Texas Ratio (not a good measure)

The Texas Ratio has been widely quoted as a standard measure of a bank’s health but as you will see below it is not an accurate measure.  Below is a high-level, simple definition of the Texas Ratio and then the reason why it is not a fool-proof measure.

The Texas Ratio measures “bad” loans (going bad and already bad) in relation to the bank’s financial strength (i.e. their ability to weather the storm).  The top number in the ratio is the bad loans and the bottom is the bank’s capital & reserves.  If the ratio is high, that means their bad loans are high in comparison to the resources (capital & reserves) they have on hand to manage these loans.

The Texas Ratio is not a fool-proof measure because the top number (bad loans) has the very real potential to be subjective.  Example — a bank knows one of its borrowers will not be able to repay a loan but for reporting purposes the bank can’t afford to add this loan to Non-Performing Assets.  If they do claim it as a bad loan (along with all of the others) the FDIC will have to close the bank.  In order to avoid this, they decide to extended it for three years and made it a “bullet” loan meaning no interest & no principle is due for three years at which point the entire note is due.

This is very typical of the actions of many banks over the past three years and has been cleverly dubbed “extend & pretend”.  The only way this strategy would have worked would have been for the economy and the real estate market to make a truly miraculous rebound but this didn’t happen.  In the mean time, many people were comparing Texas Ratios and judging many failing banks as healthy institutions when in fact these banks’ executives simply had trouble reporting the truth.

For the FDIC’s part, they didn’t have the staff to accurately track every one of these misleading attempts by bankers and many stayed under the radar.  They have though, in my opinion, done an excellent job of managing the banking crisis in a reasonably orderly fashion.  They now have more staff but the gray area in judging whether a loan is good or bad is still there and the Texas Ratio is only a marginally more effective measure today than it ever was.

A better measure?  This is not something I’ve researched at length but there is one measure that I’ve seen more than any other that has had a positive correlation with bank failures — percentage of loans in the construction & development (C&D) category as of mid 2007 (approximately).  Again, this is not scientific but any bank I have personally seen with 45% or more in that category as of that time period has either failed or the rumors are flying about failure or acquisition.  Certainly banks with less than 45% in this category have failed but I’m just providing a general observation.  Additionally, a small percentage of banks with over 45% in this category have been able to raise additional capital which of course enhances their viability.

The true measure of a bank requires significantly more analysis.  For larger publicly-traded banks, the equity analysts make a reasonable attempt at judging the banks and there are plenty of these reports available.  For smaller banks, you have to gather information from Call Reports which every bank (public or private) must submit to the FDIC every quarter — access these at fdic.gov, search “call reports” and follow the directions to pull specific bank reports.  Also, SNL data is a very complete database of all information contained in call reports in a format that is more user friendly but it requires a subscription.

That’s a little more than an explanation of the Texas Ratio.  Please send any other questions you have (related or unrelated).

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