as $2500 or $5000, you could purchase shares in a de novo bank (typically at $10 per share). The money would be held in an escrow account of an established bank. In the event the bank did not raise the minimum required by regulators in order to receive deposit insurance and open its doors, all the money would be returned to me. That was key.
Gaining a Bank Charter is a Rigorous Process
Investing a small amount of money into a business that is not even open yet, and that you have no control over whatsoever sounds extremely risky. I have heard stories of people investing in restaurants, mortgages, lawsuits, oil wells, etc. that never paid them a penny and in some cases cost them more than their original principal. Obtaining a bank charter is a very difficult task and requires exhaustive preparation and regulator review and approval. Regulators do not want to set banks up for failure, and most do not fail.
The Decision to Invest in 4 Different Banks
I ended up investing in 4 different de novo banks. While most of the banks said they were mostly interested in strategic, local investors (that could bring them deposits and loans), none of them gave me any type of problem when I sent in my check and forms, despite the fact that I was out-of-state and had no obvious connection to the bank or its service area. The banks I invested in were:
- The Bank of Napa, Napa, CA; currently rated ★★★★★ by Bauer Financial, $180 million in deposits, 0.66% return on assets as of Sept. 30, 2015
- Westside Bank, Hiram, GA; currently rated ZERO by Bauer Financial, $110 million in deposits, -0.13% return on assets as of Sept. 30, 2015
- Town Center Bank, Frankfort, IL, currently rated ★★★★ by Bauer Financial, $92 million in deposits, 0.06% return on assets as of Sept. 30, 2015
- Patriot Federal Bank, Canajoharie, NY, currently rated ★★★★★ by Bauer Financial, $102 million in deposits, 0.28% return on assets as of Sept. 30, 2015
Note to Self: Don’t Invest Right Before the Financial Crisis
Three of the four banks have been somewhat successful, adding deposits and each opening a 2nd branch (and even Westside Bank did not fail like 20+ small Georgia banks did in 2008-2015). However, the initial results of this investment were somewhat disappointing. While it is cool to say that you “own a bank,” cool don’t pay the bills. Only one of the four banks has paid any dividend. Patriot Federal Bank paid a $0.05 quarterly dividend per share (my basis was $10; 2% effective yield) up until late 2013 then stopped. Three of the four banks have extremely lightly traded OTC stocks: Patriot Federal Bank (PFDB) was at $7.15, Bank of Napa NA (BNNP) at $9.05, and Town Center Bank (TCNB) at $2.99. They are so lightly traded that I don’t know if you could even sell them if you wanted to. Beyond the share price, the return on assets for each of the banks isn’t that great. Warren Buffett says that banks that earn 1.3 to 1.4% on assets will sell at a premium to book value, and those earning 0.6% or 0.5% won’t sell at all. All 4 banks are at or below this level, however, my sense is that in an ultra low interest rate environment, Buffett’s acquisition criteria may no longer apply. Banks are getting much bigger and now have expensive Dodd-Frank regulations to deal with; this may be a negative on small banks, but its possible it might be a positive if more medium-sized banks desperately need to grow as well (and acquire small banks).
Liquidity is an Issue
Most bank stocks acquired in 2005-2006 have performed poorly, and unfortunately, many de novo banks have done worse. I would have been far better off investing in something like the Financial Select Sector SPDR ETF (XLF), where I would have roughly broken even in the share price (after suffering massive declines followed by a gradual recovery) and picked up around $4 in total dividends while remaining liquid. De novo banks can be a very good investment; my timing was just bad and I didn’t forecast or understand changes in the banking business. While 100+ banks were chartered every year but one between 2000 and 2007, the Great Recession caused a drought between 2010 and late 2013 when no de novo banks were chartered at all; this was ended by the Amish-focused Bank of Bird-In-Hand. A few things I will look for the next time I invest: get a clear sense of management’s strategy to grow deposits and loans at an EXTREMELY high rate and make sure the bank has a clear exit strategy. I would tend to prefer a group that had no reservations about selling to a larger bank after only 5 years. Unless a bank is on track to grow to $1 billion in deposits and acquire other banks themselves, selling out is probably the right answer 9 times out of 10. Because mega banks like Chase and Wells Fargo pay through the nose to lease or own good real estate for their branches, I’d want the bank to own its own real estate or have control over it through an option, on a great corner. Many of the de novo banks I have seen involve insiders owning the real estate and leasing it back to the bank.
2017 Update: Good News for One of My Investments
In 2017, roughly 12 years after it was founded, Patriot Federal Bank agreed to merge into Kinderhook Bank Corp. (OTCQB: NUBK). Shareholders of Patriot Federal Bank will receive 0.30 shares of Kinderhook Bank Corp. stock for each share of Patriot Federal Bank. Since Kinderhook shares were trading at around $33.15, my original investment at $10 per share was pretty much made whole again ($33.15 x 30% = $9.95). The combined bank will have 11 offices and over $500 million in deposits, so I would not be surprised if it were once again an acquisition target down the road. Also, NUBK has started to trade higher since the original announcement.
2017 2nd Update: The Good News Keeps on Coming
Bank of Marin announced they are buying Bank of Napa in a $51 million stock swap, or $20.25 per share of BNNP. Again my original investment was $10 per share. This works out to over 100% return on investment or about 6% a year due to the long holding time of around 12 years. Had the financial crisis years been removed, obviously it would have been a much better investment.