Received wisdom has it that banking is moribund in the U.S. Growth is permanently stalled due to a combination of regulatory moves that limit fees (on credit and debit cards and deposit overdrafts), painfully low interest rates that compress margins, and a sluggish economy. Regulatory uncertainty about potentially dramatic reductions in trading profits depending on the outcome on the Volker Rule cloud the picture further. European exposures are worrisome as well. On top of that, core common equity capital requirements are being increased by a factor of 3-4 times pre-crisis levels. The biggest issue is the ultimate liability banks will have on litigation stemming from their pre-crisis sales of mortgages and securities. It is no wonder that banks’ stock prices are depressed.
While that is not a pretty picture at all, let us not lose sight of what is still pretty good underlying profitability potential, despite the regulatory changes. Once rates return to somewhat more normal levels, and the wave of litigation subsides, profits can improve substantially even if we do not make any heroic assumptions about growth, revenue offsets to the regulatory restrictions on fees, or an early return to health for the mortgage markets.
Let us use the following, fairly conservative assumptions, and assume no meltdown in Europe:
- Litigation charges and loan repurchases due to faulty “reps and warranties” are eliminated
- The net interest margin is rolled back to each bank’s 2Q 2010 level
- Fees are reduced by the estimated impact of the Durbin amendment governing debit card fees; regulatory restrictions will not be able to be offset by new fees
- Loan loss levels for corporate loans and unsecured consumer loans return to 0.75% and 5.0%, respectively; mortgage losses continue at half the bank’s 2011 rate (still astronomically high by historical standards)
- Provisions cover current period write-offs
- Costs of managing foreclosed properties abate
- Trading income remains at 2Q 2011 levels—not stellar but also not the depressed levels of subsequent quarters. This assumes no draconian long term effects of the Volker Rule, although trading revenues never return to heyday levels
- No ability to offset consumer fee reductions with new fees
- No growth of earning assets
- No efficiency gains
- Equity levels are increased to the fully phased in Basel III levels
I use the 2Q 2011 revenues and expenses as a base because they reflect the full effect of the credit card and overdraft fee reductions, and include moderate trading revenues as opposed to severely depressed levels in the second half of 2011.
The result is that the profitability measures for the strongest of the top four commercial banks provide an acceptable level of ROE, in the 13-15% range. That is not nearly the returns reached pre-crisis but enough to warrant valuations at 10-20% above stated book value. The weaker banks would need to get their cost of funds down by 60-80 bp and improve the efficiency of their operations and their capital to reach those levels of ROE. I did not assume that would happen, although the banks are working on it and may well be successful.
|JPMorgan (NYSE:JPM)||Citigroup (NYSE:C)||Bank of America (NYSE:BAC)||Wells Fargo (NYSE:WFC)|
|Net interest income||51,747||51,500||49,738||45,342|
|Operating noninterest income||58,772||32,196||51,352||38,720|
|Pretax operating income before loss provisions||53,071||36,952||38,706||40,122|
|Net interest margin||2.89%||3.00%||2.66%||4.20%|
|Noninterest expenses/Operating revenues||51.98%||55.85%||58.74%||52.27%|
|Loss prov / Revenues||8.21%||15.24%||13.85%||8.59%|
|Operating pretax / Revenues||39.81%||27.72%||24.43%||38.35%|
|Price - Current||32||28||5.5||26|
|Current Forward P/E||4||4||5||6|
For the four banks as a whole, pretax earnings improve by $44.4 billion, to $119 billion, due to:
- Annual net interest revenues improve by $12.7 billion, or 8%. These revenues are partially offset by a $4.2 billion reduction in fee income as the debit card legislation takes effect.
- During the nine months ended September 30, 2011, the banks took charges for rep and warranty liabilities of $18.6 billion, and recorded litigation and other mortgage related expenses of $10.5 billion. The amounts exclude Citigroup’s litigation costs, which are not disclosed. Nor do they include the elevated operating costs of servicing delinquent mortgages except in the case of Bank of America, which has indicated that they run at about $1 billion a quarter. On an annualized basis, if such charges were absent, pretax income would be $38.7 billion higher.
- Net charge-off would be lower but reserve reversals would no longer benefit earnings, so provisions are a bit higher, by $2.8 billion.
Profitability ratios for JPMorgan (JPM) and Wells Fargo (WFC), measured as a pretax return on revenues, return to pre-crisis levels of 39%. Because equity levels required on fully phased in Basel III rules would be higher than in the 2Q of 2011, and 2-3 times higher than pre-crisis, the ROE would be only 13-15% for JPMorgan and Wells. For Citigroup (C) and Bank of America (BAC), which suffer from a higher cost of funds and high operating costs (for Citi these include undisclosed litigation costs), the ratios are much lower: the pretax return on revenues is 28% and 24%, respectively, and the ROE’s are 8% and 5%. Clearly, these firms have more work to do to address their idiosynchratic issues to get their returns on revenues up. They would need to reduce their capital requirements under Basel III as well in order to achieve the 13-15% ROE’s of their rivals.
Current stock prices reflect PE multiples of 4-6 on those forward, normalized earnings. If we assume that JPMorgan and Wells trade at a PE of 8 given low growth prospects, the price appreciation for JPMorgan would be substantial at 66%. It would be less for Wells given that its price has held up better than others’, and its earnings have not been as depressed. Assuming lower PE’s of 6 for the less profitable banks, the price appreciation for Citi and Bank of America would be 32% and 66%, respectively, assuming no efficiency improvement; they would sell at steep discounts to book value. Efficiency improvements and a commensurate multiple expansion would then merit much greater appreciation.
Investing in these institutions is not for the faint of heart. Given the litigation overhangs and the fragile state of global markets, there can be much near term volatility. But assuming this country will still require banks ( a reasonable assumption), and they do not collapse in the interim (a less sanguine assumption), one day their profitability will normalize and they will merit higher prices.
Disclosure: I am long C, hedged with written call