Texas Ratio Not The Holy Grail

Financials have been one of the most watched sectors the last year as the impact of the credit crunch filtered its way through the sector's balance sheets. Investors have focused their attention on the Texas Ratio to monitor the financial health of banks. Although some may see this as the Holy Grail for determining the health of a financial institution, it is an imperfect measure that should be used in conjunction with other metrics.

What is the Texas Ratio?
The Texas ratio is defined as the sum of all non-performing assets and loans that are more than 90 days past due, divided by tangible capital and loan loss reserves. A ratio above 100% is considered a warning sign. It measures a worst-case scenario situation where we posit, if all of the loans in the numerator go bad, how much of the banks capital and reserves will be wiped out?

A team of analysts at RBC Dominion Securities coined the term Texas Ratio in the 1980s, while dealing with the high level of bank failures in Texas after the energy boom of the early 1980s became a bust. They determined that it was an accurate predictor of which banks would have financial problems. (For more on bank failures, read What Caused The Great Depression? and Emergency Banking Act Of 1933)

Problems With the Ratio
Although the Texas Ratio has been heralded by investors due to what some see as its predictive factor in determining bank failures, the ratio is an imperfect measure and makes several assumptions that are unrealistic:

1. There are no long-term studies on the predictive powers of this measure, and investors are gravitating towards using this measure due to anecdotal reports of its efficacy in the media.
   
   
2. The measure assumes that all the non-performing assets will stay non-performing and not be worked out with a new payment schedule. It makes a similar assumption that all loans past due 90 days will become non-performing assets.
   
   
3. That all the loans and assets in the numerator will be a total loss to the bank and there will be zero recovery when the bank sells the loans or other real estate owned (REO). This is not a valid assumption, as troubled assets rarely become a total loss to the institution. Wachovia (NYSE:WB) recently sold some of its troubled assets at 50 cents on the dollar to a private firm. According to The Wall Street Journal it is selling land and construction loans totaling $40 million to a LandCap Partners headed joint venture. This is one example that shows that not all of these loans can be considered a total loss.
   
   
4. That capital and reserves will stay constant. A bank typically adds to its loan loss reserves every quarter and can raise capital as well. When a bank increases reserves and capital, then the ratio will decline, if the denominator stays constant. The net income of the bank every quarter is also added to capital.

Don't Rule it out, But Don't Rely On It
Integrity Bancshares (OTC:ITYC) has a Texas Ratio of 371%, and IndyMac Bancorp (OTC:IDMC), which was taken over by the Federal Deposit Insurance Corporation (FDIC) had a Texas Ratio of 116%. More traditional measures to gauge the health of a bank are numerous and should be used in conjunction with the Texas Ratio. These include the allowance for loan and lease losses to non-performing assets, and the level of core deposits as a percent of all deposits. (For further reading, check out Analyzing A Bank's Financial Statements.)

Although investors have latched onto to the Texas Ratio as a predictor of the health of banks, the measure is imperfect and relies on assumptions that are not accurate in some cases. The ratio should be used in conjunction with other generally accepted measures.