Sunday, September 28, 2008

Watch List: National City

So it looks like we have a deal. Policy-makers, doing the job they're paid for, have created a compromise plan to bail out financial markets.

The rescue is too late to save Washington Mutual, which was seized late Thursday by federal regulators. That news sent its stock to the floor. It also did a number on Ohio-based National City.

NCC lost -25.7% Friday to close at $3.71. The shares have traded between $2 and $27.21 for the past 52 weeks. Shares are down -77.5% year to date. I think they're a buy. Here's why:

(1.) Banks make money by lending. That's also how they lose money. NCC's "classified" loans total $3.7 billion, or about 3.2% of NCC's total. These are credits more than 90 days past due.

Every bank has classified loans, even in the best of times. To cover these losses, bankers set aside cash in a reserve fund. NCC's loan-loss reserves, according to the latest data from the FDIC, total $3.4 billion.

Not every classified loan will go bad. In fact, the FDIC's Quarterly Banking Profile for the period ended June 30 says the net chargeoff rate for banks with more than $1 billion in assets was 1.32%. NCC's reserves are higher than that -- it can cover 3% of its loans, or 92.6% of its classified loans. So if every classified loan goes bad, NCC will need to come up with $316 million to cover them.

National City can do this very easily: The upside to having 3% of your portfolio classified is that 97% is not. Those loans are still earning interest. Consider: $112 billion at 8% earns $9 billion a year in cash. Even if the cost of funds behind those loans -- what it had to pay to borrow the money to lend it -- is 5%, or $5.6 billion, then NCC is still turning a gross lending profit of $3.4 billion, and that's before it earns a dime in fees.

(2.) National City has no option-adjustable mortgages on its books. These loans allow borrowers to pay less than their full monthly interest payment, and they've caused banks no small amount of consternation. Anyone worried that NCC is the next WaMu should write this down: WaMu's option-adjustable mortgages alone were larger than NCC's entire mortgage portfolio. WaMu made billions in loans and let borrowers pay no interest. Smart move? You be the judge.

(3.) NCC has a huge stake in Visa it could sell to raise cash -- in fact, it has very strong assets. And they're selling for very cheap -- NCC is trading for a fifth of its tangible book value. Its market cap is $2.9 billion. From a purely fundamental perspective, this bank strikes me as being worth more than that -- and that was true with or without a bailout.

Those are all good reasons to buy these shares. But this is a market where good reasons won't get always you very far. Nevertheless, NCC presents a potentially good short-term trade: Assuming a sub-$4 entry point, I like the idea of a laddered exit prices of $4.75, $5.50 and $6.25 covered by a trailing stop to contain downside. Granted, that's academic if the shares open at $8.25, and that's not out of the question as Wall Street responds to the bailout. With any luck, it won't be signed into law until Tuesday, and National City will drop back down to $2 in the interim. Hey, I hate to be a greedy bastard, but I do have an obligation to shareholders.

A rising tide lifts all boats, and the bailout is sure to bring back investors who sold off on Friday. We'll see…

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