Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Texas Ratio====== The Texas Ratio is a wonderfully simple yet powerful financial metric used to measure a bank's credit health and proximity to failure. Developed by the savvy bank analyst Gerard Cassidy during the Texas real estate and banking bust of the 1980s, this ratio provides a quick snapshot of a bank’s troubles. It compares a bank's "bad stuff"—its non-performing loans and foreclosed properties—to its "safety cushion"—the tangible capital and reserves it holds to absorb losses. Think of it as a financial stress test. If the pile of problem assets grows larger than the bank's ability to cover them, the bank is in hot water. For investors, especially those with a [[value investing]] mindset, the Texas Ratio is an indispensable first-glance tool to quickly weed out seemingly cheap banks that are actually teetering on the edge of a cliff. It's a classic case of "an ounce of prevention is worth a pound of cure." ===== How to Calculate the Texas Ratio ===== Calculating the ratio is straightforward, which is part of its charm. You don't need a PhD in finance, just a bank's balance sheet. The formula is: //(Non-Performing Assets + Real Estate Owned) / (Tangible Common Equity + Loan Loss Reserves)// Let's break down these ingredients: ==== The Numerator (The Problem Pile) ==== This part of the equation represents a bank's most troubled assets. * **[[Non-Performing Assets]] (NPAs):** These are primarily loans where the borrower has stopped making payments for a significant period (usually 90 days or more). They are the biggest headache for any bank. * **[[Real Estate Owned]] (REO):** This is property, such as homes or commercial buildings, that the bank has seized through foreclosure after the borrower defaulted. While it’s an asset, it’s one the bank is forced to own and would much rather sell, often at a loss. ==== The Denominator (The Safety Cushion) ==== This is the capital a bank has on hand to absorb losses from the problem pile. * **[[Tangible Common Equity]] (TCE):** This is the bank's core capital. It’s calculated by taking the bank's total equity and subtracting intangible assets like [[goodwill]] and preferred stock. TCE represents the real, physical capital available to cover losses before the bank becomes insolvent. * **[[Loan Loss Reserves]]:** This is a pool of money a bank specifically sets aside to cover expected losses from bad loans. It's an admission that, in the business of lending, not every loan will be paid back. ===== Interpreting the Magic Number ===== So you've done the math. What does the resulting percentage tell you? Gerard Cassidy’s research found a very strong correlation between a high Texas Ratio and subsequent bank failure. Here’s a general guide: * **Below 50%:** This is a sign of a healthy bank with strong risk controls. Its problem assets are small compared to its loss-absorbing capital. * **Approaching 100% (or 1.0):** //Red flag!// A ratio nearing this level suggests a bank’s safety cushion is almost entirely depleted by its bad loans. The risk of failure is significant, and regulators are likely watching closely. * **Above 100%:** //Danger zone!// When the ratio exceeds 100%, a bank's problem assets are greater than its entire tangible equity and loan loss reserves combined. Historically, a very high percentage of banks with a ratio over 100% have ultimately failed. ===== A Value Investor's Perspective ===== For the value investor, the Texas Ratio isn't just an academic exercise; it's a vital tool for risk management. Banking can be an opaque industry, but this ratio cuts through the noise. ==== Why It's a Great First Screen ==== Banks can often look cheap based on metrics like price-to-book value. However, a low valuation might be a "value trap" if the bank is hiding a mountain of bad debt. The Texas Ratio acts as a quick, brutal, and honest check on the quality of a bank's loan book. If the ratio is high and rising, it’s often best to walk away, no matter how cheap the stock seems. It helps you obey [[Warren Buffett]]'s first rule of investing: "Never lose money." ==== Limitations and Best Practices ==== While powerful, the Texas Ratio shouldn't be used in isolation. Keep these points in mind: - **It's a Snapshot:** The ratio reflects a single point in time. Smart investors look at the //trend// over several quarters. Is the ratio improving (declining) or getting worse (rising)? - **Context is Key:** During a severe recession, the industry average Texas Ratio will naturally rise. Compare a bank's ratio to its direct competitors to see if it's an industry-wide problem or a company-specific one. - **Use in Combination:** The Texas Ratio tells you about risk, but not about profitability or efficiency. You should always use it alongside other key banking metrics like [[Return on Equity (ROE)]], [[Net Interest Margin]], and the [[efficiency ratio]] to get a complete picture. Ultimately, a consistently low and stable Texas Ratio is a hallmark of a prudently managed bank—exactly the kind of boring, predictable, and profitable business a value investor loves to find.