The Silver Lining on Zions' Big Charge

Zions Bancorp. (ZION) swallowed some harsh medicine last quarter in an effort to put the financial crisis behind it.

The Salt Lake City company's $83.8 million charge related to its collateralized debt obligation securities was a step in the right direction, an analyst said.

"The CDO portfolio has caused a lot of confusion," says Paul Miller, an analyst with FBR Capital Markets. "It's starting to weigh less and less on the company. We think they've taken most of the charges on that and may even see some recoveries in the future."

There were good signs in the quarter, including lending that beat expectations and improvements in credit quality.

However, the large impairment charge created a big distraction. Zions took it because more banking companies are expected to default on trust-preferred securities that it holds, executives told analysts after the market closed Monday.

Zions, which has $54.3 billion of assets, owns a portfolio of trust-preferred CDOs issued by roughly 800 bank holding companies. These companies can defer interest payments, either because management decides to or because regulators require it, for up to five years without default.

Well-capitalized, profitable banking companies are usually able to make their payments. About two-thirds of the deferring banks within Zions's portfolio are well capitalized and profitable, Doyle Arnold, the vice chairman and chief financial officer, said.

However, some of the small banking companies are beginning to use a form of bankruptcy that could "render invalid the assumption that a well-capitalized bank has a low probability of default," Arnold said.

Some bank units are in "decent shape" but can't transfer cash to their holding companies because of regulatory constraints, Arnold said. Holding companies in those cases may be unable to make their trust-preferred payments before the end of the five-year deferral period, he said.

Because of this, Zions recognized "that some of the default probabilities on our banks really may be different from the default probabilities of the parent bank holding companies that issued the trust preferred," Arnold said.

Since the trust-preferreds are typically the only security issued by these smaller bank holding companies, Zions generally ranks "at or near the highest in the liquidation preference, which means we're still entitled to share in the proceeds of a bankruptcy sale," Arnold said.

Yet Zions could still take a loss as the assets of the bank may not be sufficient to cover the cost of the trust preferreds. Zions intends to be "extremely active" in pursuing its interest in these cases, and so far it has pursed a "small" number of cases, Arnold said. He added that the company has been generally successful in recovering its investment.

Zions increased the probabilities of default and expected loss on a "number of them," which led to the majority of the other-than-temporary impairment this quarter, Arnold said. Zions could recognize additional charges in the future.

The remainder of the charge came from higher prepayment assumptions. During the fourth quarter Zions experienced a "significant increase" in prepayments by healthier institutions and expects this to continue for several years as new bank regulations regarding the capital treatment of trust-preferreds are phased in, Arnold said. It increased its assumption rate from 3% to 10%.

The impairment charge was partially offset by $10.2 million in CDO securities gains, but the charge still eliminated 25 cents per share in earnings. Its fourth-quarter earnings per share of 19 cents fell short of analyst expectations polled by Bloomberg by 16 cents.

Overall, the company's core operations were in line with expectations, Miller says. Zions reported profits of $35.6 million, down almost 20% from a year earlier and 43% from the third quarter.

Zions was helped by improving credit quality. Its annualized ratio of net loan and lease chargeoffs to average loans fell 82 basis points, to 0.2%, from a year earlier, making it comparable with levels in 2007.

"An 8% national unemployment rate and 2% GDP growth isn't what any of us would call a robust environment, but our credit quality metrics are rapidly returning to levels last seen when the economy was in much stronger shape than it is today," Harris Simmons, the chairman and chief executive, said during the call with analysts.

Simmons partially attributed the improvement to better risk management and credit risk reduction efforts during the last few years and to the ability of some customers to repair their personal and business balance sheets.

Miller was "pleasantly surprised" with Zions' loan results. Zions had warned in November at an investor conference that loan balances had declined more than $150 million from the end of the third quarter. However, many borrowers took out loans in December in anticipation of rising tax rates in 2013. Total loans rose about 1%, to $37.7 billion, from a year earlier.

Zions also announced Monday that it would issue $200 million of preferred stock. This stock along with additional preferred stock that is likely to be issued in the first half of 2013 will help pay off a different series of stock that is callable in the third quarter. This is the right move for Zions as it continues to replace more expensive debt with debt at lower rates, Miller says.

"I think 2013 will be more of the same for Zions," Miller says. "It will highly depend on interest rates and what the economy does. In my outlook, the economy will remain somewhat soft, and Zions will slog through it like any other bank."

Zions' shares were trading at $22.65 on Tuesday afternoon, down about 1% from Monday's closing.