A previous article described a stunning decrease in Bank of the Sierra’s (NASDAQ:BSRR) non-performing loan percentage, an important measure of risky loans. This metric showed that Bank of the Sierra’s loan balance sheet improved, but didn’t point out the specific reasons.

BSRR has reduced their risk greatly over the past five years because of factors under their control and good luck. Changes in loan mix, local economy improvement, and geographical diversification have all helped them become a safer bank investment.

Loan types

Bank of the Sierra’s management chalked the improvement up to “loan growth … in portfolio segments with low historical loss rates” (2015 10-K). That appears to be true. To show you the improvement, I’ve prepared a chart comparing the worst period for non-performing loans (Q3 2009) and the most recent quarter (Q3 2016). They just happen to both be from the third quarter of the year, which helps us avoid any seasonal variation in loan performance.

(Loan mix table)

Here a “non-accrual loan” is one where the borrower is not paying, so the loan does not add to the bank’s income anymore. The “loan mix” percentage is just the part of the total amount of loans that the category represents.

BSRR has decreased the loans it approves in some areas that had high non-accrual rates during the Recession (Q3 2009). “Other Construction/Land” and “Small Business Administration Loans” had some of the highest non-accrual rates and their part of the loan mix dropped substantially. “Non-owner occupied commercial real estate” and “farmland” were doing well, so BSRR increased the loans they approved in those categories.

Also notice the addition of “mortgage warehouse lines”. These are short-term lines of credit extended to mortgage bankers while they are selling their mortgages to the final investor. Essentially a borrower gets approved for a loan, then the mortgage originator looks to sell the loan to a larger investor. When the borrower's loan is sold, the mortgage banker pays back the line of credit. This process takes around a month from start to finish.

The short duration of the “mortgage warehouse line” lowers the risk of BSRR’s loan portfolio. No non-performing loans are reported in this part of the portfolio because they are paid off so quickly.

Additionally, they are usually only approved if a mortgage is close to completion. This adds an extra layer of due diligence which lowers risk further.

Oil and agricultural risks, geography

Being a regional bank means risks to the local economy affect Bank of the Sierra's earnings more than larger national issues do. BSRR is located in California's Central Valley, which provides a wide range of agricultural products to the world. Low crop prices and consistently elevated unemployment (compared to San Francisco and LA) are the largest risks to bank profitability in the area. As I mentioned in a previous article on BSRR, Kern County is also home to three quarters of California's crude oil production. Thus lower oil prices in the past few years have also put pressure on the regional economy.

Luckily for Bank of the Sierra, these risks have all been shrinking over the past year. Area unemployment is down since the Great Recession, as you can see in the following graph:

(Graph of Tulare, Kern, Kings, Fresno, and Madera county unemployment)

Additionally, oil prices have been trending up. OPEC has kept output up and prices low for a few years to compete with new US shale oil production. There is talk recently of a cutback in production, which would help all oil producing regions, including those in the California Central Valley. These fortunate developments have been providing a further boost to Bank of the Sierra’s balance sheet, reducing the risk of future loan defaults.

Risk reducing acquisitions

To avoid these regional issues, BSRR has been broadening its geographic footprint. In 2014 they acquired Santa Clara Valley Bank, broadening their reach south into neighboring Los Angeles County. In 2016 they expanded west by acquiring Coast National Bank in San Luis Obispo County.

Both of these counties have lower unemployment rates than BSRR’s traditional territory. This is because they have different economies that have not been as affected by crop and oil prices as those in the Central Valley.

(Comparison Graph of unemployment in LA and SLO counties)

This geographic diversification will help Bank of the Sierra’s non-performing loan rate remain low, and may provide a needed boost to interest income. Regional bank investors should watch Q4 2016 and Q1 2017 for any performance boost from this year’s acquisition of Coast National Bank. If this occurs, look for BSRR to move higher eventually.