Valuentum Exclusive Analysis for the Discerning Investor

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Image: The Financial Select Sector SPDR ETF has experienced a tremendous amount of pain in recent weeks.

From Value Trap: “It’s likely we will have another financial crisis at some point in the future, the magnitude and duration of which are the only questions. My primary reason for this view is not to be a doomsayer, but rests on the human emotions of greed and fear and the nature of a banking entity’s business model, which does not hold a 100% reserve against deposits. Our good friend George Bailey, played by actor Jimmy Stewart, in the movie It’s a Wonderful Life knew this very well when he tried to discourage Bedford Falls residents from making a “run” on the beloved Building and Loan. It’s a movie that some of us have watched a dozen times or never at all, but it’s a scene, to me, that’s unforgettable. We attribute such a run-on-the-bank dynamic to the Great Depression, but WaMu fell prey to this very situation in 2008. If the market does not have confidence in a banking entity, that banking entity will likely cease to exist.

...the Financial Crisis taught more than just the importance of assessing capital-market dependence risk. For starters, there was really nothing in Lehman Brothers’ historical GAAP financial statements that would have warned you about what was to come. There was really nothing in WaMu’s SEC filings that could have put you ahead of the run-on-the-bank dynamic. Both companies had been operating the way they had for years, and during the go-go years prior to the bust, their share prices kept marching higher. The historic GAAP financials didn’t help investors in these cases. The technicals told the real story. The markets were factoring in future liquidity events at financial institutions around the world, and both the Fed and Treasury needed to provide a huge backstop to prevent the global financial system from unraveling.” – Value Trap, published 2018

By Matthew Warren

We are putting our banking coverage universe (XLF, KBE) under review with expectations to lower our fair value estimates by 30% across the board, with roughly 20% of that due to base case assumptions coming down and the other 10% to reflect the tail-risk scenario of possible permanent capital impairment due to the stress from the financial crisis (provoked by the coronavirus) that we have entered. The latter factor is very dynamic and could increase or decrease along with facts on the ground.

Base-case projections are coming down for multiple interconnected reasons all based on the fact that we have (most certainly) entered a recession in these past few weeks due to the shutdown of so many discretionary activities as people begin to cocoon at home for the purpose of social distancing.

Credit losses will mount as economic activity slows, especially in oil & gas (XOP) and the travel and leisure portions of the economy. Banks have enjoyed near-zero credit losses for the past while and now it will swing to above average losses across large parts of the portfolio. Government action from a potential U.S. fiscal stimulus package (which reportedly could be a $1+ trillion accord) will mitigate some of these losses, but don’t be mis-led that marginal and overleveraged businesses will not in fact default in large numbers.

Bank revenue will also come under pressure thanks to lower rates from the Federal Reserve and the market action in general. With short rates at zero and the 10-year government bond yielding ~1%, it will be more difficult to earn a proper spread on deposits, and the endowment effect will be in reverse as zero cost deposits will not be as valuable for the foreseeable future.

Net interest margins ('NIMs') will certainly come under pressure and that will show up in the coming quarter’s results and forward guidance. There will also be revenue pressure from lower economic activity, market levels, and eventually market action. There will be less revenue from investment banking, trading, wealth management than in the recent past.

These revenue pressures will cause efficiency ratios to come under pressure as costs cannot be cut fast enough. Some costs like collection costs will be forced higher, while we expect some discretionary spending like advertising to be cut back. Many banks have made a lot of progress on their efficiency ratios during this past 11-year upturn, and it will disappoint investors to see this trend reverse. Some banks might even pull back on digitalization efforts, to the detriment of future efficiency.

The good news is that US banks are in a much better starting position going into this financial crisis as compared to the last on in the Great Financial Crisis ('GFC'). Capital levels are higher, as is liquidity. There are not a lot of subprime mortgage loans or collateralized debt obligations ('CDOs') on the books. So far, residential and commercial real estate values are not sliding like they were so rapidly the last time around, though this is something to watch if the magnitude and duration of this recession end up worse than what people are currently expecting.

The bad news is that European, Japanese (EWJ), and Chinese (FXI, MCHI, KWEB) banks all look fragile at this juncture in our opinion, and banking problems, sovereign defaults, and deflation can all cross borders in domino and chaotic fashion, as we learned in the GFC. Aside from continuously gauging the magnitude and duration of the recession and financial crisis, we will be watching these tail risks from overseas.

Concluding Thoughts

What is clear is that temporarily shutting down large parts of U.S. economy is absolutely unprecedented, and there will be substantial knock-on effects and difficulties in getting things restarted. This is most especially true if the coronavirus re-emerges following the periods of social distancing around the world, or when the weather turns colder again in the fall, and humanity could be facing a different strand of the coronavirus.

Don’t forget that all bank institutions use a lot of financial leverage by their very nature, and the Fed and Treasury can never truly stop a run-on-the-bank dynamic (i.e. that which happened to WaMu in 2008). We think BOK Financial (BOKF) is in particular trouble given its energy loan exposure. Others to avoid include Cullen/Frost Bankers (CFR), Cadence Bancorp (CADE), and CIT Group (CIT). The credit card entities, Capital One (COF) and Synchrony Financial (SYF) may be worth avoiding.

We’d stay far away from the regional banks (KRE) given their exposure to small business pain amid COVID-19. We don’t think the fiscal stimulus on the table does much to help small businesses. Deutsche Bank (DB) may be the first of the big European banks to topple, and this weakness could eventually spread to the U.S. banks given counterparty risk. Most foreign banks, including Santander (SAN), Credit Suisse (CS), UBS (UBS), ING (ING), and BBVA (BBVA) remain exposed to crisis scenarios.

We’re also witnessing some very troubling developments with banking preferred shares, with the bank-preferred-heavy ETF, Global X SuperIncome Preferred ETF (SPFF) dropping ~15% during the trading session March 18. The preferreds of HSBC (HSBC) and Ally Financial (ALLY) are top weightings in that ETF. Banking technicals are raising some major red flags across the board, and given actions by the Fed and Treasury, this crisis has all the makings of being worse than the GFC.

In any financial crisis perhaps excepting a depression, there can come a time to invest new money in bank stocks. Though it seems likely we have not yet reached the bottom in the markets yet, the highest-ground bank franchises in the US are JPMorgan (JPM) and Bank of America (BAC), in our view. While sharp declines in their equity values may be expected (no one truly knows how deep the coming flood will be), they’re likely to make it to the other side with most of their equity capital firmly intact. With all that said, however, one doesn’t have to hold banking equities.

It may be time to phone Mr. Buffett before things really start to unfold.

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Banks - Regional and Asset Management: AB, AINV, AMP, ARCC, BCH, BEN, BGCP, BKU, BLK, BMO, BNS, CM, FSIC, ISBC, KKR, LAZ, LM, MAIN, MTB, NABZY, NYB, OCN, PBCT, PFG, PSEC, RY, SBNY, SBSI, STT, TD, VLY, WBK 

Banks & Money Centers: AXP, BAC, BBT, BK, C, DFS, FITB, GS, HBC, JPM, KEY, MS, NTRS, PNC, RF, STI, TCF, USB, WFC

Airline Related: AAL, ALK, DAL, HA, JBLU, LUV, SAVE, UAL

Hotel Related: H, IHG, WH, CHH, RLH, STAY, BEL, WYN, EXPE, BKNG, TRIP, TZOO, TCOM, HTZ, CAR

Other Related: VGK, FEZ, HEDJ, EZU, IEV, IEUR, EPV, EURL, SPEU, DBEU, EEA, HEZU

Treasury Related: TLT, TBT, IEF, SHY, IEI, EDV, TMV, TMF, VGLT, SHV, BIL, VGSH