On Friday at ~ 17:30 ET, my pals at CNBC led by Melissa Lee ran a segment entitled “Banks to Lead the Market in 2014?” A gaggle of experts then proceeded to explain why the top four “too big to fail” banks – C, JPM, WFC and BAC -- are set to “break out” in the coming year and that they have “momentum.” It was even suggested by these same options market sages that the XLF SPDR is the way to exploit this hot opportunity. BTW, I am scheduled to be on CNBC Monday ~ 15:30 ET to talk about Q4 earnings for banks and non-banks alike.
Now it may be the case that the thundering herd on the Buy Side has, in fact, decided that large cap financials are the place to be. There are generations of people on Wall Street who have made careers investing in the large cap financials and the love affair persists. Unfortunately, most Buy Side managers have no idea how banks make money and even less understanding about the changing role of the “irregulators” in this sector. Let’s go through each of these names and see what the fundamentals suggest. But let’s first make a couple of macro comments about the operating environment, banks and non-banks.
Last week, Joe Garrett of The Garrett, McAuley Report (December 30, 2013) noted that levels of credit utilization in the banking sector are very low, almost to an alarming degree. For those of you who watched Fed Chairman Ben Bernanke’s absurd press conference on Friday, you may wonder why Chairman Bernanke was laughing. Me too. Here’s what Garrett said:
“The FDIC Quarterly Banking Profile is always interesting reading, and here's something I saw: U.S. Banks have total deposits of $11.02 trillion and $7.65 trillion in loans and leases. If you do the math, that's a 69.4% loans-to-deposit ratio. Each bank is different, but we like loans-to-deposit ratios of 80-90% and maybe 100-110% if you're doing lots of asset selling like mortgage banking.”
What Joe is telling us in his usual gentlemanly fashion is that banks are severely under-leveraged. Joe, who works as an operations consultant to commercial banks large and small, has forgotten more about the banking industry than Ben Bernanke and his colleagues on the Federal Open Market Committee ever knew.
The basic problem facing the industry is that the low interest rate environment created by the Fed to help banks maintain their net interest margins back in 2009 and 2010 has now become a source of deflation. As we noted back in November, there is no free lunch. Either we kill economic growth via financial repression of savers or we embrace the painful process of debt restructuring for the major industrial nations. This is not a question of “austerity” as Paul Krugman and others maintain, but rather a simple case of misunderstanding the role of credit in our society.
Low rates are killing the consumer and demand for credit, even as regulations such as Dodd-Frank and Basel III have made it impossible for banks to fully deploy their deposit base. Seeing that banks parked ~ $3 trillion in excess reserves at the Fed, the FOMC then decided to buy government and mortgage securities via QE. This too is deflationary, however, since the “spread” earned by the Fed is simply transferred to the US Treasury. If you measure “austerity” based on the budget deficit, then the Fed is responsible for austerity. We talked about this problem in an earlier ZH post with David Kotok from Cumberland Advisors.
The other issue to which Garrett alludes is the question of asset sales. Since the subprime bust and especially since the end of the safe harbor on “true sales” by the FDIC in 2010, the off-balance sheet game played by the big banks has come to an end. Yes, there are still structured notes and derivatives games, but the big dollars that propelled bank valuations into the stratosphere came from very large asset securitizations. As I wrote in American Banker over the holiday:
“The poisonous combination of Dodd-Frank legislation, the mortgage foreclosure settlement by the state attorneys general and the Basel III capital rules prevents commercial banks from making anything but prime loans. Add to this the end of the safe harbor for "true sales" of asset-backed securities by the Federal Deposit Insurance Corp. in 2010 and you can virtually guarantee that no FDIC-insured commercial bank will underwrite a nonprime, non-QRM loan or securitization ever again.”
So given that the Bernanke, Janet Yellen and the rest of the FOMC have decided to kill demand for credit via extreme interest rate policy as well as regulatory requirements like Dodd-Frank and Basel lll, how should investors view financials? Short answer: With great caution. The larger, better known groups in the banking sector have been turned into utilities. Meanwhile, the non-banks such as my employer are showing far greater growth rates and market valuations. But nonbanks also have far less of a following among the financial media and Sell Side research analysts. So the basic watchword for investors pondering all financials is simply this: caution.
In terms of fundamentals, C is probably the most improved of the TBTF banks over the past 12 months and the equity price shows it. The stock is at its 52-week high and indeed the best value since 2009. But even at $50 the equity market value of C is just 1/10th of the value prior to the 2007 subprime meltdown when the equivalent stock price was over $500. Off-balance sheet finance drove the bank’s valuation up and up, then cause C to fail catastrophically.
Looking that the bank holding company performance report for C, the first thing that jumps out is that the bank is continuing to shrink in terms of assets and funding. Indeed, going back to the point about the deflationary nature of the FOMC’s interest rate policies, most of the 93 institutions that are part of the large bank peer group defined by the Fed and FFIEC are shrinking. When credit shrinks, so does consumer demand and employment.
Earnings from interest and non-interest sources at C are likewise down sequentially as well as year-over-year, although net interest income is up thanks to an end of restructuring charges, settlements and aggressive cost cutting. Net interest income at 2.5% of average assets is 30bp below peer because of C’s relatively higher funding and credit costs. C makes up some of this deficit because the yield on its subprime loan and lease assets is almost 7% -- 2.25% above the peer group average yield for loans and leases. But provisions expense is also 2x peer because of the higher charge offs from C’s subprime loan book. Overall, the yield on C’s earning assets at 3.69% is just below the large bank peer average.
What all of these numbers tell you is that C is pretty much in the middle of the performance pack as far as large banks are concerned. So as an investor, you are really not being paid in a risk-adjusted sense for the higher loss rate on C’s assets. Just remember that Capital One Financial (COF) is a better peer for C than the other three money center banks. There is little or no organic growth on the revenue or earnings line, save cost cutting, yet the Sell Side analysts have somehow managed to publish forward earnings estimates showing double digit growth in 2014. Keep in mind that Sell Side estimates for revenue growth are flat.
So to believe the Street earnings estimates for C of $4.67 for 2013 going to $5.32 in 2014 (+ 14%), you must believe that C is going to continue cost cutting and raising fees on all non-interest services. With a PE of 13+ and a price/book of 0.81, there may well be some upside possible for C, but just remember that there is no real visibility on revenue growth.
Bank of America
BAC is arguably still the laggard among the top four large cap banks, trading at a price/book of 0.79 and a 12 P/E. At ~ $16.50 per share, BAC is at the 52-week high but that is still just 20% of the pre-crisis peak of ~ $54 or well over 2x tangible book value. In the current economic, interest rate and regulatory environment, expecting any commercial bank to trade at such multiples to tangible book is simply not reasonable. The secular bull market in financials that started in 1995, paused in 2000-2001, and then soared until the crisis began is not a good metric for assessing future market performance IMHO.
Looking at the BHC performance report for BAC prepared by the Fed you can see why BAC is still trading at a discount to book. Net income as a percentage of average assets is still half (0.49%) vs. the large bank peers (0.95%), although a 1% ROA is hardly reason to get excited. Remember, when big banks were trading at 2x tangible book six plus years ago, they were heavily involved in asset securitization and thus were reporting over 2% ROAs and equity returns in the high teens to low 20% range. We live in a different world today.
Going back to the point made by Joe Garrett about bank leverage, BAC’s ratio of net loans and leases to total assets is just 44% vs. 60% for the large bank peers. No surprise that BAC has started to grow its loan book, but at a rate (3.76%) that is below peer (5.43%). In terms of margin analysis, BAC’s reported net income as a percentage of average earning assets of 2.28% vs. 3.17% for the large bank peers. The gross yield on BAC’s loan and lease book of 4.14% is 50bp below peer.
So the good news here is that BAC has a good bit of room to improve its operations, but the bad news is that the Fed and other regulators are going to do everything in their power to make sure that this does not happen. Sell Side analysts are projecting a 3% revenue growth rate for BAC in 2013, but just 0.3% in 2014. Earnings are projected to treble to $0.89 per share in 2013 and then rise to $1.32 (+ ~ 50%) per share in 2014 – this on zero revenue growth. As with C, you have to ask yourself how much more cost BAC can cut out of operations to achieve this Sell Side EPS target.
JP Morgan Chase
JPM is arguably fairly valued at the current $59 equity price, roughly 1.2x tangible book and about a 10 P/E. Unlike C and BAC, JPM was growing faster than its peers at the end of Q3 2013. Net income as a percentage of average assets at 0.71% is below the 0.95% peer average, but then again, neither figure is cause for excitement. Net loans and leases at JPM grew 2.2% last quarter vs. 5.4% for the large bank peer group defined by the FFIEC.
In terms of the JPM loan & lease book, the yield at the end of Q3 2013 was 4.54% vs. 4.74% for the peer group. JPM makes up for the pedestrian performance on its lending assets because of the yield on its trading book -- 2.07% or roughly 2x the peer group average.
Of interest, the Sell Side analysts have a -1.3% revenue estimate for 2013 and a 2.1% revenue estimate for 2014. In terms of earnings, the Sell Side has JPM doing $4.40 per share in 2013 vs. $5.20 the year before. For 2014, however, the Sell Side community estimates that JPM will do almost $6 per share in earnings or a mere 33% EPS growth rate YOY. Again, all of this happens on flat revenue.
WFC is arguably the best performing of the four TBTF banks, with a price to tangible book well north of 1.6x and a forward P/E of 11. At just over $45 per share, WFC is at its 52-week and the all-time high as well. You could say that the name is fully valued at this level.
Looking at the BHC performance report for WFC at the end of Q3 2013, the bank is clearly one of the better performers in the peer group. Asset growth has been steady, although loan growth has suffered due to the catastrophic drop off in mortgage volumes experienced by the entire banking industry. Again, you can thank Chairman Bernanke, Barney Frank and Christopher Dodd for the mortgage lending market implosion now underway.
With an ROA of 1.53%, WFC’s asset returns are 50% higher than the large bank peer average. Net interest income at 3.4% is also above peer though only in the 56th percentile of the 93 banks in the group. The shame of it is that there are a number of large banks in the US that consistently perform better than WFC and the other money centers, but their shares are too illiquid to attract significant investor support.
Given WFC’s dependence upon mortgage lending as part of its overall business model, the Sell Side analysts have a -2.2% estimate for revenue in 2013 and a 0.9% estimate for revenue in 2014. Earnings, however, are projected to grow $0.50 to $3.87 in 2013 and another $0.12 to $4.00 per share in 2014. Given the grim outlook for the mortgage lending sector, these numbers for WFC make at least some sense compared with the estimates for C, BAC and JPM. The real question is whether WFC can maintain its premium equity market valuation in the face of weak or no revenue growth.
Bottom line for financials is that 2014 is looking to be a tough year, even if the Sell Side wants to believe that growing earnings is still possible on flat revenue after years of cost cutting. The thing to keep in mind is that banks have been fighting to cut costs and grow non-interest revenue (i.e fees) for the past several years. Given that loan loss provisions are probably as low as they a going to go, finding additional revenue on the expense side of the ledger is going to be difficult indeed for all banks.