Big Bank Roundup, Bank of America Catches Our Eye
In this article, let’s catch up with how far the big 6 banks in the US have come since the height of the financial crisis exactly a decade hence. We will highlight the improvements in the banking system, some of the key risks, and a few high level thoughts about the individual franchises leading the US banking system. We like Bank of America the most, and we include diversified banking exposure in the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio.
“Both a European bank crisis and/or a Chinese banking and economic crisis would be mutually reinforcing to the downside and a major cause of global deflation.” – Matthew Warren
By Matthew Warren
When you take a look at the big 6 banks in the US (SPY, DIA), the picture that emerges is very different than it was exactly a decade ago, when we were at the trough of the stock markets and peak stress in the banking system. Back then, banks were falling like dominoes in the US and various other countries around the world. Lehman Brother’s failure accelerated the chaos and regulators and lawmakers were frantically trying to put back together a system that was falling apart in accelerating fashion. A run on the banks had morphed into a run on the money market funds.
All of this because of a cycle of bad loans feeding a frenzy in the US housing market, feeding a frenzy of bad lending. People were borrowing from their homes and credit cards to keep up with the Jones. Unsustainable jobs and unsustainable earnings streams were everywhere you looked. Those that catered to discretionary spending were on a sugar high. Residential mortgage backed securities (RMBS) were being created from sub-prime liar loans and the bottom tranches most exposed to loss were being recycled into Collateralized Debt Obligations (CDOs) with plenty of new AAA paper created out of thin air.
Out of junk.
And when the bubble burst, home prices slowed, stopped, and reversed. Home building collapsed from well ahead of household formation to near zero. Sub-prime mortgage banking collapsed and the whole industry would have collapsed without the federal government backstopping Fannie, Freddie (FMCC), and the FHA. Hedge funds holding CDOs collapsed. And eventually, the Wall Street houses whose investment banks were warehousing and then originating RMBS and CDOs for huge near-term profits, were stuck without a chair when the music stopped. Investment bank funding started to dry up as fixed income investors didn’t want to roll over their risk exposures to the next day, week, month, or year. Bloated, opaque investment and money center bank balance sheets were being scrutinized for bad paper and busted deals stuck in the warehouse.
This frantic collapse was finally contained by a Federal Reserve that promised to fund (provide liquidity and purchase troubled assets) any and all systemically important institutions and a (second time around) yes-vote by Congress to create the TARP program, which led to an incredibly important capital injection into the country’s biggest banks. With capital and liquidity addressed, investors finally regained confidence that the banks would have the time and space to allow earnings power to offset credit losses inherent in all of the balance sheets, to wildly varying degrees.
The Financial System Is Much More Stable
In the wake of all this came new and quite powerful regulations which have indeed changed the landscape for the better. Banks have since undergone annual stress tests, which mean they must prove they have enough capital to withstand potential down cycle loss contained in the assets on their balance sheets. This annual to-do forced them to consider carefully what they were putting on their balance sheets and how much capital they were holding to handle potential large losses in a sharp economic downturn scenario. Capital plans must also be approved by regulators, which means that the big banks cannot pay out dividends or repurchase shares without the express approval of the regulators. If the regulators want a bank to retain more equity against potential loss, then that is exactly what has transpired.
The end result of all this is a much more stable system, if perhaps less rapid growing or dynamic. It is less prone to disaster. The banks hold more equity, more liquidity, and are arguably carrying much less risky loans on their balance sheet, though this assertion will be tested in the next major economic down cycle. Importantly, investors also seem to be rewarding stability, return on capital, and cash returns to shareholders instead of the most rapid possible earnings growth. This is very different from the end of the last cycle when investors were chasing low quality earnings growth like a herd driven off a cliff. So, is there no race to the bottom in terms of quality degradation this time around? Time will tell, but the signs are encouraging.
Where are we in the credit cycle one might ask themselves? The answer is: This has been a very long cycle, though not a steep climb given the slow and steady GDP and bank asset growth. Cost of funds has been incredibly low as deposits have remained sticky at near zero yields for an extended period of time, despite the Fed having steadily marked up short-term interest rates. Cost of labor and other costs of production have steadily come down as a percent of revenues as the long cycle has continued. Cost of impaired credit has remained incredibly low for an extended period of time with only a few problem spots turning up in places like auto lending (SC, ALLY, GM, F, HMC) and increasing concerns around commercial construction and some commercial property lending. Commercial and industrial loan losses have been quite benign despite some concerns that have popped up in areas like energy (XLE). The combined picture is one of very benign conditions that have lasted for a very long period of time and one wonders if bank profitability is over ripe to be challenged come the eventual downturn in the economy. Only then will all of the regulatory improvements be tested in real time. I would argue that I don’t see anything like the excesses of a decade ago.
Addressing the Two Major Risks for Bank Investors
So what is the real risk for bank investors, and why did bank shares trade off so aggressively in the stock market downturn in the fourth quarter of 2018? Is it a knee-jerk reaction with people expecting another housing and consumer credit bust? Do people simply fear the stove by which they were last burnt? My thesis is that the biggest risk to the big 6 banks come from two distinct sources that have been hanging over the markets like a shroud in the background for at least the last decade.
The first risk is counterparty risk from European banks failing like dominoes, whether due to a substantial economic downturn or a breakup of the European Union or both. The big 6 banks all have high, though varying, counterparty risk to each other and of course to banks across the pond. While they would tell you that they have very disciplined risk exposures to any one bank and hedges in place, one wonders how well hedges would work in a scenario like the one I am describing. The second major risk is a financial crisis in China (FXI, MCHI) and the economic fallout that would occur from that. Both a European bank crisis and/or a Chinese banking and economic crisis would be mutually reinforcing to the downside and a major cause of global deflation. As we witnessed a decade ago, deflation is truly a devil for a banking system to contend with. Any country, bank, or person with substantial debt outstanding is in real trouble when earnings and assets start to deflate, but the amount of nominal debt outstanding remains fixed. It is simply a meat grinder. Let’s hope Europe and China either hobble along or sort out their imbalances without sliding into crisis.
The Relative Fundamental Positioning of the Big 6 Banks
And as to the relative positioning of the big 6 banks? I would argue that three of the big banks are interesting to some degree and the other three really are not that interesting. I would place JP Morgan (JPM), Bank of America (BAC), and Wells Fargo (WFC) in the interesting camp. They have solid franchises with millions of households and small businesses contributing to their deposit franchises, a true competitive advantage over time. They have the relationships and distribution networks in place to gather and hold deposits on the one hand; and find credit-worthy demand for loans on the other hand.
All three banks have substantial fee-based income streams in place to bolster the deposit and lending franchise. In a world where retail banking requires scale and massive investment in digital banking, these banks can afford to compete and eat the lunch of the thousands of smaller banks in the country which are share donors. This adds to meager overall system growth opportunities. It adds to profitability and return on capital. These banks are well capitalized, hold substantial liquidity, and are all quite efficient given their business mix.
Citigroup (C), Goldman Sachs (GS), and Morgan Stanley (MS) are much less attractive firms. Citigroup is subscale as a national bank in the US. Goldman Sachs and Morgan Stanley have large opaque balance sheets with a high degree of wholesale funding. They have very fledgling US retail banking operations. A great deal of their earnings is highly cyclical and subject to market share gains and losses in the oversaturated global trading and investment banking universes. The latter three are worth watching and do have some merits. However, they are lower quality than the former three.
The institution that I find the most interesting right now is Bank of America, given its substantial improvement over the past several years. If this trajectory can continue, shareholders will be rewarded. They have the relationships in place to keep harvesting better and better returns on capital. We currently value Bank of America’s shares at $30 each, but we could see upside to the mid-$30s on the basis of our residual income modeling framework. The Financial Select Sector SPDR ETF (XLF) is included in both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio.
Related ETFs: XLF, VFH, KRE, KBE, IYF, FAS, IYG, FXO, KIE, KBWB, FNCL, UYG, IAT, QABA, RYF, KBWD, PSCF, FAZ, IAK, IAI, KBWR, KBWP, KCE, PFI, RWW, SKF, SEF, FINU, KRU, FINZ, KRS
Key European banking equities to watch: DB, UNCFY, ISNPY
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Matthew Warren does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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