Zombie Dance Party: Same Girls, New Music
"As long as the music is playing, you've got to get up and dance. We're still dancing.”
Bloomberg News reports that Bank of America Corp. (BAC), the best performer in the Dow Jones Industrial Average for 2012, has more than doubled since the start of the year “as the company rebuilds capital and investor confidence.”
My friend Meredith Whitney just upgraded BAC to a “Buy,” a call that is a little late given the stock’s performance to date. But at just 0.5x book value, to be fair to Meredith, you could argue that the bank is still undervalued. And many people do in fact believe this. If we accept the basic bull market thesis for BAC being touted by Whitney and others, what is a reasonable valuation for BAC?
Let’s set some assumptions.
First, if you believe the bull market thesis for BAC, you must assume that the bank is going to prevail in the massive litigation it faces with respect to legacy mortgage securities. This is a considerable assumption, but Whitney and the rest of the Sell Side analyst community seem to already have taken this leap of faith. For the sake of their clients, let’s hope they are right.
BTW, watch some of the more critical bank analysts ask BAC and other TBTF banks about the adequacy of reserves for civil litigation and put back claims by Uncle Sam in the Q4 earnings calls this January.
Second and more important even than the litigation is the question of business model. Earlier this week, BAC CEO Brian Moynihan said that he was satisfied with a high single digit market share in the US mortgage sector. Wells Fargo (WFC) is close to 40%. BAC at < 10% market share nationally is perhaps a more profound assumption than the question of the BAC mortgage litigation. BAC was once the dominant player in mortgage lending, both directly and through third part originations (TPO). To have this bank’s huge balance sheet at such a low level of deployment is bad for the real estate market and for future earnings.
Thanks to Senator Elizabeth Warren (D-MA) and the ill-considered Dodd Frank legislation, the TPO market has virtually disappeared. The lending capacity once represented by Countrywide, WaMu and Lehman Brothers is gone. BAC is still purchasing some production from outside providers, but the volumes are miniscule compared with the pre-2007 period. Thus the question comes: When Street analysts are showing a positive revenue growth rate for BAC and its peers, from where precisely is this revenue going to come?
Because of Dodd-Frank, Basel III and the Robo-signing settlement, the largest US banks are being forced out of the mortgage market. Earlier this week, I talked about this dynamic on CNBC’s “Fast Money.” Suffice to say that analysts who assume that BAC will double in 2013 may not understand the new drivers – or lack thereof -- of revenue and earnings in all of the TBTF banks.
That said, I think it may be reasonable for BAC and even much maligned Citigroup (C) to double in the next twelve months, but not because of revenue or earnings growth. If BAC hits street estimates for revenue in 2013 (+3-4%), is this a sufficient driver to justify a double in the stock? No, but a doubling of the dividend is a good enough reason for cash starved investors. In a very real sense, the biggest driver for stocks like BAC or C is not internal revenue growth but the zero rate policy of the FOMC.
During 2012, the preferred stocks of names like BAC and C have appreciated more than 15 points in price. Yields for preferred issuers like the TBTF banks and General Electric (GE) have fallen by almost two points. Is this because the revenue growth or earnings of these names have been growing? No, these metrics are flat to down. The appreciation of these securities has been driven by the FOMC and the Fed’s ridiculous zero rate policy. ZIRP does not create jobs nor is it helping bank revenue.
"Reduced expenses for loan losses and rising noninterest income helped lift insured institutions’ earnings to $37.6 billion in third quarter 2012," notes the FDIC in the most recent Quarterly Banking Profile. "Two out of every three insured institutions (67.8 percent) reported year-over-year NIM declines, as average asset yields declined faster than average funding costs." The fact that the TBTF banks are relying on fee income and line items like investment banking to hit revenue and earnings targets is very telling.
So when you see Sell Side analysts like Meredith Whitney being so constructive on the TBTF banks, even with the poor operating performance, investors need to ask themselves a question. Is the prospective appreciation of BAC and C the result of strong business fundamentals? Or is the prospective appreciation of these stocks more a case of traumatized investors fleeing to the fantail of the Titanic to avoid the icy cold financial repression of zero interest rates? Keep in mind that most of the improvement in earnings which seems to impress Whitney and other analysts has come as a result of expense reductions, mostly credit costs. Efficiency ratios for the large banks are over 60%, of note.
Even if you believe that BAC is going to escape the most horrific outcome in the mortgage litigation, the valuation target that is reasonable for this bank, C and the other TBTF institutions such as JPMorgan Chase (JPM) and WFC, is probably between 1 and 1.25x book value. So yes, given that valuation framework, you can justify a doubling of BAC from current levels to say $20-25 per share. But keep in mind that this stock was trading at $40 back in 2008 and over $50 in 2006 prior to the acquisition of Countrywide. Are we likely to see BAC go to over 2x book value again? Well, maybe, but not because of strong earnings or revenue growth rates.
Should names like BAC or C manage to get above 1.25x book, it will be because of the Fed and ZIRP. And as and when Fed interest rate policy changes, look out below. As I noted on CNBC, without the benefit of a strong mortgage origination and securitization business, the TBTF banks are going to become far less volatile and far more boring. Even the marginally higher capital levels of today, pre-Basel III, will imply lower asset and equity returns. And this is not a bad thing.
Yet investors are really not prepared mentally or emotionally for a market where the large banks are not delivering double digit revenue and earnings growth, whether organically or via M&A. Most institutional investors, keep in mind, have no idea how the TBTF banks actually make money. So when well-meaning Sell Side analysts predict wondrous stock price appreciation for the Zombie Dance Queens, the proverbial sheep on the Buy Side sing with joy -- and rush into the interest rate trap so lovingly constructed by Chairman Bernanke and the Fed. Keep in mind that the corollary of ZIRP is massive interest rate and market risk on the books of all banks. Think trillions of dollars in option adjusted duration risk.
Without the benefit of gain on sale from mortgage origination and securitization, it is difficult to construct a long term bull scenario for any US bank, large or small. As and when the Fed normalizes interest rates, the business models of the TBTF banks are going to be far less exciting. Mark-to-market losses on securities will wipe out stated earnings. New and innovative ways of presenting “pro forma” earnings will appear on the scene. The TBTF bank CEOs will rightly blame Washington.
In this future banking market, names like C which currently trade on a 2 beta will have higher dividends, but relatively flat earnings and revenues. Cost cutting, not growth, will fund these payouts to investors. Occasionally you will see big numbers from these names when the investment bankers have an especially good quarter. But overall the TBTF banks are evolving into low growth utilities with nice dividends. This is precisely the way banks used to be before President Bill Clinton’s “Great Leap Forward” in terms of housing and home ownership. And, again, this is not a bad thing.
But investors in the TBTF banks need to understand that the business model for this industry has changed. The business model for banks is going to continue to evolve away from the high-beta, high volatility model of the 2000s to something that looks more like banking in the 1950s. The action in terms of significant volume growth is in the non-bank sector. Get used to it.
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