Chit Chat Stocks - TFS Financial (Ticker: TFSL) with Jim Gillies

Episode Date: May 25, 2023

TFSL is a financial holding company that provides high-yield savings accounts and underwrites mortgages. Due to the recent banking panic and turmoil, shares currently offer more than a 9% dividend yield. Listen as Brett and Ryan ask questions about the company, its business model, and valuation. Enjoy the show! ***************************** Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney  Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Interested to see more of Jim's work? Check out their Twitter here: https://twitter.com/JimPGillies?s=20 Contact us: [e-mail] Timestamps TFS Financial | (2:36) Interest Rates | (36:22) Dividend | (48:30) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. My name is Ryan Henderson, and I am joined by my co-host, Brett Schaefer, as always. Today, we've got our Thursday deep dive interview, where we interview an analyst to discuss a single stock or industry. Today, we have on the show, now recurring guest, Jim Gillies. We're talking about an obscure or slightly limited following financials company. And he wanted me to make sure it was clear that this is kind of high risk, high reward. So maybe not some of the typical investments that he's brought to the table before, a little more on the speculative side, but it is TFS Financial. And he talks through, he outlines basically everything that could go wrong and everything that could potentially go

right. But yeah, Jim's an awesome investor. We have gotten a lot of ideas from him over the years and he's really kind of helped us grow as investors in general. So really hope you enjoy this interview. I guess without further ado, here's our discussion with Jim Gillies. Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast.

Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guest is not formal advice or recommendation. Now please enjoy this episode. Welcome in. Today, we are joined by five-time, six-time, seven-time guests, somewhere in there, multi-recurring guests at this point, Jim Gillies. He is the lead advisor at Hidden Gems Canada for The Motley Fool. If you are interested, after this episode, more of Jim's work, we've done a number of

different episodes, including Windmark, Nelnet, who else am I? I forget, International Petroleum. Yeah, RCI Hospitality, I think. RCI. So we've done a number of episodes with Jim. And today we are talking about another potential hidden gem. And when I was messaging with Jim, he said, I've got a fun one that's high risk, high reward potentially here.

So it's called TFS Financial. Maybe can you start? I'm curious how you found this. So how did you even come across this to begin with? I've owned it for a while, personally. I think the former fool, Jim Royal, put me onto it years ago. And I do want to proviso this one. This could be a really, really bad idea.

This could blow up spectacularly. Not because from the business, but because we are in the middle of what I've been calling a slow-moving banking crisis. Silicon Valley Bank says hi. The problem with banking is it's a confidence game, not in the sense that it's a scam or something like that. If banks have the confidence of their depositors and the confidence of investors, they tend to be a pretty good business. You all have heard of bank run. If people decide that, oh, the bank's going to close tomorrow and they all run to get money out today and banks run levered, these things go boom. TFS can be the most magically wonderful run bank in the universe. It isn't, but it's not badly run. If the confidence were

to evaporate, bye-bye. Fair dues warning, but they can't all be fun things like Nelnet or RCI. hospitality yeah you're really trying to drive some virality here with this episode for us right i just i just want to i want people to understand so and i'll put it out here and i'll flesh in the story a little bit um somebody and it might be me somebody has this one really wrong okay so uh where to begin about tfs okay tfs oh go ahead yeah i mean i don't know maybe some history is important here i know you're gonna talk about that you are gonna get some history um okay so uh tfs is 85 years old founded in 1938 at the tail end of the great depression by Mr. and Mrs. Ben and Jerome Stefanski, okay?

They are basically collecting deposits from their Eastern European immigrant neighbors in Cleveland, Ohio, kind of, like I said, at the tail end of the Great Depression. The GI Bill post-World War II comes along, like I'm literally going to give you history. The GI Bill comes along,

made, you know, everyone wants the house, everyone returning from war wants a house. Interest rates are kept super low to spur that. And it's a great time. It's a good time to buy a house. So the 50s, 60s, 70s, here's TFS. They're expanding their savings and loan business. They're opening branches in and around the Cleveland suburbs. By the way, all my notes are on this screen. So that's why I'm always continuously looking off here because I realize you're videoing this and I'm going to look like I'm staring in my corner most of the time um but you know basically what they're trying to do is they're providing home mortgages for you know clevelandites right cool great uh 50 years go by five zero

and ben stefanski and now advanced highly advanced in age ben stefanski is succeeded at the helm of the family business by his son, Mark, in 1987. But they keep on doing what they're doing. 20 years into Mark Stefanski's tenure, he decides to go public. Now, this company is not public in the sense that you guys think, or what we tend to think of as just a typical public company. IPO, take the capital, use it for growth purposes or cash out insiders or whatever. No. TFS is what's called a mutual association. Have I lost you at this point? Well, I think there's a quote, maybe just to spur some more discussion on this from there. I think they have it all throughout their investor relations page. It says,

on September 30th, 2021, approximately 81% of the holding company's outstanding shares were owned by a federally charted mutual holding company. And I talked about the difference between book value for minority shareholders and book value for mutual owners. So I haven't seen that before. I don't think a lot of listeners have seen that before. So what's the difference? Well, and realize that is going to, if you were like, say, screening for financials, this one looks awful or not awful, but it doesn't look great. And I'll skip to evaluation portion here if I were to – a typical screener right now today would say that this thing is trading, this bank is trading at 1.84 times book value and 43 times earnings. Who is excited about a bank at

43 times earnings and 1.84 times book value, right? Except that's not real, and I'm going explain why. It comes down to this is a mutual association. Mutual association is a financial institution that takes in deposits and lends them out. For a mutual association, deposits don't just represent the savings of its depositors. They also represent ownership stakes in the mutually owned institution. You guys are a lot younger than I am. You ever seen It's a Wonderful Life? okay so you know great movie great movie uh but the evil villainous mr potter during the bank run where you know the the long-suffering and self-sacrificing george bailey and his wife give the two thousand dollars they've in 1946 by the way the two thousand dollars they've

saved for their honeymoon they use it to to backstop the bank right and at the same time you know some rando from the town runs in and says mr potter the evil villain that's mr potter of course spoiler but you know it isn't almost uh what it's just misunderstood it's a misunderstood capitalist 75 year exactly it's a 75 year old movie i don't think i need to give a spoiler warning for that um or whatever it is 75 years or something like that but anyway pot he comes and says mr potter is paying 50 cents on the dollar you know uh for for the townsfolk's deposits and a bunch of people run and you know but but he's doing so and it's better to get 50 cents than nothing if the bank runs out of money because of course banks run leveraged

um he's doing so to gain control because your deposits also represent an ownership stake in the business so he's trying to get control of the bank to kill it he's trying to get control of the bailey building alone to kill it um and so basically key takeaway depositors of a mutual thrift are also its owners. Okay. So if you want to grow, essentially a mutual thrift is basically limited. You have your deposits and you have any retained earnings you've built up over time. But if you want to go public, the US Federal Reserve will allow a thrift to what's called either partially or fully convert to a more traditional stock issuing, stock holding corporation. And it's what's called a partial conversion or a second step conversion or a

two-step demutualization. If I haven't lost you yet, I'm about to. The thrift sells a minority stake in the bank, the shares of which become publicly traded and are what we all know and love of the shares. The rest of the shares are assigned to a new mutual holding company. Let's call that an MHC, which represents the interests of the depositors and the owners. So the MHC shares, they are effectively unissued. They count as shares outstanding, which is why those valuation ratios, the book value per share, trading at 1.8 times book value, trading at 43 times earnings, they count for accounting purposes, but they've not actually been issued yet. They're just held at the MHC. And in fact, if they were issued, you would sell them at the current stock price,

which in this case would have, in theory, and I'll explain why, you would have TFS here basically drowning in cash if they sold those things. Because at this point, I'll get to that. But basically, MHC shares, effectively unissued. They counted shares outstanding, but they've not been issued. They haven't actually been sold. They don't actually have a claim on the earnings. If the company, if the thrift pays a dividend, which TFS does, the MHC traditionally waives the right to receive the dividend. If the thrift wants more capital later, it can sell some or all of the rest of the MHC shares to its members and become 100% shareholder owned. And in doing so, the capital raised would lead to an excessively well-capitalized company.

Some companies, some banks, some thrifts basically take that first step and then do a second step later on or acquired. In this case, what TFS did in 2007 was to sell that minority stake and then keep the remaining content in the mutual holding structure. and eventually there's there's the hope it denutralizes the rest of the way down the road uh the ceo mark stefanski here has said he's going to leave that decision for the next generation of stefanski's running this business uh he is 68 years old his daughter is vice chair person so might you know you can call her a nepo baby i suppose but maybe maybe she makes the decision down the road. So basically, what you have here when they demutualized partway is they sold about

a third of the shares, 31%, 32%, which then meant inside the NHC, there was 68%, 69% of the shares outstanding were in that mutual structure that aren't really issued, but they're there. you're with me so far cool we follow okay brett's nodding but you look like you want to ask well i yeah so okay here's the confusion is it dilute how dilutive is it if they get like become a whatever a normal bank or a normal public trade right okay it's not not at all well Well, because it's not like a preferred stock. No. Okay.

No, if they were to issue the rest of the shares. And by the way, so yes, they did. I've just checked my notes here. They raised about a billion in capital in that first step of demutualization in 2007, raised about a billion dollars by selling a 32% stake. So 32% of the shares go out, 68% stay in the MHC. Today, 81% of the shares are in the MHC, and only 19% of the shares are outstanding. How did that work?

Are they just buying back? They bought back a ton of stock. Yeah. They bought back, I think, over 50% of the shares that were initially – or close to 50%. Of course, they're equity cookies that people get, incentive stock and whatever all the way. But yeah, no, they bought back a ton of stock. So those just end up being designated back to the mutual holding company? Oh, no.

The ones they buy back are canceled. Okay. All right. That makes more sense. They're gone. Okay. So here's TFS. They're newly public.

Sort of, kind of. They're newly public in 2007. And they're a plain vanilla home lender, mainly in Cleveland and surrounding areas of Ohio. They're kind of now really spread across Ohio now. They also have operations, smaller operations. Their second largest operation, their state, is Florida. They have some stuff in California. But, you know, basically the lion's share is Ohio and Florida.

um so everything's great right okay something happened to the housing market in 0809 something and the they didn't get in trouble the way some of their peers did giving mortgages to anything with a pulse but they did kind of loosen some of their underwriting and you know there was some programs that one of them was called home today uh that applied and this is a direct quote less stringent underwriting and credit risk standards exactly what you want to hear from a lender right oh sure thank you yes give give easy credit to people who can't pay you back fantastic um now the total for the home today program was about one one and a half percent of

loan book at the time. Most were protected by mortgage insurance. That's great until the company who gives mortgage insurance, they go out of business because home implosions, 08, 09. As well, they did try to alter the credit score requirements, but there's some damage. And so they'd also been a little too generous providing second mortgages and mortgages and HELOCs during the housing market run up of the mid-2000s. And so these things altogether basically caught the attention of the regulator. And the regulator, in response, issued several what are called memoranda of understanding, MOUs, basically demanding things like a review of potential overexposure to home equity loans, risk management procedures for managing interest rate risk, management compensation. But importantly, under the MOUs, TFS is barred for four years, mid-2010 through mid-2014. They are barred from paying dividends or buying back its own stock.

So you're done until you can demonstrate that your house, no pun intended, your house is in order. um again they they weren't frankly they weren't anywhere near as bad as a lot of the other companies out there um but the other companies that were worse a lot of them are no longer with us you know um and because it's a regulator when the regulator is telling you thou shalt do this or that um regulators don't tend to move terribly quickly they have no incentive to move terribly quickly right uh so this was you know even though they they cleaned up everything what they needed to do and like for example that uh that uh home today program um in uh fiscal they have a september fiscal year so fiscal 2007 is the year the 12 months ended in september of 2007 um at the end

of fiscal 2007 so kind of right at the peak of uh you know before the mortgage market rolls over the Home Today program made up 3.7% of the $8.2 billion loan portfolio. 3.7%. For comparison purposes, and there has not been a Home Today loan written under that program, written by this company since 2009. And today it is 0.35%. It's about $50 million. So it's one sixth of what was around in fiscal 07. It's about 0.35% of, I think it's about a 14, I think it's about a 14.5, $14.6 billion. I'm looking it up now. $14.56 billion loan portfolio. So this is a rounding error basically at this point, even if they're all zeros, who cares? And they're not even remotely zeros so but anyway they have this four-year period they are not allowed to pay um they're

not allowed to pay um dividends they're not allowed to buy back their own stock but you know they they they clean up what they have on the books uh they they shore up the portfolio against interest rate risk they diversify geographically that they really um in um again in fiscal 08 i think ohio was was close to three quarters of their lending uh today it's about 53 florida was about 20 florida is actually today about 18 it's actually lower because they've expanded another area so just you know get a little geographic diversification going on um and and and they they made sure that they kind of tried to address some of the interest rate risk in case interest rates went up i mean i know it's a quaint notion but you know sometimes they do go up

um and so um basically they uh i i think they i'm trying to look here at my numbers here uh about a third about a third of the their loans in 07 or like right before the things go boom about a third of their loans were in variable rates or adjustable rate mortgages or just very like a heloc which just floats with rate rate changes in real time um today i think it's about 52% or 53% is in these adjustable rate products. And TFS, throughout this period, so now we're kind of getting into the mid-teens, 20-teens. TFS is really, we're like, we're going to lift the MOUs, let's be nice. And they're really signaling, we are going to return capital. We've been barred from returning capital shareholders for four years. We're going to

party when when these mous come off right we're gonna go and so it was uh and that happens in mid 2014 and they immediately come out with a 28 cent per share annual dividend and an aggressive buyback so 28 cents in 2014 uh by the way today the dividend is a dollar 13. okay uh the yield on this thing is about 9.4 percent that's today on that that's that's today today the yield is 9.4 percent which i do you remember that part at the very start where i said someone has this really wrong and it might be me um 9.4 percent is the market screaming at you this dividend is going to get cut right that's i mean that's let's let's let's not an earnings yield at 10 is considered like you know people look at that and say it's this is dirt cheap so when it's a different yeah

yeah especially in earnings at 10 times people are saying they think that the earnings are going to go down yeah there there is no good story tied here people people are not people don't think in and they haven't for a while with us with this bank that uh um ceo stefanski um i'm gonna to paraphrase. What did he say? Every press release, or maybe he doesn't do it anymore, but he used to. Every press release, he would like, it's sunshine and blue skies for TFS Financial. I don't know if he still does that, but he used to a lot. And I'm just here to say, the world does not look at TFS Financial and see sunshine and blue skies right now. But I'm not sure the market's right either, to be honest with you.

Anyway, so 2014 happens, dividend comes back, and it's been aggressively raised. Buyback comes back, it's been aggressively raised. Ryan, to your earlier question, that's how you get from 32% of the shares start out as being publicly traded after the demutualization to just shy of 19% or around 19% today. um they have you know they've really kind of stuck to their stuck to their knitting the delinquency on the portfolio i mean they've stuck to plain vanilla mortgage lending and house lending primarily um i had really quick numbers here um like 80 80 over 80 percent of their loans are their core residential mortgage offerings uh about 18 and a half percent are HELOCs or lines of credit. Again, I mentioned that one product, the Home Today stuff that got

them in trouble to circa 2010. That's a rounding error. They have some small construction loan exposure, less than 1%. They have really stuck to their knitting. They have a delinquency rate, super low. They look like what a bank with 85 years of experience of just doing very plain vanilla lending that's this look this looks like okay so okay so now when we you know we've covered the demutualization we've covered uh you know the the history here we we get to today and silicon valley bank did no one any favors like this was a 14 15 stock um earlier in q1 they just reported uh we're recording this on friday the 28th uh they they reported earnings last night and the market didn't particularly enjoy them but whatever

um that's i mean they were cheap before they're cheap now so whatever um but you know the the fear when silicon valley bank goes down is that That deposit flight from all but the so-called too-big-to-fail institutions will kill every bank eventually. And then eventually you get the Canadian banking sector where you have six big banks and really nobody else. The contagion concerns. Exactly. It's like backstop all depositors. And I can see the argument.

I understand that. I don't happen to think that that's likely. but Silicon Valley bank kind of spooked people and signature and, you know, first Republic looks like it's circling the bowl as we speak. So, you know, what do you do? 34, 34% dividend yield. I saw today on first Republic. So that's a great example of that's a great example of that. Well, you know, when they,

when they cut all of their preferred dividend yields to zero and said, yeah. Oh, and by the way, these aren't cumulative. So you guys are out of luck. um that that that would be first republic fools or folks sorry forced to have it um and uh you know yeah that that was probably i know there were people who were excited to get back into first republic for bargain hunter at 16 but uh you know i was like with all due respect you should stay on the sidelines i'd like to say uh you should run to or you should teach yourself to run towards fires because as a value investor that's that's interesting to me uh but don't run towards all fires you know some fires will kill you and first republic was very much and also i had the same

question of bed bath and beyond oh is this a fire worth running to no no it isn't um anyway and fires in the financial sector especially when a fire can spread well exactly and and look i mean um there are some really there's a really good history just to kind of maybe take it back for a bit um i i alluded to the canadian banking sector uh for those who don't know i am a canadian which I suppose you should probably have figured that out since I run Hidden Gems Canada. Proud Canadian, stressed out Maple Leafs fan. Our banking sector, the whole thing is too big to fail. It's highly, highly regulated. They're incredibly diverse. They're mortgages, they're personal loans, they're lines of credit, they're investment banking,

they are insurance products, they are wealth management, they are investing you know, crap mutual funds. I mean, they're incredibly broad businesses. A bunch of them have been around since before Canada was literally a country. They predate Canada's Confederation in 1867. A couple of them, I think, have paid dividends longer than Canada's been a country. But during the 2008-2009 crisis, they got just pummeled, just like everything else financial did, right? And I was on record at the time of saying, Canadian banks do not cut their dividends. Canadian banks do not. The government will backstop them. They're better off than a lot of the other banks, which didn't have their exposure. They're certainly better off than

Lehman or Bear Stearns or whomever, who focused, of course, on investment banking and had worse leverage. But I said, Canadian banks don't cut their dividends. They will raise capital before they will cut their dividends and they will survive and they will grow. At the time, you had Bank of Montreal trading at an 11% or 12% dividend yield. You had a couple, I think you had most of the rest of them over 8% or 9% dividend yield. If you just bought a basket of the Canadian banks when it looked the worst, I think your annualized return including dividend in reinvestments well north of 15%, probably beating the total return index over that same period of time by a good five or six percentage points a year. Running towards fires is a good

thing. The question I've been asking myself, I'm saying, okay, TFS is a fire. Like I said, I've owned it for a while myself personally, but they are on fire today, but I don't think it's warranted, or I'm not sure it's warranted. And again, with my fair dues warning at the start, I might be wrong. But and so let me see if I can justify that perhaps stupid commentary. So first off, go back to the valuation argument. So once you realize that the MHC unissued shares, which are counted in the PE ratio and the book value ratio. Those aren't real. You get to what you were asking about earlier, guys, the minority shares, minority value per share. That's what matters. And what matters is, so there's 280, just over 280 million shares outstanding for this,

but 227 plus million of them are held by the MHC. So we ignore those. So the actual share count outstanding is about 53.2 million. And when you divide the earnings in the book value by that and apply it to the current stock price, you get a stock that's trading at about just over 8.3, 8.4 times earnings. And a price to book for the minority shares, price to book of 0.35 times. And I've got handy, I've got myself a nice little price chart of what the valuation has been. And if I tell you that that 0.35 times, that is the lowest valuation on record. The average valuation is about 0.6 times book value. But this 0.35 is lower than the four years when they were under MOU restriction, no dividends, no buyback. It is

lower than the pandemic drawdown in the first quarter of 2020 when the world was ending. You guys might remember the world actually did not, in fact, end. It is the lowest in history. So that's an interesting signal, I think. And again, things are signals to me. And OK, well, the fear associated with Silicon Valley Bank, of course, was deposit flight and the big tech guys had many, many, many multiples of their deposits north of the $250,000 FDIC guarantee deposited there and like, oh, crap, and pull it out. I don't know if I curse on this show, so I'll keep it clean. Again, remember here, there's a little bit of a different beast here, a little bit of a different beast and the depositors are also the owners of those MHC

shares, right? So there's a little bit, but maybe I should pull up the actual spreadsheet because I'm looking at from last quarter's notes. They did report last night. So this is a company that is the bank that has about 16.2, 16.3 billion in total assets. Of those assets, 14.6-ish, just shy of 14.6 are loans, the vast majority of which, like almost all of them, are mortgage loans uh the plain vanilla stuff that they do um so what is financing the loans and what is financing the loan so about again 14.5 14.6 in in loans that's that's really the key meat here uh backstopping that is just a hair over 9 billion in deposits uh so checking accounts savings accounts certificates of deposit uh you know brokered or otherwise i'll kind of i'll hold

it there do you i guess what do you think of these depositors i mean it's just mostly just people in cleveland and all over and florida yeah like like like i'm i'm gonna guess that you're not shopping from say austin texas or uh milwaukee wisconsin or portland oregon looking for an extra few basis points on a CD and, oh, I found one in TFS. I'm going to guess it's mainly local or relatively local. And they kind of talk a little bit about that, but they are very much about, oh yeah, we've raised deposits from our local neighborhoods to then go out into the world and provide these same people mortgages and what have you. So 9 billion deposits and about five, As of last night, with the just released earnings report, $5.2 billion in borrowings, mainly from the FHLB, right?

So the FHLB, the Federal Home Loan Bank, if you will. So that is a system chartered during the Great Depression with a mission to basically provide financial institutions with products and services to assist in the financing of homes. So banks like TFS buy equity in the FHLB system and then get access to liquidity through loans and advances. They're secured by TFSS's investment in FHLB's equity, as well as a blanket pledge of its mortgage portfolio. OK, so I was a little concerned. I think if you are looking at bank stocks during this time, given what's happened with Silicon Valley Bank and given what's happened with First Republic, I think you have to,

the first question I think has to be, are these deposits safe? Like, I think you have to be asking that question. Um, and so I asked that question, well, the, and, and, and actually I took some comfort from last night's earnings report when I saw that the, the deposit base at the end of December, so the end of 2022, was $9.014 billion. So $9 billion and $14 million. And then just reported last night, the quarter ended March, so March 2023. So now Silicon Valley Bank, for those who don't remember, it went boom on March 10th. So this is right in the teeth of it. A lot of the banks that I follow and look at, they bottomed out on March 24th. So this is as of March 31st. Deposits shrank from 9.014 billion to 9.003 billion, $11 million.

And it's at a time when people can earn more on the cash. I mean, there's withdrawals coming out of all sorts of banks. It doesn't necessarily mean people are flooding out. Let me lead into that next question we have then is, and I think a lot of people have this on their minds, you and anyone that's not an expert in financials knows that interest rates affect banks. How has the trend in interest rates impacted them over the last year? And what do you think that sets them up? Are they under earning right now? Are they over earning? I'm glad they don't have exposure to commercial real estate. And if they do, maybe let us know. But interest rates, how is that affecting them? And what could it mean for the next few years? Yeah, I'm looking for my, so this, the most recent, I thought I had that, there we go. So this recent, most recent earnings report. So because of the speed of interest rate hikes, right, the fastest ever, that is hurting a lot of banks. I think it's arguably hurting all banks. It was most pronounced at Silicon Valley Bank because they had themselves billions of dollars, I think 90-odd billion in face value or purported value, 90-odd billion of, and I promise I'm going to get CFS, but they had 90-odd billion of held to maturity, long-dated, low-interest

paying mortgage securities, essentially, that they couldn't sell, which had a value. I think it had something like a $16 billion mark-to-market loss. But because they weren't selling it because they called it health and maturity, they didn't have to take that loss. But the $16 billion quotational loss is interesting because that's basically also equal to what their equity was. So if they sold one of them, they'd have to remark the book. And then we call that, the word we use is insolvent, which is not a good word for banks. um so with tfs here um they are not unaware of interest rate risk and the risk there is they've got a bunch of mortgages issued previously during the time of zero interest rates

and but you know to keep competitive they now have to pay a higher rate an ever higher rate on what they what they are um what they're what they're taking in from depositors uh you know and and look again they got about they're getting other other 14 plus billion in um funding 9 billion of its depositors 5.3 it's from the fhlb uh that that is uh they've got that swapped out with an interest rate swap so that's largely fixed so they should be good there uh fhlb yeah so okay Did I transpose some of those? No, no. I was just making sure that –

Yeah, they swap out their interest rate risk where they can. You can't really do it when you're borrowing from – or I've got $10,000 in a checking account and whatever. I'm not going to – they're not going to swap out on individual accounts. But they do make some use of swaps for interest rate management purposes. But Brett, to your point, it is getting a little crimped here. So the most recent quarter or for the first quarter of this fiscal year, fiscal 23, interest on earning assets was 3.6%. Interest on liabilities was 1.85%. So the interest rate spread was 1.75%. The net interest margin was about 1.95%. This latest quarter, they just

brought out. Interest on earning assets, 3.79. So it's up about almost 20 basis points. But on the interest earning liabilities at 2.23, it's up over 40 or almost 40, sorry, 38 basis points. So the interest rate spread has fallen from 1.75 to 1.56. The net interest margin has fallen from 1.95 to 1.78. There has been an impact from the rapid interest rates hikes. This may, in fact, get worse in the next few quarters. It may not. What they have, again, is to combat that. First off, any new lending they're doing, especially the fixed rate mortgage, obviously, any new lending is now at higher rates. We understand that. Rates have gone up. So the days of the 2.5% mortgage are probably done for

a while. The other thing is of their loan book, as mentioned, about 52%, I think it's slightly over 48% is in fixed rate loans. So if we loaned out super low, but also there's 15 and 20-year loans on the books here, right? Because from previously issued. So those are much higher, But the stuff that they lent out at super low rates, that's just got to work its way through, and those are paying what they're paying. Probably not a lot of people refinancing their mortgages right now, but yet the depositors and the borrowings, those rates are going up. So that's going to pinch a little bit, and it has been pinching a little bit. I think an all-time low valuation in the history of the company as public, I think that's probably factored in a little bit, but whatever. and so the other thing though is 52 percent of their loan book is variable or adjustable rate

mortgages so the variable stuff is just floating as the rates have been going up now those have been going up now period full stop um adjustable rate mortgages there's a certain amount i think they pretty much all adjust over the next five years i don't have that open really quickly i don't think. Yeah, I'd probably just be guessing, but I'll do a search for arms just for fun. Yeah, okay. So as of, there we go, as of the end of fiscal 2022, so the year ended September 30th, 2022, the adjustable rate mortgages, so again, not the variable stuff, just the adjustable rate mortgages made up a total of $4.7 billion of the loan book, which is, I think, ballpark just over a third. Most of that resets in 2025 through 2027. So you're going to have to live with some

of that. But when they reset, they might be significantly higher if interest rates keep going higher. Or if you believe some pundits who say it's going to flatline, Canada has already flatline. We've plateaued our earnings rate or interest rate hikes. I know you guys are still going, but I suspect you might follow our lead at some point. So that's going to eventually tamp down. And of course, the pace of increases is greatly slowed. And that's all we really kind of ask. It's hard to work your way through. I think I'm roughly right, but precisely wrong. I think the Fed funds rate went from, what, 25 basis points to 4.5% in the span of a year. That's – yeah.

I think I'm pretty close, right? That is going to throw some – that is going to hurt. Yeah, and I was listening to an interview the other day where it's like – who knows if it's going to just stay flat. But I think because of the banking collapses as of late, it may have forced the Fed's hand to – have to keep it and not keep raising it. So I guess for context, for listeners, 9% of home loans in the US are adjustable rate mortgages. So it's surprising, I guess, to me that FSL has 50% in either basically variable or adjustable. Am I wrong here? Is that common? Well, it's funny you put it that way because as a Canadian with a radically different mortgage system where all of our mortgages are adjustable, like a standard mortgage is just a standard – you go out and buy your first house, you take a 25-year amortization, and then you have a term.

Generally, the most common is a five-year term, so you know what you're going to pay for five years. But at the end of those five years, you have to go and reshop your mortgage. And if interest rates have gone up, you're going to be paying more. And if interest rates have gone down, you're going to be paying less, right? But for us, like, you know, you're saying there, oh, this is kind of strange. I would humbly submit to my American friends that you guys don't know how good you got it. The rest of the world deals with this all the time. No, but no, this doesn't, that's not what bothers me.

There are some things that bother me. Um, no, but I actually think it's prudent that they have about 40% in, in ARMs and then another chunk in, you know, well, cause the variable stuff is HELOCs, right? Like, I mean, like I've got like on my house here, you know, I have a HELOC against my house. So if I, if I, if I needed to buy a car, I could just, you know, strike a check from the HELOC and there's my car. but like the HELOC is tied to prime plus a slight premium, which I don't remember because it's been

so long since we've used it. But let's say it's prime plus 1%. Well, when the prime rate was flirting with zero, we might've been paying, I don't know, 2.5% for the HELOC. But today, uh you know if we took if we borrowed against we might be paying eight percent on it right and and that you know and and there are people who live on their helox who live for years and also too i don't know if this is the case in the u.s i can tell you it's the case in canada a lot of helox are um their interest only so so you can borrow against your helox and then never pay it back you can just you know just as long as you're making the interest payment but if you bored at two and a half and now the interest rate's gone to eight and a half uh uh you've

you've probably cut down on your uh on your fine dining experience outside because you know you're paying that much more for your housing costs um and there's a whole other subset argument we could talk about financial planning prudence but um no i i that doesn't bother me at all in fact i actually We think it's prudent to have that type of exposure so you can not get hurt by a bunch of people took out 30-year mortgages at 2.5% and now a comparable mortgage might be say 6.5% and a deposit might be demanding 4%. There's not a bank in the world that could make lending at 2.5% and paying at 4.5%. not a bank in the world will make that math work. Yeah. And I guess, because maybe it's sometimes

hard to follow the interest rate talk as a listener, but because they have so much of their loan book that's variable or adjustable, they're able to raise what they earn much quicker than someone who has a bunch of fixed rate debt that doesn't necessarily have to be mortgages. I mean, in Silicon Valley Bank's case, I think it was mostly longer term treasuries or something like that that they're going to sell. I think they were Fannie and Freddie mortgage-backed securities. Oh, they were MBS? Okay.

Yeah. They were like 1.5% in a world where your deposits were demanding three. That ain't going to work, guys. I guess ultimately, this is a bank that could see some interest margin compression potentially in the short term. I would say it already is. Do you think there's any chance that they end up cutting this dividend or shrinking it? There is.

I think you have to always accept that that's a possibility. And I think that the way the stock price has been acting the last year or so, I think the market suspects it's going to go away. The funny thing is, remember, they don't pay the dividend to the mutual association, the MHC shares. They only pay it on the publicly issued shares. Their payout ratio is still less than one, still less than 100%. So that's interesting. And again, as I've tried to go through, we haven't even talked about how well capitalized this bank is. right uh but but i've tried to go through um and and and at the fool we are the analysts at the

fool we're generalists so we don't have a dedicated specific uh tech analyst or banking analyst or retail analyst so so um i i would welcome input from banking analysts to uh educate me on what i don't know um but i look here i say okay i i'm reasonably comfortable with I'm reasonably comfortable with the deposit base. I'm reasonably comfortable with the loan book, with the split between the adjustable and the fixed and the variable and the fixed.

Capitalization-wise here, they've got their tier one capital, tier one leverage ratio capital in net average assets is 11.27%. The rules are you need to be 5%.

They're more than double what they need to be. Their total capital to risk-weighted assets, they're at 20.64%. The rules require to be at 10%. They're really well capitalized. And that's why I say if they sold the rest of those MHC shares, even at the low price today at 0.35 times book value, they just decided to, oh, the heck with it, just flood the balance sheet with money because that will survive them. I'm not sure what to do for you. Capitalization, I'm not worried about. Credit quality looks good. Interest rate, there is, as you said, and we've talked about, there's some compression there, but I don't see how there wouldn't be in

the world that we've just kind of lived through. And I don't want to drive with my eyes on the rear view mirror. I want to believe that I think, my personal belief is that going forward, interest rate hikes, if they happen, will be fairly muted and slow from here because I do think the Fed is scared. I can tell you the Canadian Central Bank was clearly scared and they stopped a lot earlier. And it looks like they're being rewarded for it. Inflation in Canada, I think we fell to about 3% or just over 3% in the last report. So it's working. I've also kind of been on record in various places saying all the talk about a recession and what that's going to – I'm not really buying the recession

or at least the severity of a recession coming, so I'm not too worried there. So I'm trying to go through here and go, okay, so what I've been able – what my takeaway from this bank is is that everything looks – it's a nice little boring savings and loan, plain vanilla mortgage lender focused in Ohio and Florida. Good credit quality, great capitalization ratios. The interest rate issues, probably, I think I get it, but I think it's handleable. I'm comfortable with the balance sheet, all-time low valuation, approaching 10% dividend yield. One of us is wrong. And as I said, it might be me, but these are the things that I tick down and go, what am I missing? It sounds like if rates stay flat and the multiple doesn't change, investors are getting a 9% return.

Nine and a half, whatever the dividend is. And at least there's some comfort in knowing you don't need a multiple re-rating to do well here. You'll literally get the cash on an annual basis. quarterly basis. I guess my question would be kind of upside-wise, have deposits been growing? Is there the chance that this dividend grows over time? Well, I think they've raised the dividend since they brought it back at $0.28 in 2014. I think they've raised it every year. Now, not all raises are equal, of course. I think they raised this year to $1.13 from $1.12. They They made a pause, the raises during pandemic.

I don't have that sheet up in front of me, and I'm not going to bother looking for it. You can look it up. Going from $1.12 to $1.13 just to say you raised the dividend, that doesn't impress me too much. But the fact is the dividend is, as you say, still being paid. I would probably want them in this present in market. The one thing as well, just so that Q2, and I'll kind of tie it into this here if I can, is they have really pulled back on their lending. Now, their first mortgage loan portfolio, which is, of course, as I said, the lion's share of their loan book, average credit score 761, seems pretty good. average loan to value of 66%. So, I mean, houses could literally fall by a third and

the collateral, if you have to see that, you know, probably covers the loan. But what was interesting in the report from last night, new loan growth and new mortgage loan growth was $87 million for the quarter and $306 million year-to-date. That compares to $453 million in the quarter a year ago and $618 million year-to-date in the period a year ago. So they've cut year-to-date numbers by about half and in the most recent quarter, they've cut lending by about, what is that, four-fifths, 80% or so? That's like this ballpark. They're clearly seeing something and being really stringent on credit.

Like that's the only takeaway I can have there. Do you think it's the affordability? I don't want to call it a crisis, potential crisis. Less mortgage demand? Yeah. And maybe there's no mortgage demand out there. I think in the U.S. it's just dried up. I think it's probably a complex and nuanced answer. I can tell you what's going on here.

I live in Southwestern Ontario. Just think the greater sprawl that is Toronto. House prices here went stupid during the pandemic and people clearly willing to blow their brains out taking ever greater mortgages and stuff that make me and my significant other, who is a chartered accountant. We're great fun at parties. We have hives. We think we hear some of these stories and see what's going on, but people are making it work. During the 2022, things came down. House prices in Ontario, across Canada even, even where we live, I think house prices were down 20% to 25%. But volume has just gone away because it's too expensive. If I've got a mortgage locked in sub 2% and I have to get a new

new mortgage when I sell and a new mortgage would be at 6% or 6.5%. Why on earth am I going to sell? I'm not going to give up my 2% mortgage. Even in Canada, I'm not that dumb. It might be an affordability thing, but now you're seeing in Canada where I am, it's ramping back up again. We're back, baby. Again, I don't think that's a great idea, but it's not my money, so it's fine. I think it's probably pretty nuanced, Ryan. I can see it being an affordability issue, but I mean, like, I can also point you in that. Well, you guys know John Rotonti is a good friend of mine. So, you know, Rotonti has been banging the, banging the drum on, on home builders and on, you know, the fact that the US has been under building for the

better part of a decade and a half. And yet you've got household formation, you know, people are getting married. They want to buy a house. They're moving to places where they can buy a house. There's not enough houses in your country or mine. And so you'd think there should be more demand. So I think it's a pretty nuanced, probably a pretty nuanced calculation, which is a fun way to say, I really don't know. But what I can say is just by looking at the numbers, they pulled in hard in this quarter. Maybe there's not the demand there. I don't know. But they're still insisting on... Let me see if I got the right screen up here. Let's see. Yeah. The new loans they just did in this most recent quarter. So again, the portfolio

had an average credit score of 761, average loan-to-value of 66%. What little loans they did this quarter, average FICO score of 774, average loan-to-value 71%. They are not hosing out high-risk loans to high-risk people here, or high-ratio loans to high-risk people here, which again makes me say, okay, are they dialing it back? for a few quarters, perhaps. Let some of the older stuff roll off the books, which is good.

And just trying to let the banking market kind of calm down. Because as someone who was doing this professionally during the credit crisis, I tell you, boy, that was a scary-ass time. But it fades. It fades, people forget,

and then, of course, they go commit the same problems that they had the last time. So I, I, I am, I am watching that. I'm, I am not thinking you're going to get a great capital return from here anytime soon. So yeah, the, the dividend is probably all you're going to get for a while folks. um but i also uh you know if if all of the positive and the conservative things that i think i see here uh i i don't know why this thing couldn't get back to a historical average level say 0.55 0.6 times uh the book value the the just the you know the publicly traded book value And just for a comparison of that, as I flip sheets yet again, you know, like 0.55 times book value, you know, would give you a $19 stock price.

You know, stock price is $12 today. So, and then what if you got more? What if it actually went higher than just the long-run average? Yeah, any multiple expansion would be kind of cherries on top of already a pretty strong dividend. There's also the upside that maybe eventually they do go through with the second stage and go right to, you wouldn't want to do it at this low price if you didn't have to. Or the U.S. banking sector, what was there, like 25,000 or 30,000 banks a century ago, and now there's 4,000? The ones that are gone from that number went somewhere. A lot of them were acquired, and a lot of these small thrifts and whatever, they do ultimately get acquired.

I can't see Stefanski selling at this low valuation, but it wouldn't shock me to see this one eventually gobbled up by a larger entity. All right. I think that's all the questions we have. Do you think there's anything else to add, or do you think we covered it well, Jim? I hope I've covered it reasonably well. Uh, again, I welcome the banking analysts out there to come tell me what I'm missing. Um, uh, and, uh, you know, I, I, I hope this continues my streak of at least bringing interesting names. Um, they've all been winners.

They've all been winners. So I'm going to try to go against you. I'm going to try to take myself down, I guess. Um, we'll see. All right. Well, that is going to do it. then we want to remind listeners that Brett and I are not financial advisors. Anything we say or discuss here on Chit Chat Money is not formal advice or recommendation. We are, however,

general partners at Arch Capital, so clients may have positions in the securities discussed in this podcast. Thank you all for listening. Thank you, Jim, for coming on again, and we'll see you all next time. Thank you.