Bank Stocks Will Return to Prior Norms

Alan Greenspan, in his book called The Age of Turbulence, said,

Crisis, at least for a while, destabilizes the relationships that characterize normal, functioning markets. It creates opportunities to reap abnormally high profits in the buying or selling of some goods, services, or assets. The scramble by market participants to seize those opportunities presses prices back to market appropriate levels...

Newton’s third law is happening before our eyes in the financial sector, ‘every action has an equal and opposite reaction’. The mark to market accounting regulation that was officially implemented on November 15, 2007 has taken down the bank stocks with chilling velocity. It’s hard to believe that it has been less than two years since investors assumed that money invested in a bank stock was a low risk proposition.

Personally, I never touched bank stocks because they never seemed to move. For years, JP Morgan (JPM) hovered around $40, Wells Fargo (WFC) around $30, Bank of America (BAC) around $45 and Citigroup (C) around $45. It was one of the guarantees in life: death, taxes, and low volatility bank stocks. On November 15th of 2007, all of that changed for the worse. This new accounting rule tied bank balance sheets to illiquid mortgage securities. As a result the banks had to raise capital to cover the short term losses at a ridiculous pace; you know the rest. JP Morgan now resides around $25, Wells Fargo at $18, Bank of America at $7 and Citigroup at $3.

On April 2nd, FASB will vote on the proposed alterations to this nightmare mark to market regulation. We have heard rumors of two new proposals. The first will change the requirements for actually taking a writedown and the second will allow companies to determine whether a particular market is active or inactive and they will be able to declare a related security as ‘distressed’. I love these new proposals because they maintain transparency for investors but the new regulation won’t force the bank to raise capital during times of short term overreactions. This solves a big problem for the banks.

The question on investors' minds is how will the new mark to market rules affect the plan of the Treasury, Fed, and FDIC to pump trillions of dollars into purchasing these toxic mortgage securities? Many investors are confused because it appears that all of this money won’t be needed because of the regulatory change. Let me tell you why it is still needed. These toxic assets need a pricing mechanism. Geithner, Bernanke and company have put into place the necessary components to bolster the market for these securities. Banks won’t want to sell them off because of the new mark to market rules but there will still be trillions of dollars of demand for them. Huge demand with no supply is superb news for the banks and for lending. It’s exactly what the government wants. These toxic assets won’t be toxic any longer. Writeups will replace writedowns and bank share prices will return to prior norms. This solves another big problem for the banks.

The government is in the process of eliminating negative balance sheet pressure for the banks and at the same time they are solidifying the pricing mechanism for these toxic securities by maintaining and strengthening the market for them. It is a brilliant plan. It is the solution we have been waiting for and it has created the buy of the year.

Disclosure: Author holds long positions in BAC, C

Comments

[Tom Armistead:]

Watching TV yesterday, a number of commentators had made an amazing discovery, a penetrating insight: the market price of many MBS is less than their true economic value.

As this informatin spreads, bank stocks will recover in due proportion. Somewhere between Merrill Lynch's 22 cents and a dollar, maybe 50 cents on the average.

With the Fed pumping cheap money into the system and loan rates not dropping porportionately, banks will be able to get very profitable spreads and this will also push share prices up.

Mar 24 08:41 AM

[lvltghost:]

I hope they don't just return to prior norms. JPM now has 40 extra a share in wamu, BAC now has 40 a share in countrywide and merrill. Wells fargo has the same in wachovia. They should be able to trade around $100 easily now.

Mar 24 10:32 AM

[Alex Filonov:]

Jason, I have to congratulate you on BAC position. I was wrong and you were right. It's no small deal to get a double in less than a month.

Mar 24 11:06 AM

[jepittman:]

Its still not too late sonny.


On Mar 24 11:06 AM Alex Filonov wrote:

> Jason, I have to congratulate you on BAC position. I was wrong and
> you were right. It's no small deal to get a double in less than a
> month.

Mar 24 03:08 PM

[mikeliu:]

Returning to normal valuation, not the old price level.

The real valuation of banks will continue to be driven by their earnings after the M2M rules have been made irrelevant. Therefore, it is unrealistic to expect bank stock prices will all of sudden return to old price levels as the true earning prospect has not changed. Therefore, in the case of Bof A, its short term prices will be determined by its earning in 09, which probably will be lower than $0.7 in 09 (assuming Merril and Countrywide will not draggs down earnings). Applying a 12X multiple, BAC's normal price probably will around $8-$15. That is great weath creation from $3.

Mar 25 08:59 AM

[hroni:]

You present a pseudo-argument, cyclical in nature, justifying the cherry-picking administration process of "Whatever Works". Hey, I'm 150% up on my BAC investment just like the next guy but I know if it's because of something I deserve or because I was handed a suitcase full of money.

Mar 25 10:37 AM

[mikeyk:]

Jason and co - have the last 18 months taught you nothing? the economy and asset values are not collapsing because of m2m accounting - as if we could change the accounting rules and the values of these assets would rise dramatically making everything ok. The economy and asset values are collapsing because the tide has gone out and everyone can now see that many consumers/banks/corpor... were not wearing any clothes. The excess leverage (and share prices) that took off this decade and peaked in 2008 is not the norm but the exception. Average household sector debt of 140% in the US and 170% in the UK is not tenable. Neither are banks with leverage of 25 to 40 times their equity. US borrowing was funded primarily by Asian and Middle Eastern surpluses which themselves were the result of leveraged anglo-saxon consumers buying Asian and Middle Eastern exports. That money will surely now be directed to their own economies. Bottom line: without the leveraged consumer and inflated asset values, on smaller capital bases (if these banks remain privately owned), with slower economic growth, and with less leveraged investors, it will be a very long time (if ever) before these banks share prices return to 2007 levels.

Mar 25 12:49 PM

[Obi-Wan:]

I would tread very carefully here. There's one x-factor that will rear its ugly head in this sector: More gov't regulation and control = an industry in a heap of trouble.

Heck, Congress can't even manage its own purse strings let alone someone else's!!!

Mar 25 04:32 PM

[Fred Voetsch:]

So let's see...Jason Schwarz or Meredith Whitney? Jason Schwarz or Meredith Whitney? Which one to listen to?

...hmmm....

Well, here are a few of your previous articles that might give me a hint:

seekingalpha.com/artic...
Let's see...September 16, 2008...was that a good time to buy? I can't remember....

seekingalpha.com/artic...
"Inaccurate data moves the markets in the short term but over time, the market will overcome its panic and focus on real data. With all the negativity that has been thrown around this year the truth actually sounds like a lie. We have GDP growth at 3.3%, unemployment is still in the 5% range despite a housing meltdown, Apple can't produce enough iPhones to sell, and corporate earnings (excluding financials) have held up remarkably well. These positives will get priced in as the panic continues to subside."

...I really love:
seekingalpha.com/artic...
...in which you stated, "There is a secret concerning high foreclosure rates that investors have yet to grasp. It's all about turning lemons into lemonade, something American consumers do so well. Analysts project 1 in 33 homeowners will face foreclosure over the next two years. These foreclosures will free up an additional $4 billion a month in consumer spending. Maybe this wave of foreclosures isn't so bad after all."

And here you predict a second-half rally in 2008:
seekingalpha.com/artic...

In this one you try to convince us that "p/e ratios remained tame":
seekingalpha.com/artic...

Do you still believe that, even though earnings were -$23 in Q4 and the current P/E using Q4 earnings is well over 50? See www2.standardandpoors....

Best of luck to you, Jason, and I mean that sincerly, but people, please don't listen to this kid. He doesn't yet know how to be objective about investing and he ignores or distorts negative data, as the foreclosure comment shows.

Mar 25 04:57 PM

[bones33:]

How can you fail when Uncle Sam continues to hand you money.

Mar 25 06:05 PM

[Misha:]

Some of you may have noticed that Citi and BAC are buying MORE toxic assets:

www.marketwatch.com/ne...={79b2b74f-6175-47b3-9...247wallst.com/2009/03/.../

BAC: "Our purchases in [mortgage-backed securities] increase liquidity in the mortgage market allowing people to buy a home." Give me a break! The only reason anyone would buy those assets is if they believed that they are undervalued in the marketplace. And on their balance sheets…

Mar 25 07:20 PM

[Skeptical Ben:]

I wouldn't believe this, except why would we expect different behavior from the banks since they have no negative recourse if they're wrong AGAIN. Too big to fail, too stupid to succeed.


On Mar 25 07:20 PM Misha wrote:

> Some of you may have noticed that Citi and BAC are buying MORE toxic
> assets:
>
> www.marketwatch.com/ne...={79b2b74f-6175-47b3-9...247wallst.com/2009/03/.../
>
>
> BAC: "Our purchases in [mortgage-backed securities] increase liquidity
> in the mortgage market allowing people to buy a home." Give me a
> break! The only reason anyone would buy those assets is if they believed
> that they are undervalued in the marketplace. And on their balance
> sheets…
>

Mar 26 01:47 AM

[RickWade:]

I actually think that Meredith Whitney has had her time in the sun. She was the recipient of exceptional circumstances, many beyond her initial vision, and now she risks riding her negative stance on banking too far into the recovery.

Schwarz on the other hand has made some brilliant calls as of late: BAC heading back to $20 when it was at $3, The Bubble of Uncertainty about to burst with the Dow at 6500, and the Citi float call. He was the first that I saw to highlight the doom of mark to market accounting last year as well. He might be more in tune to this market than Whitney is.

Mar 31 01:30 PM

[j_remington:]

Property values won't return and the assets are being inflated. Reality is that toxic assets' cash flow is not dependable.

www.sacbee.com/busines...

Mar 31 02:58 PM

[User 390671:]

When the dust settles and the recession subsides, BAC will be left as one of the biggest of the biggest banks. Its holdings will include what was arguably the nation's top brokerage house, Merrill Lynch, and what was a very big and successful mortgage company, Countrywide. Add that to BAC's already strong position as as a leader in credit cards, retail banking and commercial banking and you have the makings of a $40 billion profit center in post-recession times. (After all, BAC made $20 billion before its Merrill and Countrywide acquisitions.) With about 6 billion shares outstanding, $40 billion in earnings works out to about $6.60 a share. Give the stock a p/e of 12, which is typical for banks in normal times, and you have a stock selling for $79.20 a share. And that, of course, is absent any crazy, trendy, jump-on-the-bandwagon multiples that could well occur once banks become "in" again.
It'll take time, but BAC is poised for a nice gain for those long on its stock. In the interim, it will probably repay its TARP money ahead of schedule and resume paying a reasonable dividend.
BAC has wrongly been lumped in with C, which is a bank of a very different and much darker color. I think the NY-based financial press has been harder on BAC than is justified, perhaps because BAC is not headquartered in NYC but instead in the much smaller (and more conservative) city of Charlotte.
Time will tell. But I'm betting on BAC to be a big success story in the years to come. Those who buy it now will be very happy later, I think.

Apr 07 01:22 PM