Market Overview

In Puerto Rico, Maximum Pessimism Nears

In Puerto Rico, Maximum Pessimism Nears

On Friday morning, investors in Puerto Rico woke up to another huge negative surprise when Doral Financial (NYSE: DRL) announced that they would be revising their capital plan. The bank was informed that it may no longer include some or all of the tax receivables from the Government of Puerto Rico in its calculation of its Tier 1 Capital.

Puerto Rico tax receivables accounted for $289 million of the bank's approximately $679 million Tier 1 Capital as of December 31, 2013, so they have a significant problem. It's likely they will need to raise capital. The FDIC's determination will cause Doral Bank to no longer be in compliance with its capital requirements under its Consent Order with the FDIC; because of that they will no longer be able to accept or roll over brokered deposits, which means they could lose about 18 percent of their deposit base.

They now need to come up with new capital or submit a plan of liquidation to the FDIC.

Investors should stay away from the bank until we see a capital plan put in place -- any capital plan is going to dilute existing shareholders to a very large degree. They're probably going to have to do what other Puerto Rican banks have had to do: look to large private equity and hedge funds to invest capital in exchange for a significant portion of the bank. Once the plan is announced, there will be plenty of time for investors to buy the stock, anticipating an eventual rebound and recovery in Puerto Rico.

Related: Successful Investors Read, And Read A Lot

While investors may not want to buy into the Doral debacle until the capital plan is revised, they may want to keep an eye out for the weakness to spill over into the other Puerto Rican banks. The financial difficulties of the island have pushed Puerto Rico close to the state of maximum pessimism that usually signifies buying opportunity.

Count billionaire fund manager John Paulson as one who thinks the territory will turn around and experience a brighter future than many think. Speaking at the 2014 Puerto Rico Investment conference, Paulson said, “I see the future of San Juan as the most vibrant financial center in the southern U.S. or in the northern part of South America. I think we are at the beginning of a turnaround in the economy of Puerto Rico.”

Paulson is planning to invest $1 billion in the area over the next two years.

Investors can get in on a future recovery by using any weakness to snap up other banks in Puerto Rico.

Popular (NASDAQ: BPOP) is one of the largest banks in the region and the stock is still trading at just 70 percent of book value. The bank had been expanding in the mainland U.S., but recently announced a change in its approach.

Popular is exiting several markets to focus mainland community bank operation on New York and South Florida markets. It's divesting regional operations in California, Illinois and Central Florida. The bank is also going to streamline back office operations and relocate centralized functions to Puerto Rico, New York and South Florida. The bank should prosper in a recovery in Puerto Rico and see its stock price move substantially higher over time.

First Bank (NYSE: FBP) was already recapitalized with hedge funds, including Thomas Lee and Oaktree taking significant stakes in the bank, in return for a capital infusion. They both own a little over 20 percent of the bank. The bank is still working to clean up its balance sheet and nonperforming assets are still at a relatively high 5.7 percent of total assets, but the performance of the core banking operations has improved over the past two years.

If the real estate markets and local economy are nearing a trough, the stock has enormous upside potential. Puerto Rico is a fiscal mess right now and the short-term future could be a little rough for investors. However, some very smart people are betting that the worst is behind them and if that's the case, there is an enormous amount of money to be made in Puerto Rican banks.

Tags: John Paulson Puerto Rican banks Puerto Rico

Posted in: Long Ideas Education Trading Ideas General Best of Benzinga