In depth analysis of Zions Bancorp (from July 2009 Partner Letter)

1. ZIONS BANCORP – PARTNER LETTER EXCERPT
Jason C. Norbeck, CFA
Managing Partner
JCN Investments, LLC
JULY 2009 - ZIONS BANCORP headquartered in Salt Lake City, Utah with $55 Billion in assets is the 30th largest Bank Holding Company in the United
States. Zions structure is somewhat unique in that the Holding Company owns 8 independently chartered bank subsidiaries that each operate in their
respective states each with a separate management team and Board of Directors. The goal of the separate subsidiary structure is to achieve the operating
efficiency and breadth of product offerings of a big bank combined with the knowledge and relationships of a locally operated community bank. Zions
individual banks listed by order of size are as follows:
Independent Primary Assets Deposit Share
Bank Subsidiary States (000s) in State
Zions First National Bank Utah and Idaho $21,163 2nd (Utah) 6th (Idaho)
Amegy Bank of Texas Texas $11,882 8th
California Bank and Trust California $10,827 11th
National Bank of Arizona Arizona $4,950 4th
Nevada State Bank Nevada $4,184 5th
Vectra Bank of Colorado Colorado $2,722 10th
Commerce Bank of Washington Washington $880
Commerce Bank of Oregon Oregon $50
Zions Bancorp is, in my opinion, a conservatively run collection of banks, with an honest, capable and owner oriented management team. Zions
Bancorp has strong capital levels, very strong liquidity and a valuable deposit franchise that provides its banks with a stable source of low cost funding.
However, Zions Bancorp currently has a higher level of non-performing assets relative to its peers (6.02% versus 5.26% for its peer group) as it operates
in three states (California, Arizona and Nevada) that while attractive from a long term perspective have been extremely weak over the last two years.
Zions was especially hard hit in 2007 and 2008 by losses related to loans to private homebuilders in those states. Zions Bancorp also has a relatively
large concentration of Commercial Real Estate Loans, a lending category that many analysts expect will experience severe losses on a go forward basis.
And finally Zions Bancorp has experienced large writedowns on its securities portfolio, including many securities that were AAA Rated at the time of
purchase but have since been downgraded and thus impaired. As a result of these negative factors and the general upheaval within the banking sector,
the price of Zions stock has dropped by 88% over the last two years.
The general rationale for our investment in Zions Bancorp is that its purchase price at 0.5 times tangible book value, 0.3 times regulatory capital level
and 2.8 times the company’s long term earnings power is attractive in relation to the risk of the investment, a risk that is reduced by the bank’s strong
liquidity position.
Annual
Annual Earnings
Zions Bancorp Tangible Shareholder's Tier 1 Capital Normalized
Before Credit Losses
($ in millions) Book Value Equity (Regulatory Capital) Earnings
(Pre Tax)
(After Tax)
As of 3/31/09 $2,807 $5,579 $5,183 $950 $500
Partnership Cost Basis $1,400 $1,400 $1,400 $1,400 $1,400
Price Ratios 0.5x 0.3x 0.3x 1.5x 2.8x
While Zions Bancorp is currently experiencing higher credit losses (a trend that is likely to continue and possibly accelerate), it is a bank (or collection
of banks) with a conservative credit culture and with the vast majority of its lending secured by collateral. In addition, the Zions Bancorp has sufficient
capacity due its strong core earnings power and excess capital level to absorb higher credit losses in the future ($ in millions).

2. Excess Excess Pre Tax Estimated Annual Average Annual Credit Losses
Regulatory Tangible Pre Credit Credit Loss Credit Losses (most recent Quarter)
Capital Common Equity Earnings Power Capacity (last 10 years) Annualized
$1,870 $650 $900 - $1,000 $1,800 - $2,000 $129 $605
In addition to strong capital levels and strong earnings power, Zions Bancorp also has very strong and stable liquidity. This is important because most
bank failures are caused by disruptions in liquidity rather than by credit losses that erode capital. It is not to say that asset quality does not matter,
however the risk to a banking institution (especially in the current environment) is foremost a function of liquidity, which is generally defined as the
stability and mix of a bank’s funding sources and the liquidity of its assets and its backup sources of liquidity in relation to potential demands for cash
that arise from debt maturities and deposit withdrawals. The earnings power of the bank and its excess regulatory capital in relation to its future credit
losses and asset impairments are a secondary source of risk to a bank.
A bank can usually survive weak earnings (driven by elevated credit costs) if it has strong and stable liquidity and a bank can usually survive with weak
liquidity if it is producing strong earnings, however a bank can seldom withstand weakness in both liquidity and earnings/capital. It is important to note
that the majority of bank and financial institution failures during this crisis have been the result of poor liquidity management rather than earnings
and/or credit losses leading to capital shortfalls. Market participants that focus solely on capital ratios and credit trends will usually miscalculate the risk
facing a bank or financial institution.
In the words of the US Treasury in its recent report on the current crisis and future regulatory reform:
The nation’s largest financial firms, already highly leveraged, became increasingly dependent on unstable sources of short term funding.
Regulators did not require firms to plan for a scenario in which the availability of liquidity was sharply curtailed.
This creates an interesting challenge when assessing the risk of a bank, as the majority of bank and financial institution failures (epecially the high
profile ones) have involved companies that were well capitalized by regulatory standards, with expected loan losses that were manageable in relation to
their capital base and to their future earnings power but that failed because they were aggressively funded. Actually from a risk standpoint, loss loans
and increases in non-performing assets are more dangerous to a bank in that the disclosure of those losses may potentially cause liquidity pressures and
disruptions in funding than from those losses actually causing a capital shortfall that results in the failure of that institution.
A bank will fail if its capital is critically impaired due to loan losses or if its earnings power is eroded by a high percentage of non-performing loans,
however that process is usually slow and drawn out, nothing like the high profile shotgun failures that have happened over the last two years.
So if liquidity and the stability of funding are so important to the health of a financial institution, how do you define it and measure it. Following is a
simplified chart of the funding alternatives excluding equity that are available to a financial institution (divided into three categories).
Customer Deposits Additional Wholesale Borrowing
Wholesale Borrowing
(Available only to Banks) (Available only to Banks)
Non-Interest Deposits Repurchase Agreements (Repos) Fed Funds (through Federal Reserve)
Savings and Money Market Accounts Commercial Paper Federal Reserve (Primary Dealers)
Certificates of Deposit (CDs) Bank Borrowing Federal Home Loan Banks
Deposits in Excess of FDIC limits Long Term Debt Brokered CDs
A federally regulated bank in addition to having access to funding from Customer Deposits, also enjoys “Wholesale” funding options (including Fed
Funds, Federal Home Loan Bank Borrowings and Brokered CDs) that are not available to other non-bank financial institutions. As one travels through
the graveyard of failed financial institutions during this crisis, many failures involved non-bank financial institutions funded primary through unstable
Wholesale Borrowings of short maturity. This list includes the large number of Mortgage REIT companies that failed in 2007 that were primarily
funded by “warehouse” lines of credit (collateral secured loans with various Investment Banks callable at any time). When the Investment Banking
Industry withdrew funding for the Mortgage REIT industry virtually every Mortgage REIT failed in very short order. Included in the list of failures was
Thornburg Mortgage, a firm that specialized in prime jumbo mortgages whose portfolio delinquency rate never exceeded 1.00%.
The next high profile non-bank financial failure was Countrywide Home Loans, a company that despite owning a small bank subsidiary was virtually
completely funded through Wholesale borrowings that were maturing at a very rapid pace. As its funding dried up and its assets became less liquid, the
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3. company was forced to fold itself into Bank of America. And the Investment Banks – Bear Stearns, Lehman Brothers and Merrill Lynch, firms highly
dependent on short term Wholesale borrowing, all failed or where taken over by firms with more stable funding sources. The surviving large
investment banks, Goldman Sachs and Morgan Stanley in addition to several other large non-bank financial institutions (such as American Express and
GMAC) recently applied for and were granted Bank Holding Company status, in order to obtain the enhanced liquidity options of a regulated bank.
While a regulated bank has substantially enhanced liquidity options compared to a non-bank financial institution, there are still considerable differences
in terms of both cost and stability of funding amongst different banks. It is the growth in Customer Deposits, especially Non-Interest bearing Deposits,
and Savings and Money Market Accounts (those that result from core banking relationships) that provide the low cost funding that drives the
sustainable organic growth of a bank. For a conservatively run financial institution, Wholesale funding is used as an alternative source of liquidity to
balance the temporary periods of mismatch between loan demand and core deposit growth.
The large bank failures of this crisis to date (separating regulated bank failures from non-bank financial failures), generally involved institutions that
used Wholesale borrowing as a vehicle to fund a rate of growth that exceeded each institution’s core relationship deposit growth. A high reliance on
Wholesale borrowing limits a bank’s ability to access backup sources liquidity during periods of stress. Financial institutions that relied on securitization
(the process of converting loans into securities to be sold for cash) as a core method of managing and creating liquidity were especially effected when
those markets stopped functioning in August 2007. The liquidity pressures on financial institutions only grew throughout 2008 as a majority of
Wholesale liquidity options became increasingly restricted. Throughout 2008, banks were experiencing extreme liquidity pressures from both sides of
the balance sheet as their assets became much less liquid, especially loans with longer maturities as thus fewer repayments (like home mortgages) while
simultaneously experiencing significant liquidity pressures from the liability side of their balance sheet as debt and CD maturities in many cases
exceeded a bank’s ability to issue new debt. When deposit withdrawals further pressured liquidity, several large banks failed or were forced into the
arms of their more liquid rivals.
The Federal Reserve, the US Treasury and the FDIC have understood these issues all along and have introduced many programs throughout this crisis for
the purpose of enhancing bank liquidity. The Federal Reserve enacted the Term Auction Facility (TAF) and the Term Asset-Back Securities Facility
(TALF) which include an expanded list of firms eligible to borrow directly from the Federal Reserve while allowing those firms to use expanded forms of
collateral for increasingly longer terms. The FDIC attacked liquidity pressures with its guarantee of all interbank lending, and the Temporary Liquidity
Guarantee Program (TLGP) which allows banks to issue debt guaranteed by the FDIC and insures an unlimited amount held in a non-interest bearing
bank deposit account. And the US Treasury via Congress raised the FDIC insured limit to $250,000 per account and enacted the Troubled Asset Relief
Program (TARP), to remove illiquid assets from the balance sheets of the banking industry. Upon approval of the TARP, the US Treasury quickly
shifted from the purchase of illiquid assets to direct capital injections into the banking institutions, not to fill a capital short fall per se, but rather because
it became very clearly the quickest and cleanest way to restore confidence and therefore improve liquidity conditions within the banking system.
The myriad of programs have largely proven successful as liquidity in the banking sector is greatly improved as compared to a year ago. As a result, bank
failures have been recently limited to only a handful of smaller institutions.
In terms of liquidity Zions Bancorp is especially strong. Following is a breakdown of funding for Zions Bancorp in comparison with its larger bank
competitors and in relation to the larger bank failures during this crisis.
Funding Sources Non Interest Savings and Wholesale
as a % of Tangible Assets Deposit Money Market Borrowings
(Last Reported Quarter) Equity Accounts Accounts CDs minus Cash
Zions Bancorp 10.0% 20.7% 48.0% 14.9% -0.6%
Bank of America 8.6% 11.9% 23.3% 12.7% 27.7%
Wells Fargo 7.7% 14.8% 42.3% 12.6% 19.1%
Citigroup 7.6% 7.5% 38.7% 1.4% 21.6%
IndyMac 4.6% 1.7% 7.1% 0.0% 84.0%
Wachovia 5.9% 8.7% 30.2% 21.2% 29.5%
National City 9.4% 10.9% 28.5% 25.7% 21.0%
Downey Savings 7.5% 4.9% 10.9% 59.4% 13.0%
Washington Mutual 7.8% 10.3% 39.6% 14.2% 24.8%
While this chart is an overly simplified snapshot of liquidity that lumps together all non-deposit (Wholesale) borrowing without any regard for its
duration and stability. The chart does indicate that in terms of liquidity Zions is in a very strong position as its cash position actually exceeds its
aggregate Wholesale Borrowings. In addition, Zions’ mix of deposit funding is favorable as it consists mostly of core relationship deposits. Zions current
non-reliance on Wholesale Borrowings also provides the bank with a significant source of back up liquidity as it has roughly $16 Billion, (over 27% of
assets) in untapped borrowing capacity with the Federal Reserve and The Federal Home Loan Banks should its banks face liquidity pressures in the
future. While Zions Bancorp experienced a considerable uptick in nonperforming loans in during Q12009 which will pressure near term earnings
results, the company also grew its deposit funding by 15% from last year which will drive its long term value during more normalized conditions.
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4. As we shift our discussion from assessing risk to assessing the value of a banking franchise, how a bank funds itself is also very important. In fact, as I
alluded to before, the long term value of a banking franchise is driven primarily by its ability to maintain and grow its low cost funding sources (non-
interest deposits and low interest savings and money market accounts) coupled with its ability to generate profitable sources of revenue (non-interest
income) from its banking relationships.
In an interview earlier this year, Warren Buffett (probably the world’s foremost expert on how to value a banking franchise) discussed the rationale for
his investment in Wells Fargo. Following are excerpts from different parts of the same interview, please note his repeated emphasis on Wells Fargo’s
low cost funding.
“You don't have to be a rocket scientist when your raw material cost (cost of funds) is less than 1-1/2%. So I know that you can
have a model that works fine and Wells has come closer to doing that right than any other big bank by some margin. They get
their money cheaper than anybody else. We're the low-cost producer at Geico in auto insurance among big companies. And when
you're the low-cost producer - whether it's copper, or in banking - it's huge.”
“Wells just has a whole different attitude. That's why Kovacevich (Chairman of Wells Fargo) calls them retail stores. He doesn't
even like the word banking. I mean, he is looking to have a maximum enduring relationship with many, many millions of people.
Tens of millions. And at the base of it involves getting money in very cheap. When you do that that's a helluva start in the
business. The difference between getting your money at 1-1/2 % and 2-1/2% on a trillion-dollar asset base is $10 billion a year.”
“The key to the future of Wells is continuing to get the money in at very low costs, selling all kinds of services to their customer
and having spreads like nobody else has.”
“But they've got the secret to both growth, low-cost deposits and a lot of ancillary income coming in from their customer base.”
While analyzing a bank is definitely a complex exercise, a core driver of value can be simplified and summarized in four words: Stable Low Cost
Funding. Like Wells Fargo, Zions Bancorp has a very low cost of funds, one of the lowest in the banking industry, which provides the bank with a
competitive advantage within the markets that it operates.
Cost of Funding (as a % of Tangible Assets) 2009Q1 2008 2007 2006
Zions Bancorp 1.32% 2.09% 3.06% 2.71%
Average for Banks w/ Assets over $10 Billion 1.80% 2.41% 3.44% 3.16%
Average for Banks w/ Assets $3-$10 Billion 1.91% 2.43% 3.34% 2.98%
Average for Banks w/ Assets $1-$3 Billion 2.12% 2.63% 3.49% 3.08%
Average for Banks w/ Assets $500M - $1 Billion 2.18% 2.65% 3.36% 2.99%
Wells Fargo 1.02% 1.82% 3.14% 2.91%
Bank of America 1.96% 2.48% 3.71% 3.37%
Citigroup 1.73% 2.80% 3.95% 3.76%
JP Morgan Chase 0.96% 2.17% 3.53% 3.31%
US Bank 1.39% 2.18% 3.31% 2.97%
Zions funding advantage translates into one of the highest Net Interest Margins in the industry. In fact if one measures a bank’s Net Interest Margin
adjusted for credit losses Zions is second only to Wells Fargo, a standing it has held consistently throughout the decade.
While the cost of funding is not the sole determining factor in the valuation of a bank, and while Zions Bancorp does not excel at deriving additional
sources of non-interest income from its banking relationships when compared to best in class firms like Wells Fargo and US Bank, the bank’s low
funding cost does directly correlate to the value of its deposit franchise which is a key component to assessing the downside risk to our investment.
In summary our investment in Zions Bancorp allows us to obtain a very valuable deposit franchise (which provides a stable source of low cost funding)
in a number of the fastest growing, most desirable states in the country at a significant discount to value in large part because the market overemphasizes
asset quality and underemphasizes liquidity and cost of funding when analyzing the risk and the value of a financial institution.
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