Take a quick glance at the big global banks and you’ll think that they are undervalued with the potential for long-term outperformance. The KBW bank index, a closely followed index of 24 global banks, is trading at the lowest level in fifteen years. The price-to-book and price-to-earnings of global banks are at historical lows. But take more than cursory look at these banks, and you’ll find that the post–crisis global economy, fortified by central banks throughout the world, will be an environment much different than history has shown us. As I explain throughout this article, the action to take is to sell Citigroup (NYSE:C), Bank of America (NYSE:BAC), JP Morgan (NYSE:JPM), HSBC (HBC) and Wells Fargo (NYSE:WFC).
Indeed, global banks' share valuations are low by historical standards. Most are trading at less than 1 time book value. In the most recent quarter, the price-to-book of Citigroup was 0.47, Bank of America 0.29, JPMorgan Chase 0.71, HSBC Holdings 0.88 and Wells Fargo 1.08. But the time when bank stocks were considered cheap when they were around book value, and expensive when they were around twice book value, has passed.
In September, the U.S. Federal Reserve announced "Operation Twist". The policy involves selling $400 billion in short-term Treasuries in exchange for the same amount of longer-term bonds in an attempt to lower long-term bond yields along with interest rates on everything from mortgages to business loans. While this may give consumers and businesses an incentive to borrow, it hurts banks’ net interest margins. Banks make money by borrowing short-term (from the Fed and depositors) and lending long-term to entities without such access to short-term funding. This “borrow short lend long” mechanism is one of the basic principles of banking profitability. Any reduction in the spread between short-term rates and long-term rates will reduce revenue.
When the Fed took interest rates down to near zero in 2009, banks were able to profit by simply borrowing from the Fed (and depositors) at a near-zero rate and buying longer-term treasuries. In 2010, as new loans began to reflect the lower interest environment, the profits of 2009 began to dwindle. Now, with Fed's salvo of Operation Twist and zero interest rate policy (ZIRP), banks will be hit with the double-whammy of both higher borrowing rates and lower lending rates
Moreover, exposure to the contagion-driven European sovereign debt debacle could force banks to write down assets. Fitch Ratings warned that U.S. banks have "manageable direct exposures" to the stressed European markets, but warned that further contagion posed a serious risk. Citigroup said it has $31.7 billion of gross funds at risk in Greece, Italy, Portugal, Spain and Ireland. Bank of America had $16.7 billion exposure to the five countries at the end of June, including loans and leases. JPMorgan Chase disclosed a net exposure to the five countries of about $14 billion, according to their quarterly report. And, add to that the hard-to-quantify CDS exposure that these banks have to Europe’s debt, and it is easy to foresee banks’ already-shrinking profit margins dented further.
The current financial environment has many uncertainties, none more so than Dodd-Frank’s Volker Rule. The Volcker Rule is a critical component of Dodd-Frank that prohibits banking entities that benefit from government protections—such as FDIC insurance on customer deposits or access to the Federal Reserve discount window—from engaging in proprietary trading and from certain relationships with hedge funds and private equity funds. President Obama fought hard to make sure this important provision was a part of Wall Street reform legislation, and the banking regulators are hard at work to effectively implement the law. Proprietary trading has been a hugely lucrative business for Wall Street. Large banks reported at the end of 2009 that trading accounted for 77 percent of their net operating revenues. The Volcker Rule could cost banks billions in annual revenue. Also, the overhead cost of implementing Volker and other provisions of Dodd-Frank will certainly be a profit-shrinking endeavor.
Let’s be clear. The eye-catching valuations of the big banks may have been appealing in years gone by, but with the current confluence of revenue-sapping problems, banks are sure not what they appear to be. The big banks should be sold.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.