The tax-refund loan business has caused Pacific Capital Bancorp considerable headaches of late, but mindful of the unit’s hefty contributions to earnings in prior periods, the Santa Barbara, Calif., company seems reluctant to part with it.
The $7.4 billion-asset Pacific Capital announced after the markets closed Monday that it would record a $22.4 million provision for the third quarter to cover losses from refund-anticipation loans, or RALs. Its shares plunged 17.7% Tuesday on the news, and it is expected to report a thin profit when it releases earnings today.
While risky, the RAL business has historically accounted for one-fourth to one-half of the company’s earnings. Chief executive officer George Leis said during a Monday conference call that the business is too “viable” to ignore — and that he would “consider many strategic things” rather than dump it.
“This has served our bank extraordinarily well for so many years,” said Mr. Leis, who joined Pacific Capital as head of its wealth management business in 2006 and was promoted to president and CEO this year when William S. Thomas Jr. retired. “It’s allowed us to buy several banks for cash; it’s been a great revenue generator. I believe we can absolutely get our arms around this.”
Pacific Capital works with a number of tax preparers, including Jackson Hewitt Tax Service Inc., providing short-term loans to taxpayers who are repaid when they receive their income tax refunds from the Internal Revenue Service. It records the fees it charges as interest income, and collected $118 million from the business in 2006 — almost double the $65 million it recorded in 2005.
The company said losses from the RAL business this year would be significantly higher than in years past because of an IRS fraud crackdown that has included increased refund denials. Joseph K. Morford 3rd, an analyst with Royal Bank of Canada’s RBC Capital Markets, said losses have traditionally ranged around 1.25% of Pacific Capital’s portfolio but soared to 2% this year.
Mr. Leis said Pacific Capital is preparing to put a number of controls in place to manage risk in the business and eventually hopes to keep losses beneath 1% of loans. Controls include hiring statistical analysts to identify patterns that indicate fraud and running risk-control software to detect red flags in tax returns throughout the tax season rather than just at peak times. It will also put tighter controls on — and in some cases cut ties with — some of its tax preparer partners.
“Our analysis shows a great deal of the losses come from RALs generated by a small percentage of tax preparers,” Mr. Leis said during the conference call. “By eliminating those preparers from our program and placing tighter criteria on any preparer that begins to show weakness in their quality control, we believe we can significantly reduce our loss rate.”
The company said the loss provision related to the refund loans would reduce third-quarter earnings per share by 27 cents. Before Monday’s announcement, analysts had expected the company to post per-share earnings of about 28 cents.
Pacific Capital earned $16.8 million, or 36 cents a share, in last year’s third quarter.
Manuel Ramirez, an analyst at KBW Inc.’s Keefe, Bruyette & Woods Inc., said he was surprised by the magnitude of the provision. “The level of risk management is not commensurate” with the RAL unit’s contribution to earnings, he said.
Mr. Morford wondered why Pacific Capital waited until now to install some of the controls.
“I just don’t know why you wouldn’t have fraud screening in place for the entire tax season,” he said.
Analysts said improving risk management is a positive step, though whether it will have much effect on the stock price is another question. The stock has consistently traded at a significant discount to its peers, and analysts blame the volatility and risk of the RAL business.
“Investors have tended to vote with their feet on that,” Mr. Ramirez said.
Pacific Capital’s shares recovered some of the lost ground on Wednesday but remain down about 38% for the year.
Analysts say buyers probably will not be interested in the unit until the risk management processes are in place and the losses subside.
“It’s going to take at least another tax season to show” improvement, said Aaron Deer, an analyst at Sandler O’Neill & Partners LP.
But a sale is not out of the question. Brett Rabatin, an analyst at First Horizon National Corp.’s FTN Midwest Securities Research Corp., said Mr. Leis has been sharpening the company’s focus on its traditional lending businesses and wealth management. It sold its indirect auto lending and equipment leasing businesses, and pared back its refund-loan products in April when it stopped offering holiday and paystub lending.
“I think the new management is a lot more interested” in selling “than previous management was,” Mr. Rabatin said. “The unfortunate thing is, right now it is more valuable to Pacific Capital than it is to someone else.”
