Merchants Bancorp (MBINN)

Merchants Bancorp (ticker MBINN on NASDAQ) is a financial services company. It owns banks. It also owns finance companies that are not banks. These subsidiaries lend money, take deposits, and charge fees. The company makes money from the interest difference between what it pays for deposits and what it earns on loans. It also makes money from fees.

What the bank subsidiaries do

Merchants Bancorp owns one or more banks. These banks take deposits from customers. Customers put their money in savings accounts and checking accounts. The bank pays them a small amount of interest. The bank then lends that money out to other customers — people and businesses. The bank charges those borrowers interest. The difference between what the bank pays on deposits and what it charges on loans is where the profit comes from.

Banks are very regulated. Regulators tell them how much money they have to keep on hand. This is called capital. The idea is simple: if the bank makes bad loans and loses money, the capital cushion absorbs the loss so the bank does not fail. If a bank does not have enough capital, regulators will force it to stop lending or to raise new money.

The non-bank finance companies

Merchants Bancorp also owns companies that are not banks. These companies lend money too. They might specialise in car loans. Or personal loans. Or mortgages. Or credit cards. These non-bank finance companies work differently from banks. They do not take deposits. Instead, they borrow money from other sources or issue securities to fund themselves. They lend that money out and keep the interest spread as profit.

Non-bank finance companies can be more aggressive with their lending than banks. Banks are slow and careful because they are regulated heavily. Non-bank companies have more freedom. But that freedom comes with a cost: they have to borrow money at higher rates, which cuts into their profit.

How much can the company borrow?

Merchants Bancorp borrows money to fund its operations. It can only borrow a certain amount relative to how much capital it has. This is called a leverage ratio. Regulators set the maximum leverage ratios. The goal is to make sure that if things go badly, the company does not fail and damage the whole financial system.

In normal times, this limit does not matter much. The company can borrow as much as it needs. But in bad times — when the economy is in trouble and loans are failing — regulators might tighten these limits. The company then has to borrow less or raise new money from shareholders. This is painful, because raising new money from shareholders when the stock is down is very expensive.

Credit quality: the main thing to watch

The biggest risk that Merchants Bancorp faces is that its customers will not repay their loans. If people lose jobs or businesses fail, they stop paying. The loans go bad. The company has to write off the lost money. If too many loans go bad at the same time, profits disappear and the company has to raise new capital at a bad time.

The best predictor of credit quality is the economy. When unemployment is low and business is good, very few loans go bad. When unemployment is high and business is weak, loan losses spike. Merchants Bancorp is therefore very exposed to what the economy does. It is a business that thrives when times are good and suffers badly when times are hard.

Studying this company’s health

If you want to understand Merchants Bancorp, look at three things. First, how many loans are failing? The company reports this in its financial statements as the “nonaccrual ratio” — the percentage of loans that are past due. If this ratio is rising, the company is in trouble. Second, how much is the company earning compared to how much it is paying out as dividends? If it pays out more than it earns, it is using its own capital, which is not sustainable. Third, is the company growing? If it is not making more loans and not entering new businesses, profits will flatten.

The annual report, filed with the SEC under the company’s CIK number 0001629019, gives you all the numbers. Read the section on credit losses. Read the section on each business segment — which ones are growing, which ones are shrinking? Listen to the quarterly earnings call where management discusses the business. Are they confident or nervous? Do they sound like they expect credit to deteriorate or improve?

The simplest measure: in a good environment, is Merchants Bancorp earning more money? In a bad environment, is it losing less money than competitors? If the answer is yes to both, the company is well-run. If not, something is wrong.