When talking about a bank as exceptional as New York Community Bancorp (NYCB 0.49%), a high-yielding favorite among dividend investors, I'm hesitant to be critical because the people in charge of it are such fine bankers.
Nevertheless, here's the issue: During the last 12 months, its return on assets places the New York-based bank alongside some of the worst-run regional lenders in the country.
With this in mind, you'd be excused for wondering if New York Community Bancorp has lost its luster. Has the fact that it's been one of the best-performing bank stocks during the last two decades finally caught up with it? Or is something else at work here?
The answer to these questions exposes one of the few downsides to New York Community Bancorp's otherwise immaculate business model: Namely, because it generates a relatively small amount of noninterest income, both its top and bottom lines are particularly vulnerable to interest rate risk.
The chink in New York Community Bancorp's armor
To appreciate why this is the case, it's important to keep in mind that banks make money in two ways. First, through interest rate arbitrage; that is, they borrow money at low short-term interest rates, and then lend the same money back out at higher long-term rates.
Second, they charge fees for a variety of services. These generally include maintenance and overdraft fees on checking accounts, fees associated with the origination and sale of residential mortgages, and fees for the management of assets or the provision of fiduciary services.
The beauty of these separate revenue streams is that, taken together, they reduce the volatility of a bank's top line. For example, while lower interest rates generally weigh on a bank's net interest income, they have the opposite effect on mortgage origination fees, as lower rates translate into higher loan volumes.
This is why banks like U.S. Bancorp and Wells Fargo, indisputably two of the best-run lenders in the country, strive for a roughly even split between interest and noninterest income. During the first six months of this year, for instance, they generated 46% and 49% of their respective revenues from fees.
And herein lies the source of New York Community Bancorp's lackluster profitability. So far this year, it's generated only 13.4% of its revenue from fee-based sources. That compares to an average among its peers of 42.4%. Consequently, the historically low-interest-rate environment is weighing on its top-line figure almost as much as it's depressing the bank's net interest income.
The flipside of New York Community Bancorp's business model
Just to be clear, New York Community Bancorp's anemic noninterest income is a byproduct of an otherwise superb business model.
Most banks make most of their noninterest income from retail customers -- that is, people like you and me with checking accounts, credit cards, and mortgages. New York Community Bancorp, on the other hand, has traditionally served a much smaller niche -- namely, the owners of large rent-controlled multifamily buildings in New York City.
There are two upsides to this model. In the first case, it's efficient from a cost perspective. This follows from the fact that New York Community Bancorp doesn't have to shoulder the overhead of a sprawling (and expensive) branch network to service retail customers. Moreover, because it focuses on fewer, but bigger, loans, there are economies of scale innately built into its operations.
The advantage this bestows can be seen in the efficiency ratio, which measures the percent of a bank's net revenue consumed by operating expenses. In the second quarter of this year, New York Community Bancorp's efficiency ratio was 43.4%. That's a full 10 percentage points better than the runner-up, the notoriously efficient U.S. Bancorp.
In the second case, by specializing in multifamily buildings containing rent-controlled units, New York Community Bancorp has markedly reduced the credit risk posed by its loan portfolio. This is because there's always a demand in New York City for below-market rental units. Thus, the owners of these buildings have a more reliable cash flow and, in turn, a greater ability to service their debts even in the worst of times.
New York Community Bancorp's chief executive officer Joseph Ficalora made this point at an industry conference last year -- click here for the full transcript:
[W]e consider ourselves a niche lender. We lend to a particular kind of owner, on a particular kind of product, at a particular structure that has a very conscious awareness of the actual value of the prescribed cash flow.
So the cash flows in our buildings do not typically go down during the cycle terms. The cash flows in our buildings actually continue to go up even when there are great vacancies in the market place and unemployment is extremely high in the New York market and so on. We in fact see our buildings actually increasing in value because their rent rolls actually increase.
The net result is that New York Community Bancorp has been able to avoid the egregious credit losses that most of its competitors suffered in previous market downturns. For instance, at the peak of the financial crisis, the average multibillion-dollar bank charged off 3% of its loan portfolio due to defaults. Meanwhile, New York Community Bancorp's net charge-off ratio topped out at only 0.34%.
The trappings of a great bank stock
As I've discussed on multiple occasions in the past, the significance of these upsides can't be overstated, as a low efficiency ratio and prudent risk management are necessary pillars of any successful bank. They, accordingly, go a long way toward explaining why New York Community Bancorp has been one of the best-performing bank stocks since going public in 1993.
But the downside is that, in times like the present, when short-term interest rates remain stubbornly low, New York Community Bancorp simply isn't going to be as profitable as many of its peers.
At the end of the day, however, what's important to keep in mind is that high-performing banks cut their teeth through multiple cycles. It would be a mistake, in other words, for either current or prospective shareholders to read too much into the fact that New York Community Bancorp's return on assets is currently trailing many of its peers. That will change. And when it does, you can rest assured that shareholders will be adequately compensated for their patience.
