One of the preeminent secrets to successful investing is to avoid major losses. When analyzing and investing in bank equities, that lesson takes on special significance. Because banks typically employ tremendous leverage, even relatively modest mistakes in lending can wreak havoc on the shareholders' equity and the value of the bank's stock. This article will discuss a financial ratio that is becoming increasingly common in the analysis and discussion of bank equities - the Texas ratio. (For background reading, see Analyzing A Bank's Financial Statements.)

Tutorial: Investing For Safety And Income

Background Information
The Texas ratio is a measure that Gerard Cassidy and others at RBC Capital developed while trying to analyze bank stocks during the spate of failures that hit the Texas banking industry back in the 1980s. While it appeared to work well in that period, it also went on to show its ability to predict banks at risk of failure in New England during the 1990s.

The classic version of the Texas ratio requires the investor to divide the bank's total non-performing assets (NPAs), including loans more than 90 days delinquent, by the sum of the company's tangible equity capital and loan loss reserves. If the number is at or above 1 (or 100%), that bank is at severe risk of failure.

Investors need to remember that most banks only report NPAs that are 90 days or more past due, but the ratio calls for including all NPAs. To find the missing NPAs (those past due for 30 - 89 days), go to the website and search for the bank's Uniform Bank Performance Report.

Does the Texas Ratio Make Sense?
Calculating a ratio is only part of the story. It is also important to look under the hood, so to speak, and make sure that the ratio is actually conveying important and relevant information. To that end, there are solid reasons as to why the Texas ratio can indicate which banks are experiencing real trouble.

Banks realize that some fraction of the loans they make are going to go into default. That is why the companies are required to establish loan loss reserves on their balance sheets and count them as an expense. If the actual level of bad loans exceeds the bank's estimate, the difference is charged off against the shareholders' equity line on the balance sheet.

This is where the problems really begin. Banks operate on relatively thin levels of equity and the regulators pay careful attention to how well capitalized the banks are. If a company has a very large number of loans (relative to equity) that are likely to be written off, the bank is effectively the "walking dead" and must either raise capital quickly or face the prospect of being shut down. We saw this play out during the banking troubles in 2008, as both IndyMac and Integrity Bancshares had Texas ratios of more than 100% and then failed shortly thereafter.

Are There Drawbacks to the Texas ratio?
No ratio is perfect, and the Texas ratio is no exception. For openers, the Texas ratio does not account for the potential value of collateral. If a borrower defaults on a loan and the bank seizes collateral worth 90% of the loan amount, the ultimate loss to the shareholders is much different than if the bank could recover only 10% of the loan amount.

Of course, there is a significant counter-argument here. During the housing bubble of 2005-2007, many banks made loans with exceptionally high loan-to-value ratios (LTV Ratio) and based those loans on what proved to be very richly valued real estate. What's more, waves of foreclosures tend to depress the recovery rates for all banks, and loan loss reserves are already supposed to incorporate an element of recovery into the estimates.

In addition, Texas ratio does not account for potentially overvalued assets on the balance sheet. Bank executives must mark to market the value of any assets that are classified as "held for sale", but assets deemed "held to maturity" can be carried at cost on the balance sheet without that quarterly adjustment. So even though the value of a mortgage-backed bond may have declined sharply, the bank could still have that bond on its balance sheet at its original cost, so long as management categorized it as "held to maturity". This loophole can be exploited to effectively shield bad assets and make the bank look stronger than it really is. (For more insight on mark to market, read Mark-To-Market: Tool Or Trouble?)

What Should Investors Do With the Texas ratio?
The best use of the ratio is as a warning of potential trouble at a bank. While a ratio of 100% or more (or something close to 100%) is a clear enough warning in its own right, investors should track the change in both the direction and magnitude in this ratio over time.

Along with watching the ratio, investors should be on the lookout for other evidence that can correlate with the Texas ratio. For instance, keep track of the progression of bad debt at a bank - is the level of non-performing loans rising? It is also important to examine the nature of the bank's business. Is it concentrated in a particular geographic area? Is it a well-diversified lender, or does it focus all of its lending on one area, such as condo development or subprime?

It is important to keep a sense of scale when looking at changes in the Texas ratio. A move from 10% to 30% is not nearly as serious as a move from 80% to 100%. While the former may be a cause for further investigation, the latter may be telegraphing an imminent failure.

A Ratio Is Only a Ratio
As with any ratio, the Texas ratio is a valuable tool when used in the right situation, but little more than a blunt object when used incorrectly. It is critically important to remember that ratios do not make anything happen; they're speedometers, not engines. Various price-earnings ratios (P/E ratios) and returns on invested capital don't make stocks outperform, they simply help guide investors toward companies with certain shared characteristics that have outperformed in the past. Likewise, a Texas ratio will not make a bank fail; it simply highlights those banks that are at greater risk of failure.

The Texas ratio is but one ratio that investors should use when analyzing bank stocks, although it is a ratio that can give you powerful feedback on whether a bank is in serious trouble. Investors should always conduct robust and thorough due diligence (DD), using as many tools as possible to form a more complete picture of a prospective investment.

For further reading see, Bank Failure: Will Your Assets Be Protected?

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.