Another One Bites the Dust: Heartland Tri-State Bank
On Friday July 28, the FDIC closed Elkhart, KS based Heartland Tri-State Bank in what was the first failure since First Republic Bank closed shop a few months back. So far, little has been released about the reasons for the failure, aside from a cryptic reference to an “isolated event”. Heartland had $140M of total assets as of its March 31, 2023 call report — yet the estimated loss to the Deposit Insurance Fund (DIF) is $54.2M. Was this failure a continuation of the March crisis, or something else entirely?
If the failure was a continuation of the March crisis, we would expect to see a combination of losses on securities and a run on deposits. Deposit runs force the realization of unrealized losses when a bank is forced to sell securities to fund withdraws. Is that what happened here?
Deposit Run?
The bank runs during March were caused by large, uninsured balances of venture capital and other high net worth clients. Heartland is a small community bank with little to no exposure to these depositor types. It could, however, have a large amount of uninsured deposits or a highly concentrated deposit base. Let’s have a look to see of this is the case:
Heartland had $54M of deposit accounts with a balance exceeding $250K (out of $130M total). Not all of these amounts are uninsured — there are 77 accounts in this segment, meaning at least 77 * $250K = $19.25M of the $54M are insured balances.
What about concentration? Maybe Heartland had one or two “whale” clients with huge balances that withdrew, hobbling the institution. Even if there was a single depositor who held the entirety of the uninsured portion ($54M — $19.25M = $34.75M), and that client withdrew fully, Heartland had the liquidity to meet those withdraws in its securities portfolio.
Maybe Heartland was heavily underwater on its investments. Deposit runs force a bank to realize unrealized losses, like we saw with FRC and SVB earlier this year. This can result in a bank that was adequately capitalized the day prior to become insolvent overnight.
Securities Losses?
Heartland had a substantial amount of securities — $55.6M AFS (over 1/3 of total assets — its loan book is only $48.2M). Most of these securities are agency MBS and municipal bonds. These bonds have negligible credit risk, but they do have interest rate risk as we saw during March. Maybe they purchased a bunch of low yielding 2% — 3% bonds in 2020 which are now trading at a steep discount?
Column D shows that losses on these securities are modest. Fair value of $55.6M vs. $62.2 cost results in a loss of $6.6M. Even if a deposit run forced the sale of the entire securities book, $6.6M is the most Heartland would stand to lose.
And if that did happen — Heartland had the capital to absorb it. Its CET1 capital stood at $12.8M on March 31. Adjusting CET1 to reflect the losses on the AFS portfolio would reduce Heartland’s CET1 ratio from 17.7% to 10.6% — still will capitalized.
Loan Losses?
The entire loan book is $48.2M net of $1M loan loss reserves. Unless Heartland’s credit team is stupendously bad at analyzing credit risk, it’s difficult to imagine that credit losses would have caused the bank’s failure.
As shown in the previous section, Heartland had $12.8M of capital to absorb losses, plus the $1M of reserves. Roughly 28% of its loan book would have to be bad in order to chew through that cushion.
What Gives?
All of the numbers we are working off of here are from the March 31 call report. A liquidity crisis occurs over days (or even hours) — and a lot can happen in 4 months. That said, deposits have largely stabilized for the banking sector since March, making the case for a run less likely:
interest rates have increased with an additional fed hike, but not enough to materially increase losses on the AFS portfolio:
Granted, we don’t know the exact duration of the securities Heartland holds, but the call report provides an indication that most of them are between 5–15 years, so the 10 year seems like a good proxy.
So why did Heartland fail? If there was no deposit run, and no large losses on its securities or loan books, how can there be an estimated loss of $54.2M to the DIF on a balance sheet of only $140M? My completely unsubstantiated guess is fraud. Unless there was a perfect storm of deposit run, loan losses far exceeding estimates, and a fire sale of investment securities, it’s difficult to imagine how Heartland would have failed if everything was above board.