The Inoculated Investor http://inoculatedinvestor.blogspot.com/

Playing the Devil’s Advocate

A Report on Synovus Financial (SNV- $1.92): 12/18/09Updated 3/22/10: (SNV-$3.56)

Usually the act playing the devil’s advocate involves taking a contrarian position. So, in the case of a stock that istrading at about $4, down from over $30 in 2007, presenting a pessimistic outlook for the stock might not seem particularly bold or unique. However, this analysis was a response to a piece written by Tom Brown from bankstocks.com recently about Synovus Financial (SNV) that argued pretty persuasively that the bank was undervalued at the current price, based on some reasonable assumptions about future earnings. Brown also contendsthat the bank likely has sufficient capital to survive the credit cycle without diluting shareholder further by issuingshares. While I do not necessarily disagree with his overall thesis that SNV has the potential to be one of thesurvivors, based on my analysis of the bank’s capital position and credit trends I do not agree with Brown’sassessment of SNV’s near term prospects. Specifically, the data I have analyzed continues to highlight sometroubling developments in the bank’s loan book that could eventually force the company to raise new capital andcould impair earnings for many quarters to come. Clearly, being an investor with a long time horizon, short termissues should not influence my opinion of the stock as long as I believe the company will make it through alive.Therefore, let me start off by addressing each one of Brown’s arguments and then close with what I think it allmeans for the long term.

Point 1: “The worst-performing loan portfolios have begun to shrink

. In any major credit cycle,different loan categories will have vastly different default frequencies and loss severity. For Synovus, theworst portfolios, both in frequency and severity, have been (by product type) loans to homebuilders and (bygeography) loans in the Atlanta metro area and in Florida.”Brown is spot on when he points out that the residential construction book, especially in Atlanta and in Florida, has been SNV’s worst performing portfolio. As of the end of Q4 2009, $543.8M of this $2,076.6M book was classifiedas nonperforming. If an NPL ratio close to 26.2% (up from 23.7% in Q3) sounds high that is because such a ratewould have been unfathomable just 3 or 4 years ago. Fortunately for SNV, the size of the 1-4 family constructionand development portfolio and its potential impact on earnings has begun to shrink. Specifically, this portion of the book was down to $2,076.6M (8.2% of the total book) in Q4 2009 from $2,963.6 (10.7% of the total book) in Q2.Also, given how early the southeast portion of the US began to experience the housing bust, it is likely that many of these construction loans have experienced the bulk of the writedowns they will cumulatively see. However, in myview, problems with construction loans represent only the first wave of writedowns and losses for SNV and theother regional banks. The second wave, which consists of prime mortgage defaults, commercial real estatewritedowns and losses on C&I loans, is just starting to play out. In particular, when combined with the lack of consumer credit and substantial unemployment, the negative derivative impacts of the housing crisis are reallystarting to impact other types of businesses and loans. Take a look at the following chart and you can see what Imean:

Q1 2009Q2 2009Q3 2009Q4 2009

Net Charge Offs:

$246.0$355.0$497.0$362.1

Non-Accrual:

1-4 Family Construction$231.8$209.8$166.6$147.3Other Construction & Land419.3548.5606.9599.2Total Construction/Land$651$758.4$773.6$746.5Farmland3.82.82.02.91-4 Family Mortgage131175.7192.6206.9Multifamily13.517.612.722.9 Nonfarm/Non-Resi Mortgage258.3275.3397.4420.7

Non-Accrual Tied to Real Estate

$1,057.6$1,229.8$1,378.3$1,399.9Total Non Accrual$1,214.7$1,378.8$1,469.8$1,496.0

Source: FDIC.gov

The Inoculated Investor http://inoculatedinvestor.blogspot.com/

I compiled the above data from the FDIC’s website and it only includes loans classified as non-accrual (totalnonperforming assets also includes other real estate owned and loans 90+ days past due and still accruing interest).Recently, the bank has begun to dispose of some underperforming loans. In fact, in 2009 SNV sold $1.18B in problem assets, the majority of which ($755.9M) were residential real estate loans and OREO properties. Thecompany also plans to sell around $600M more of these loans in Q1 and Q2 2010. These sales may be skewing thedata a bit, but I believe the trend is clear. We can see increasing net charge offs (to be addressed more later on) andincreasing non-accrual loans in the following portfolios: 1-4 family residential mortgage and nonfarm/non-residential mortgage (commonly known as commercial real estate mortgages). I think this data definitelycorroborates what Brown is arguing in point number one. Non-accrual loans in the 1-4 family construction book were down to $147.3M in Q4 2009 from $231.8M in Q1 2009. But look at the close to 50% increase during thesame period in non-accrual loans having to do with other construction and land. Also look at the dramatic increasein 1-4 family mortgage delinquencies and in commercial real estate non-accruals. This represents the second waveof delinquencies that I believe are going to keep credit losses elevated, require SNV to continue to build its reserve,and ultimately require additional capital.

Point 2: “The inflow of new nonaccrual loans will continue to slow.”

Since the company sold so many loans in 2009, it is important to dig into the number of new troubled loans asopposed to assessing the credit situation solely based on the nominal value of non-accrual loans. While I amconcerned that the reversal of the influx of new troubled loans (with varying severities) may be short-lived, the newsfrom Q4 2009 was moderately encouraging. Specifically, the total inflow of new non-accruals in Q4 2009 was$661M, down from $756M in Q3. Also, new 90 day past due loans were down to $19.9M in Q4 from $43.8M in Q3and new 30-89 day past due loans fell to $242M from $312.1 in Q3. There is no question that these are positivetrends and absent a significant double dip recession or large drops in the value of commercial real estate assets, SNVmay have seen the peak in new troubled assets.Having said that, I am having trouble assessing the impact of a particular change, but it looks as though SNV mayhave moved the goal posts a bit in terms of classifying NPLs. From the Q3-2009 10-Q:“During the third quarter of 2009, Synovus revised its definition of nonperforming loans to excludeaccruing restructured loans. Such loans are not considered to be nonperforming because they are performing in accordance with the restructured terms. Management believes that this change better alignsour definition of nonperforming loans and nonperforming assets with the definition used by our peers andtherefore improves the comparability of this measure across the industry. All prior periods presented have been reclassified to conform to the new presentation… Accruing restructured loans were approximately$193 million at September 30, 2009, compared to $18 million at June 30, 2009. At September 30, 2009, theallowance for loan losses allocated to these accruing restructured loans was approximately $29.7 million.”Then, from the more recent 10K:“Synovus designates loan modifications as troubled debt restructurings (TDRs) when, for economic or legal reasons related to the borrower’s financial difficulties, it grants a concession to the borrower that itwould not otherwise consider. Loans on nonaccrual status at the date of modification are initially classifiedas nonaccrual TDRs. Loans on accruing status at the date of modification are initially classified as accruingTDRs at the date of modification, if the note is reasonably assured of repayment and performance inaccordance with its modified terms…At December 31, 2009, total TDRs were $588.8 million of which$213.6 million were accruing restructured loans.” Now, the company does not give a lot of additional info on these restructured loans, but from what thenational dataon housing-related re-defaultstell us (up to a 70% rate when modifications only include interest rate changes), thesemay be some of the riskiest loans in the portfolio. If all $213.6M of these loans were classified as NPLs then total NPLs would increase by 11.7% and the company’s allowance to NPL ratio would look even more insufficient.

Point 3: “The level of net charge-offs should start to decline.”

The first reason that Brown stated for a potential decline in NCOs was that he believed that new non-accruals would be down quarter on quarter. Brown was definitely right on this. In fact, NCOs declined from $497M in Q3 to$362.1M in Q4. Based on SNV’s policy to immediately write down new non-accrual loans, since new non-accruals

The Inoculated Investor http://inoculatedinvestor.blogspot.com/

were down, so too were NCOs. In addition, the company looks to be taking a very conservative stance when itcomes to writing down loans on non-accrual status. When you combine cumulative writedowns and specificreserves associated with each loan, SNV has allowed for a 42.4% cushion that should be enough to limit significantfurther writedowns in existing NPLs. Accordingly, the combination of having taken large write downs on NPLs and NCOs decreasing means that total credit costs should continue to fall in the coming quarters. This trend is alsoevident when it comes to other real estate owned costs. In Q4 the OREO expense was only $34.1M, far below the$172.4M figure in Q2 2009.As mentioned above, counteracting these positive developments, the company plans to complete its sale of up to$600M in problem assets (including other real estate owned) by the end of Q2 2010, a strategy that may cause SNVto recognize losses before it would have if it had held onto the loans. Since SNV may be unable to sell its mostdistressed assets, the assets sold in 2009 may have been somewhat cherry picked and the associated writedowns maynot accurately represent the overall losses embedded in the portfolio. In any case, under the assumption that SNV iseventually going to have write off existing dodgy assets whether it sells them or not, a temporary postponement of NCOs in a single quarter should not influence the overall analysis of the company’s long term value.

Point 4: “The level of OREO writedowns should also start to decline.

Synovus had $606 million of creditexpenses in the third quarter, including an unusually high $101 million in OREO expenses. OREO writedownsshould decline for three reasons. First, new nonaccrual loans moving into OREO have been written down tolower values than in prior periods. Second, the company will be less aggressive in OREO disposition. Finally,loss content of future OREO dispositions will be lower than in the past because properties being disposed of now tend to include more income-producing properties and less land than they did before.”Again, Brown was very prescient when it came to OREO expenses. But, as pointed out above, if the company isgoing to eventually have to write down OREO to the lower of cost or fair value, the timing of the writedowns is not particularly important to someone who wants to buy and hold the stock. Plus, I am concerned that the number of foreclosures stemming from commercial real estate loans and 1-4 family mortgage defaults are going to keep OREOcosts elevated and negatively impact earnings.

Point 5: “Loan loss reserve building has slowed and will soon stop; reserves will begin to be drawn downnext year.”

“Not only do we expect this to continue but, next year, as more loans are upgraded, we believe thecompany will begin to bring its loan loss reserve (3.5% of total loans) down by provisioning less than itsquarterly level of net chargeoffs.”This is where I think I disagreed with Brown the most. The idea that SNV did not have to continue to build itsreserve seemed unfounded. Going back to the chart on the first page of this analysis that shows the persistentincrease in the total value of non-accrual loans, I could not see a justification for SNV solely matching its Q3 provision to net charge offs. Fortunately, in Q4 2009 the company did have a provision larger than its NCOs