Where Does The Banking Sector Go From Here?

Includes: XLF
by: Ralph Sesso

Take a guess as to whether or not the banking sector has fully recovered from the banking crisis that began in 2007. Do you think it has fully recovered? Some graphs from SNL Securities shed considerable light on the results of the bank and thrift indexes.

I was a little shocked myself as to what I found. After asking several fairly sophisticated investors, I was fairly convinced that most investors are probably not aware as to how much the banking sector, and especially the thrift sector, have underperformed. I would like to bring your attention how the recovery of the banking space compares to the rest of the market.

Chart #1 shows us that the SNL thrift index has hardly recovered at all since the financial crisis started in 2007. Chart #1 indicates that the thrift sector has pretty much flat-lined since March of 2009.

Chart #1

Chart #2 shows that there has been a 37% recovery since the last day of January 2009.

Chart #2

Question: If the overall market has more than fully recovered since the downturn and the banking sector has not, is there a potential outperformance in the bank and thrift sectors in the coming years?

To help answer that question for myself, I turned to the last banking crisis which is commonly known as the S&L Crisis which lasted from 1986 through 1995. In the late 1970's S&Ls had carelessly made long-term loans never thinking that interest rates would climb from a rate of 10% in October of 1978 to a rate of 20% only two years later. People were not in any hurry to pay them back these long- term loans when they could get higher rates on CD's than the rates they were paying on the loans. As rates continued to climb, the S&L's could not attract adequate capital and became insolvent.

The S&L crisis saw the failure of about 747 out of the 3,234 S&L's in the United States. A savings and loan or "thrift" is a financial institution that accepts savings deposits and makes mortgage, car and other personal loans to individual members. The thrift index was very depressed during that period and it took investors a while to be comfortable with investing in thrifts again. The broader market did not experience the dramatic downturn that the banks did as that crisis was created by bad management within the thrifts themselves.

Chart #3

Chart #4 shows the dramatic results of the SNL index at the end of the crisis.

Chart #4

(click to enlarge)

Once investors were convinced that the thrifts were solvent again, they began in earnest to invest in them. Many mutual thrifts went public during the early to mid-nineties and many of those that went public eventually sold to larger institutions. The trend of selling out stopped cold in 2007 as banks became aware that they had issues and there were very few acquisitions as a result.

The thrift index has been slow to come back this time for several reasons. There has been a lack of loan demand as well as a lack of acquisition activity. The larger banks have recovered more than the thrifts have, but as a group they are still down 45% from the 1/1/2007 high. The healing of the real estate sector has helped both banks and thrifts and we have seen a steady decline in non-performing loans across both sectors.

I think a solid case can be made for the thrift index to outperform in the next few years though. If they increased 128%, they would just be getting back to where they were in 2007.

Disclosure: I am long CASH and bank and thrift stocks. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.